State income tax and PPP loans: don’t assume conformity

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In the wake of the pandemic, the Coronavirus Aid, Relief, and Economic Security (CARES) Act and the Coronavirus Response and Relief Supplemental Appropriations Act of 2021 have provided immediate assistance to the American workforce.

While these bills have delivered direct economic assistance to small businesses nationwide, some business owners have been left perplexed regarding the tax deductibility of their Paycheck Protection Program (PPP) or PPP2 loans.

What we know

It cannot and should not be assumed that states will adhere to the federal tax treatment of forgiven PPP loans and the deductibility of expenses related to those loans. Existing state laws dictate — whether by formal legislation or informal guidance — when specific CARES Act and coronavirus-related Tax Relief Act guidance do not exist.

It is safe to assume no two states are the same when it comes to PPP loan forgiveness. A lack of conformity increases compliance costs and time, especially for taxpayers filing in multiple states. Each state with an income tax has its own tax code that conforms and decouples to varying degrees from the Internal Revenue Code (IRC). Most states have not announced how they will or will not conform to the federal treatment. With projected revenue shortages, states may take affirmative steps to tax forgiven PPP loans.

What we don’t know

At this time, 21 states — including Michigan — and the District of Columbia conform to the current IRC for both individual and corporate income taxes. It is anticipated these states will adopt the federal income tax treatment, but it is not guaranteed. These states could pass legislation decoupling from the federal treatment.

Likewise, a state could make the argument it only conforms to the definition of gross income as expressly defined in the IRC. As many will recall, the CARES Act modified what is included in gross income, but the act did not specifically amend the definition of gross income.

The remaining states have static or a specific date of conformity to the IRC. If they want to conform to the federal treatment, these states will have to pass specific legislation to do so. If they do not want to conform, there likely will be no immediate action item. In this instance, the state’s existing laws render the forgiven loans as taxable income.

It is unlikely state tax forms and compliance software will be updated to reflect the proper reporting in all states. As such, taxpayers will have to carefully research and analyze each state to determine how its conformity or decoupling impacts the income tax calculation and liability.

Taxpayers should be prepared to invest more time in state compliance than in previous years. Business owners will need to determine if income from loan forgiveness is included in apportionment and which state it is sourced to.

How to prepare

As tax deadlines near, many businesses will need to consider filing an extension. It is unclear when states will begin announcing whether they are or are not going to issue guidance regarding PPP loan forgiveness. In states with large liability where guidance is promised, it may be better to extend a tax return rather than file and face an amended return.

Tax preparers should keep contemporaneous notes on the approach taken in each state. In the instance the state raises questions about your return, be prepared to answer accordingly and have research on file to avoid rebuilding arguments.

All in all, taxpayers cannot assume states will conform with the federal tax treatment. Start by having crucial conversations with a business adviser now, visit state websites for tax resource tools and plan to check for updates regularly.

Just like many privately held businesses, states have been struggling with their work-from-home structures and reduced hours because of COVID-19 and may not have had the chance to analyze the issues just yet. In any case, prepare for the long haul when it comes to this year’s taxes and consider an extension to allow time for states to issue guidance.

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