One of the key components of the CARES Act was the Paycheck Protection Program, a $500 billion lifeline to American businesses dealing with the effects of the COVID-19 pandemic and the resulting public health measures that slowed commerce across the country. Like any significant financial program, the PPP came with tax questions. The program provided participants with loans rather than grants, but those loans would be forgiven if taxpayers complied with the conditions of that program. Normally, loan forgiveness results in income to the beneficiary, but Congress provided an exemption for those amounts under the PPP. Taxpayers would therefore get to keep their entire grants if they complied with the conditions of the program. Or so many thought.
What Congress did not do in the CARES Act was ensure that PPP recipients could deduct the payments that the PPP loans financed. The IRS filled the void with its issuance of Notice 2020-32 on April 30th (found here), and that Notice disappointed PPP recipients and many members of Congress. According to the IRS, existing law and precedent prohibit taxpayers from deducting the expenses funded with those tax-exempt grants. The IRS explained that it would follow that law unless Congress intervened. The Department of Treasury and IRS repeated those conclusions this week with the issuance of both a Revenue Ruling and Revenue Procedure on point. That guidance was issued notwithstanding the widespread recognition that denying PPP deductions effectively renders the exclusion from gross income for forgiven PPP loans meaningless.
A number of bills were introduced since the original IRS Notice in a bi-partisan fashion to “fix” that disconnect between Congressional intent in structuring the PPP and the actual result given the IRS Notice. That fix was also included in the HEROES Act, which the House passed on May 15. Nevertheless, none of those bills managed to gain traction given the challenges of the pandemic and the presidential election. In recent weeks, however, attention has turned back to Congressional relief, and passage of the HEROES Act is part of that discussion. Senators Grassley and Wyden also called on Treasury to reconsider its position just yesterday.
Without getting into the merits of federal deductibility, I want to call attention to a huge issue lingering behind the scenes: the potential effect of a change in law on the states. States generally piggyback on federal tax laws for purposes of their own taxes, and that practice means that Congressional action can impact states to a great deal. As I’ve explored with David Gamage and Darien Shanske in a series of pieces (here, here, and here), states should generally be wary of conforming to federal stimulus measures that are enacted through the federal tax code, especially during the pandemic. We have suggested that states strategically decouple from many of the tax cuts contained in the Tax Cuts and Jobs Act and in the more recent CARES Act.
States should consider now what they would do if Congress were to change the law to allow PPP-funded expenses to be deductible. I am explaining and exploring these issues further in a series of articles forthcoming in State Tax Notes, but the basic issue is pretty clear. A federal change could result in states losing billions of dollars of tax revenue in the aggregate, and those are tax losses that states can ill afford and that are generally not justifiable.
States and the PPP
As noted above, the PPP was $500 billion aid package to U.S. businesses. That’s a big number in the aggregate, and the amounts received by businesses across the U.S. are obviously very large on a state-by-state basis. According to data from the Small Business Administration, California based businesses led the way with over $68 billion of PPP loans. The median amount was around $6 billion, and no state fell below the $1 billion mark. If we assume a modest state income tax rate of 5%, the state tax revenue at stake could reach up to $25 billion. A state with $1 billion of PPP funded expenses becoming deductible (an amount lower than any state’s businesses received in PPP funding) would lose up to $50 million of revenue. A state at the median? $300 million. The amounts could obviously be even larger for states with higher tax rates. (Admittedly, all of these amounts are based on blunt assumptions that could skew the numbers, but the magnitude of the issue is what is important, not the precise amounts.)
Needless to say, regardless of the substantive merits of state deductibility (which I argue favor decoupling in any event), these potential revenue losses are something for which states should plan. Attention is especially critical for rolling conformity states, which will likely automatically incorporate any future federal change into their own laws. That is highly troubling, especially if that incorporation occurs at a time when the state legislature is not even in session to consider decoupling.
My personal experience with the CARES Act was that taxpayers felt that the tax cuts that were automatically incorporated into state law—and the resulting refunds that resulted from the CARES Act’s retroactive changes—were viewed as earned and that efforts to decouple from federal law were framed as a tax increase and an attack on business, rather than an expression of state autonomy by maintaining the status quo. States that automatically conform are put in a difficult position given the shifting baseline and the rhetorical power of claims of tax increases on struggling businesses. It is critical that states best position themselves to make appropriate choices based on state interests, not rhetoric.
State Options
The ultimate takeaway from this analysis is that states need to think ahead and plan. The easiest approach for states wanting to protect their revenues (and thus residents) might to be to just require taxpayers to report forgiven PPP loans as income but to allow deductions for PPP expenses. That approach maintains the status quo and insulates states from future federal changes. (It also happens to comport with good state tax policy by reflecting actual income.) States could also continue to conform to the federal income exclusion, but preemptively decouple from any provision allowing taxpayers to deduct their PPP-funded expenses or affirmatively deny deductions under state law for those amounts.
Realistically, these types of statutory changes will be hard for states to enact, especially in short order. A different approach would be for states to request help from Congress. States need additional aid, and the passage of another federal bill would hopefully respond to that need. States could request that Congress provide additional assistance specifically to offset the state-revenue cost of PPP deductibility. That aid could come in the form of direct grants or Congress could give taxpayers a federal tax credit for any state tax that they pay on PPP loans.
The latter approach might be more politically palatable than additional state aid because a credit could be branded as “taxpayer protection.” A credit approach would also serve to ensure that taxpayers receive their full PPP amounts without reduction for federal or state tax and would leave states harmless from a federal change to the deduction rules. That type of federal credit would represent indirect state aid, but might simplify things for states and for Congress and should certainly be considered. At the very least, I hope that those in Congress who want to provide state aid will consider that approach in conjunction with any PPP change.
But Should States Decouple?
My comments up to this point have focused on the financial effects of a potential federal change. It is also the case, though, that states would be well advised to decouple based on general policy grounds. Making that case is a part of my other work, but I’ll say that state decoupling would be good policy for several reasons. Of course, that position will surely upset many PPP recipients and industry advocates. Decoupling would be the economic equivalent of states taxing the PPP proceeds and it would negatively affect the cash position of PPP recipients. Those results seems to conflict with Congress’ intent in providing that aid.
But whether you frame decoupling as a state tax on the PPP funds or as a proper reflection of economic income, the impact of this issue on states and the reality under which they must operate is the same. States simply do not have the fiscal capacity to provide broad economic stimulus at this time and there is no real indication that PPP recipients are more worthy of state aid than businesses that were not fortunate enough to receive that relief.
In fact, the opposite case could easily be made. States should perhaps not duplicate federal aid but direct aid to those who have been ignored by Congress. We also have indications that the PPP was structured and administered in ways that disproportionately excluded businesses in communities of color. Extending additional state aid in a way that lowered the effective tax rate for PPP recipients while requiring other businesses to pay full freight would only exacerbate those structural issues.
It should also go without saying at this point that states operate under very different financial constraints than the federal government. States have to deal with balanced budget requirements that limit their ability to respond to fiscal crises. (Though states may have more flexibility than they assume.) Whereas Congress can shift the cost of the PPP to future generations, states generally must ask some current constituency to pay. That means either shifting the tax burden to non-PPP recipients or cutting funding to state programs.
With state funding being primarily directed to education, health, and public safety, that cost shift is hard to justify. Education, health, and safety are the foundations for economic growth and create the climate in which individuals and businesses can thrive in a post-COVID economy. States would be better off maintaining the status quo on the PPP and directing the resulting revenues to the communities and businesses most in need rather than simply conforming to Congress’ choice of the most needy or deserving. Direct state grants would be a a much more appropriate solution than piggybacking on the federal PPP provisions.
I have much more to say on this topic, but the attention being given to this issue in the post-election environment suggests that states should really think about this issue now. It may be too late once Congress acts and there are solutions to be had if states operate with foresight.
The Surly Subgroup 
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