The Paycheck Protection Program (PPP) has lent $525 billion to help businesses during the pandemic, with loans from less than $50,000 to millions of dollars. If your client got such a loan, they should realize that a major portion of these loans can be forgiven and that now those forgiven amounts will not incur federal tax.

But your clients' state taxes are another matter.

Many states conform to the federal Internal Revenue Code (IRC) and fall into two categories: rolling conformity and fixed-date conformity. "Rolling conformity" states adopt IRC changes as they occur. "Fixed-date conformity" states conform to the IRC after a certain date by vote of the state lawmaking body.

In states that do not use rolling conformity, clients may find themselves on the hook for state taxes even if they would not owe federal taxes for the same situation.

States with fixed-date conformity don’t always accommodate business taxpayers, said Nick Preusch, tax manager in the Richmond, Va., office of YHB CPAs. For example, he said, “Virginia is a fixed-date state, and there’s no currently passed conformity bill that brings the CARES (Coronavirus Aid, Relief, and Economic Security) Act into Virginia law. Most likely, this will get passed in January or February. Before that, PPP loans are considered taxable in Virginia. This has been a problem with companies that had a June 30 year-end.”

Most states will have to produce more legislation and guidance, especially as the pandemic drags on, said Kaylyn Kleinhans, senior manager of state and local taxation in the San Jose, Calif., office of Sensiba San Filippo. “States that are expecting larger tax revenue shortfalls due to the pandemic may be more likely to tax PPP proceeds as they look for ways to make up for their lost tax revenue,” she said.

Yet “conformity of state taxes does not always march in lockstep with the IRC,” added Scott D. Hoppe, a CPA with Why Blu in San Francisco. “Often it lags a year or two, or only selectively conforms. It is likely states will get up to speed on conformity to PPP forgiveness and expense deductibility because this is such a visible issue.”

California offers one example of how taxing PPP loans is a work in progress at the state level. “When the CARES Act was passed, our state tax law did not conform to the federal law,” said Lawrence Pon, a CPA/PFS in Redwood City, Calif. “The governor recently signed a law that conforms to the federal law, so the loan forgiveness is not taxable income for California tax purposes ... [but] the new law makes it clear that the expenses related to the loan forgiveness will not be deductible. Members of Congress and Treasury Secretary (Steven) Mnuchin want to change this. There appears to be bipartisan support.”

“If a borrower uses the funds to pay payroll in multiple states, work has to be done to identify and apportion funds appropriately,” said Jenn McCabe, an El Segundo, Calif.-based partner in Armanino LLP’s business outsourcing services practice and a member of the firm’s Covid rapid response team. “Some tax advisors are recommending borrowers not identify forgiven amounts until the 2021 tax year. We don't agree with this advice, but it’s confusing because the expenses that the PPP covers are 100% incurred in 2020.”   

“Some practitioners believe you aren’t denied the deduction for expenses paid with PPP loans until you get actual forgiveness. For most people, that will be in 2021,” Preusch said. “Under that understanding, people with PPP loans forgiven in 2021 will have the loss of deductions in that year. On the other side, you have people who believe the denial of deduction is in the year you received the PPP funds, so [in tax year] 2020.”

Deduction wrangles seem to run counter to the intent of pandemic relief, added Martin Abo, a CPA with Abo and Company in Mount Laurel, N.J. “We understand the dilemma state budgets face [but] taxing closely held businesses, many of whom are hanging on by a thread, certainly reduce the benefits sought by the CARES Act,” he said.

“Work with your tax advisor. At a minimum, you should track your PPP forgiveness and qualifying expenses paid with the loan proceeds,” Hoppe added.