States, the PPP, and Planning for Fiscal Shocks

Adam Thimmesch

Adam Thimmesch is a professor of law at the University of Nebraska College of Law.

In this installment of Academic Perspectives on SALT, Thimmesch explores the Paycheck Protection Program and the federal and state tax treatment of funds received by taxpayers under it.

This article is one in a series evaluating potential state responses to the COVID-19 pandemic. Prior articles in this series have focused on changes that the author and others recommend states make to both their personal and corporate income taxes, with a focus on provisions of the Coronavirus Aid, Relief, and Economic Security Act (P.L. 116-136) that make little sense for states to adopt in the midst of a global pandemic. This article focuses on the Paycheck Protection Program and the federal and state tax treatment of funds received by taxpayers under that program. The article is a part of Project SAFE (State Action in Fiscal Emergencies), an academic effort to help states weather the fiscal crisis by providing policy recommendations backed by research.¹

The Paycheck Protection Program

Congress created the PPP in the CARES Act, which was enacted March 27. Congress originally allocated approximately $350 billion to the program with the intent of helping American businesses better manage through the pandemic.² The program was very attractive to businesses, and Congress modified it multiple times over the spring by adding $320 billion more in funding and by providing more favorable terms for borrowers.³ One defining feature of the PPP is that the loans are completely forgivable if the recipients establish that the funds are used on specified expenses. Those expenses include outlays for payroll, rent, utilities, and so forth.⁴ As of the close of the application period August 8, more than $500 billion of loans had been paid out under the PPP.⁵

The forgivable nature of the PPP payments would have normally given rise to questions about the taxability of those funds, because the discharge of debt generally results in an inclusion of the forgiven amount in a taxpayer’s gross income.⁶ Congress overrode that general rule, though, in section 1106(i) of the CARES Act, which explicitly provides an exclusion from gross income for forgiven PPP loans.⁷ That provision meant that taxpayers could receive PPP loans without paying federal income tax on those funds. That provision did not, however, work exactly as many think it was intended.

It is a general feature of the U.S. income tax that taxpayers generally cannot deduct expenses that are paid for, or reimbursed by, others. Code section 265(a) also effectuates that principle by explicitly prohibiting taxpayers from deducting expenses that are funded with tax-exempt income. Those long-standing features of the income tax complicated the tax aspects of the PPP greatly. Congress did not explicitly override those provisions in the CARES Act, which left open the question whether expenses funded with PPP loans would be deductible.

The IRS quickly responded to that issue. On April 30 the IRS issued Notice 2020-32⁸ and explained that expenses funded with forgiven PPP loans would not be deductible. In reaching that conclusion, the IRS relied heavily on IRC section 265(a) and the regulations thereunder, but also on established case law on related points. The IRS noted that the purpose of section 265 is to prevent double dipping, which is precisely what would occur if taxpayers were able to receive PPP funds tax free and take a deduction for the expenses funded with those amounts.⁹ The IRS confirmed that position more recently with its November 18 issuance of Rev. Rul. 2020-27 with the result that taxpayers cannot deduct expenses that are funded with forgiven PPP loan proceeds without expecting a fight from the IRS.¹⁰

PPP Deductions and Congress

The IRS’s conclusions in Notice 2020-32 and Rev. Rul. 2020-27 seem correct as a matter of tax law. Allowing taxpayers to deduct expenses for which they will be reimbursed — and that are therefore not economically borne by them — is inconsistent with existing precedent and with good income tax policy. This is not to say that the IRS’s position is unassailable, of course. It is not.¹¹ But the notice gets to the correct conclusion as a matter of law on the deductibility of the PPP-funded expenses.

The foregoing conclusion does not mean that the Notice or revenue ruling properly reflect Congress’s intent in enacting the PPP, though. As an economic matter, there is no real difference between including the forgiven PPP loans in a taxpayer’s gross income — which Congress avoided by including section 1106(i) in the CARES Act — and disallowing a deduction for the expenditures that those loans fund.¹² The IRS position therefore leaves taxpayers in largely the same economic position as if Congress had not addressed the issue at all.¹³ That point seems accurate, but it does not change my view of the Notice or revenue ruling. The IRS cannot unilaterally change the law. It is Congress that must act if it feels that a “fix” is warranted for some reason.¹⁴

Congressional action has obviously been complicated in the midst of the pandemic and the 2020 elections, but Congress has not totally ignored the issue. Several bills were introduced throughout the year that would correct this error. For example, a bipartisan group of senators introduced the Small Business Expense Protection Act of 2020 on May 5. The sole purpose of that bill was to modify the law to explicitly allow taxpayers to deduct the expenses funded by PPP loan proceeds.¹⁵ That bill has been referred to the Senate Finance Committee but has not advanced. A provision in the Health and Economic Recovery Omnibus Emergency Solutions Act, which passed the House May 15, would also change the result of the notice by explicitly providing that expenses funded with forgiven PPP loans would be deductible.¹⁶ The Senate has not taken up that bill, either. Congress’s lack of action means that the IRS notice continues to govern the deductibility of PPP-funded expenses.

As we get to the end of the year, and with an upcoming change in administrations, attention seems to be turning back to the PPP and the lack of attention to the issues noted earlier. Sens. Ron Wyden, D. Ore., and Chuck Grassley, R-Iowa, also responded swiftly to Treasury’s issuance of Rev. Rul. 2020-27 with a call for Congress to respond.¹⁷ There is obvious facial appeal to the position that Congress and the states should allow taxpayers to deduct their PPP expenses. But states should take a closer look at that issue and be prepared for the potential consequences of any congressional action. Allowing taxpayers to both exclude PPP loans from their income and deduct their PPP expenses would cost states a lot of revenue and represent additional stimulus funding to PPP recipients. States need to be aware of this possibility, prepare, and plan for what they will do.

The PPP and the States

I have previously written about how the tax changes in the CARES Act affect the states because of the overwhelming state practice of incorporating the provisions of the federal tax code into their own laws.¹⁸ The tax aspects of the PPP are no different. The exclusion from gross income for PPP loan proceeds affects a taxpayer’s gross income and thus its adjusted gross income and its taxable income, which are the provisions of federal tax law on which states generally piggyback for their own tax calculations. What is interesting about the PPP provisions compared with other aspects of the CARES Act, though, is that the effect of the PPP on states seems to be the same whether a state conforms to federal tax law on a rolling basis or on a static basis and whether or not a state ultimately conforms to the federal tax treatment of the loans.

States that conform to the federal tax code on a rolling basis would automatically exclude the PPP funds from a taxpayer’s gross income and deny taxpayers deductions consistent with Notice 2020-32. Static conformity states can get to that same position if they update their conformity dates to a date after the enactment of the PPP or, instead, just adopt the PPP changes, as California has done.¹⁹

What about static conformity states that do not incorporate these provisions? Interestingly, taxpayers in those states will ultimately end up with the exact same tax treatment. Those taxpayers would presumably have to include the forgiven loans in their income, but they would also presumably be allowed to deduct the expenses that they funded with the PPP proceeds. The result is a wash.²⁰

As it stands, then, regardless of whether and how states have responded to the PPP, state revenues will not be negatively affected by that program other than through potential timing differences between deductions and offsetting equitable income inclusions. For example, some taxpayers may plan to deduct their expenses on their 2020 returns and include the forgiven loans in their income in a later year — PPP loans have a two-year term.²¹ Other taxpayers may just take deductions in anticipation of a future legislative change or a failure of IRS enforcement.

States should be aware of these possibilities. They also need to be aware that they could face significant revenue shortfalls if Congress were to eventually change federal law to allow taxpayers to deduct their PPP-funded expenses. Rolling conformity states are especially at risk because such a change would almost certainly become immediately incorporated into their laws, with the effect of allowing considerable deductions from reported income.

For perspective, according to data from Treasury, more than $500 billion of PPP loans had been extended as of August 8. State-by-state reporting shows a wide variance in loans to borrowers in different states, as should be expected in a nationwide program. California businesses received more than $68 billion in loans, while many states’ businesses received between $1 billion and $5 billion.²² No state fell under the $1 billion mark in PPP loans.²³ It hardly needs to be said that the potential tax swings on these numbers are very large if those amounts suddenly became deductible expenses. Even $1 billion of new deductions results in a $50 million revenue swing at a 5 percent tax rate. And $500 billion of deductions at that rate? That’s $25 billion in tax revenue. Of course, state tax rates vary widely and taxpayers that received these funds might not have taxable income in any event, so we cannot estimate the effects directly. But the numbers are large and meaningful under any metric.

The potential effects are just as troubling when looking at the effect on individual states. For example, if we make a faulty assumption that loan proceeds are used by businesses that limit their operations to their own state, we can estimate the effect for each state in isolation. Let’s look at a state in the middle of the pack, Wisconsin. The Small Business Administration reports that Wisconsin businesses received just shy of $10 billion of PPP loans. Wisconsin is a static conformity state that did not update its conformity date, but it did update its law to adopt the PPP tax provisions in the CARES Act.²⁴ Wisconsin will therefore not tax the $10 billion of PPP loans received by its businesses either on the receipt of those loans or if they are forgiven in accordance with the terms of the program. Wisconsin will also follow federal law and deny deductions for expenses funded with the PPP loans.

If Congress were to change the tax code to allow those expenses to be deductible, and if Wisconsin conformed to that change, the state would allow an additional $10 billion to be deducted from its tax base. If we assume an average Wisconsin tax rate of 6 percent, that translates into $600 million of tax reductions.²⁵ Those numbers would be on top of any pandemic-related tax losses.

These numbers are very rough, obviously, and the actual impacts on states will vary for many reasons. But this basic analysis shows that the consequences for states of a change to the deductibility of PPP-funded expenses could be severe. As shown in the following table, every state has a lot at stake. According to the SBA,²⁶ the PPP approvals by state and territory as of August 8 — the close of the program — were as follows:

Planning for a Future Fiscal Shock

Based on this analysis, and the apparent bipartisan support for a change in law in this area, states should be very aware of potential changes to the deductibility of PPP-funded expenses. The PPP provided American businesses with significant assistance as the country dealt with the initial wave of COVID-19 infections and related business shutdowns, but taxpayers and states continue to feel the effects of the pandemic and the failure of Congress to respond fully to the needs of the country. If Congress were to finally respond by allowing PPP-funded expenses to be deducted, the effects on states’ budgets could be dire. States need to be aware of this issue and need to plan ahead. Congress has shown little sensitivity to the effects of its tax changes on the states in recent years, and while states may hope for a better partnership with the federal government, it would be best for states to not plan on that improvement in the short-term.

A future article in this series will provide my thoughts on why states would be well-advised to decouple from any future PPP deductibility for tax and economic policy reasons, but regardless, states must be prepared for this significant change and how they would respond. That might mean pressing Congress to provide states with more direct relief or it might mean preemptively decoupling from future changes. But states need to take control of their fiscal affairs as much as possible in these uncertain and trying times. Being aware of, and preparing for, the impact of the PPP on their budgets is one necessary step in that process.