Federal and State Tax Consequences of PPP Loan Forgiveness
During 2020 many small, and even not-so small, businesses applied for and received Paycheck Protection Program (PPP) loans which, if spent on certain permitted expenditures, are forgivable and essentially become a form of government grant.
Under the PPP law, loan forgiveness is not automatic. A borrower who wants to have their loan forgiven must apply for forgiveness within 10 months of the end of their loan’s “covered period,” which is generally no more than 24 weeks after their loan was funded. Therefore, most borrowers’ PPP loans will not be officially forgiven until 2021. Loans of more than $2 million received by some borrowers may not be forgiven until 2022, as the SBA will be auditing the loans to ensure that the borrowers qualified for a loan to begin with and spent the loan proceeds on permitted expenditures.
Although in March 2020 Congress stated in the CARES Act that PPP loan forgiveness income was not subject to federal income tax, the IRS took the position that since PPP loan forgiveness income was not taxable, expenses paid with a PPP loan were not deductible, essentially making the PPP loan forgiveness taxable income. Congress eventually made its original intentions abundantly clear and in December of last year passed the Consolidated Appropriations Act (CAA), which provides that PPP loan forgiveness is not taxable and that PPP-funded expenses are also deductible.
For many borrowers this may be the last time that they have to worry about how they have to handle their PPP loan, associated forgiveness and expenditures for income tax purposes, but for many others it may not be. Some businesses will need to contend with at least the following two potential issues regarding PPP loan forgiveness.
Timing of PPP Loan Forgiveness Reporting for Passthrough Entity Owners
First, the legislation that Congress passed back in December provides that tax-exempt income arising from PPP loan forgiveness “passes through” a Partnership or S Corporation and increases partner or shareholder basis, but the timing of when PPP loan forgiveness gets passed through may become an issue.
Consider a business which is taxed as a Partnership and which received a PPP loan last year. Due to the pandemic, the business may have suffered a significant drop in revenues and therefore may be reporting and passing-through a loss to its owners. At the individual owner level, some or all of those losses may not be currently deductible due to a lack of “basis” if the PPP loan forgiveness income is deferred until 2021. If it is, then the loan forgiveness income will pass through to the individual partners in 2021 and may provide them with sufficient basis to deduct the loss that was suspended in 2020 due to lack of basis. Depending on the partners’ individual tax situations in both 2020 and 2021, this may be a desired result, especially if income tax rates increase in 2021.
To date, the IRS has not issued any guidance on timing of recognition of PPP loan forgiveness income for tax-reporting purposes. Since PPP loan forgiveness does not give rise to taxable income, and expenses funded with PPP loans are deductible, the IRS may not ever provide guidance on the timing issue.
While deferring “recognition” of PPP loan forgiveness on tax returns until the loan is officially forgiven would certainly seem to be the safest approach, accelerating the forgiveness to 2020 may also be a reasonable position to take.
For cash basis taxpayers, section 1.451-1(a) of the regulations provides that items of taxable income are “includible in gross income when actually or constructively received.” If PPP borrowers received their PPP loan in 2020, expended the funds on permitted expenses and qualifies for forgiveness, they have an argument that they have actually and constructively received the income provided they intend to apply for forgiveness. However, since PPP loan forgiveness is excluded from gross income, it could also be argued that Section 451 and the regulations under it do not apply, and that the loan forgiveness should instead be recognized in the year in which the loan is actually forgiven.
For accrual basis taxpayers, section 1.451-1(a) of the regulations provides that “income is includible in gross income when all the events have occurred which fix the right to receive such income and the amount thereof can be determined with reasonable accuracy (all events test).” Again, an argument can be made that recognizing PPP loan forgiveness income in 2020 is valid to the extent that the taxpayer expended sufficient funds on permitted expenses during 2020 to qualify for forgiveness, or when it is recorded as forgiven in the taxpayer’s Applicable Financial Statements (section 451(b)(1)(A)). Alternatively, it can again be argued that Section 451 does not apply to income excluded from gross income, or for an accrual basis taxpayer, “all events” have not transpired until the taxpayer formally receives forgiveness of the loan.
PPP loan borrowers may have some flexibility in accelerating PPP loan forgiveness income into 2020 if, for financial statement purposes, they are able to bring PPP loan forgiveness into income on their 2020 financial statements which, at least for some issues of GAAP basis financial statements, is a possibility under current AICPA guidance. If, however, a PPP loan borrower issues a 2020 financial statement in which their PPP loan remains on their balance sheet as a liability, they would not be advised to take an inconsistent approach for income tax-reporting purposes and accelerate the loan forgiveness into 2020.
Summary: PPP borrowers whose loans will not be forgiven until 2021 are likely on solid footing if they defer reporting the tax-exempt income arising from forgiveness until 2021. However, absent IRS guidance on this issue, which may not be forthcoming anytime soon, if ever, PPP borrowers may have some options as to when PPP loan forgiveness can be reported as tax-exempt income on their business tax returns. This is especially so if the borrower has issued financial statements where it has treated the PPP loan as grant income and taken it into book income instead of reporting it as a liability on the balance sheet at year-end. If the owners of a pass-through entity run up against limitations on deducting losses passed through to them by the Partnership or S Corporation due to basis or at-risk rules, careful consideration should be given as to when the loan forgiveness income can be reported in order to currently recognize or defer such losses.
State and Local Income Tax Consequences of PPP Loan Forgiveness
While the federal income tax consequences of PPP loan forgiveness are now largely resolved, state and local taxes are another matter. All but a few states directly tie their income tax laws to the federal tax code in some way, and they tend to do it in one of two ways: “rolling conformity” and “static conformity.”
“Rolling conformity” states adopt changes to federal tax laws as they are enacted, so a rolling conformity state like Connecticut (CT) automatically follows all of the federal tax law changes that were passed last year, unless the CT legislature passes a law which “decouples” from federal law changes either in their entirety or just certain provisions of federal changes. Consequently, rolling conformity states, by default, will not subject PPP loan forgiveness to their income tax and will allow borrowers to deduct the expenses they paid with PPP funds.
“Static conformity” states adopt provisions of the federal tax code as of a certain date, but not thereafter, unless the state legislature passes a law which updates the state’s conformity date. For instance, the state of California (CA) is a static conformity state. It ties its tax code to the federal Internal Revenue Code as it existed on January 1, 2015. Therefore, it does not follow any amendments to the federal tax laws enacted after that date, unless the CA legislature formally does so via legislation. Accordingly, most provisions of 2017’s Tax Cuts and Jobs Act do not apply for CA tax purposes, nor do most provisions of the CARES Act or CAA passed in 2020. The CA legislature did enact a law last year which provides that PPP loan forgiveness is not subject to income tax, but the law also provides that expenses paid with PPP funds are not deductible either.
Until last year, New York (NY) was a “rolling” conformity state. However, shortly after the CARES Act was passed, NY enacted legislation which decouples the NY individual income tax law from all federal tax law changes enacted after March 1, 2020, including the CARES Act and CAA. For corporation income/franchise tax purposes, however, NY remains a rolling conformity state although it did decouple from certain federal tax provisions of the CARES Act. The good news is that even though NY is now a static conformity state for individual income tax purposes, the NY Department of Taxation and Finance recently announced that it would follow the federal tax treatment of PPP loan forgiveness. This means that PPP loan forgiveness will not give rise to taxable income for NY state income tax purposes, and expenses paid with PPP loans remain deductible for NY individuals. Although New York City has not made any official pronouncements regarding its treatment of PPP loan forgiveness, we assume that it will follow the federal treatment.
To date the New Jersey Division of Taxation has not issued any pronouncements on how it will treat PPP loan forgiveness for either Corporation Business Tax (CBT) or Gross Income Tax (GIT) purposes. There is a regulation under the NJ CBT law which requires taxpayers to include any income that is exempt or excluded from federal taxable income in the CBT base, but that regulation does not appear to be supported by any statute, so its authority is debatable.
As of the date of this article, the following states had announced that PPP loan forgiveness income was taxable or expenses paid with PPP loans are not deductible under that state’s income tax law:
California (expenses not deductible)
Kentucky (expenses not deductible)
Massachusetts (PPP loan forgiveness is taxable for individual tax purposes only)
Minnesota (PPP loan forgiveness is taxable)
New Hampshire (PPP loan forgiveness is taxable)
North Carolina (expenses not deductible)
Utah (PPP loan forgiveness is taxable)
Wisconsin (expenses not deductible)
In the next several weeks and months, we expect other states to either provide guidance on how they will be treating PPP loan forgiveness and associated expenses, and some legislatures are likely to enact laws which either decouple or follow federal tax law in this area.
While for federal income tax purposes, PPP loan forgiveness is not subject to income tax and expenses paid with PPP loans are deductible, not all states which impose an income tax follow federal law. Consequently, depending on the state’s conformity with federal law, PPP loan forgiveness might be taxable or expenses paid with forgiven PPP loans may not be deductible. Currently, New York State has announced that it will follow federal tax law regarding PPP loan forgiveness, and it is presumed that Connecticut will as well. Taxability under New Jersey law is uncertain. In the next several weeks and months, we expect more states and city tax authorities to issue pronouncements and legislatures to enact laws which will either conform or decouple their tax laws from federal law, some retroactive to 2020.
If you have any questions regarding the timing of PPP loan forgiveness and/or state or local income tax consequences, please do not hesitate to reach out to your Marks Paneth advisor.