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States Should Decouple From New Federal Tax Break for PPP Loans

A new federal tax break for businesses receiving federal Paycheck Protection Program (PPP) loans could also give these businesses a new state tax break in many states unless the state acts to prevent it, as some are considering. That wouldn’t mean a “tax increase on small businesses,” despite media stories and state business lobby claims to the contrary. Rather, it would be a rational state decision — in light of serious state revenue shortfalls, additional COVID-19-related costs, and balanced-budget requirements — not to add a state tax break to the federal tax break and direct federal subsidy for businesses receiving PPP loans.

Created by the CARES Act of last March, PPP provides loans of up to $10 million to businesses with up to 500 employees. If a business spends the money on payroll and other eligible expenses, the federal government forgives the loan and repays the private lender.

As its name implies, PPP is largely intended to keep as many employed workers on private payrolls as possible, and it’s been quite valuable to many businesses and their owners. The workers they otherwise would have laid off presumably generated revenue in excess of their cost; restaurants, for example, can’t provide carryout meals without employees to cook them, ring them up, and hand them out. Even if a business is still losing money, however, there’s value in keeping employees on the job rather than potentially losing them to other employers or cities.

Contrary to the normal tax treatment of forgiven debt, the CARES Act provided that businesses don’t have to count forgiven PPP loans as income. Consistent with other provisions of federal tax law, however, the IRS decreed shortly thereafter that businesses can’t deduct the expenses they cover with PPP loans from their taxable income — analogous to an individual being unable to deduct an otherwise eligible medical expense if their insurance company reimburses it. But in the COVID-19 relief legislation of December, the President and Congress overruled the IRS and provided that businesses can deduct those expenses, thereby layering a tax break on top of PPP’s federal wage reimbursement.

In about half the states, that new federal tax break will automatically create the same tax break under state personal and corporate income taxes because the state and federal tax codes are linked — unless the state enacts a law to “decouple” from it. Officeholders in a handful of those states are proposing or considering decoupling to avoid potentially large revenue losses. Some small business representatives have charged that such states are proposing to “tax PPP loans” but, in fact, they are only considering whether to maintain the tax-neutral treatment of those loans.

In the other half of the states, the tax break will only take effect if the state updates its tax laws to incorporate it. Small business representatives in some of those states are pushing the state to do so, using the same misleading argument.

Many states could face new, unanticipated revenue losses in the hundreds of millions of dollars if they don’t decouple from the new federal tax break. That could mean more cuts in education, medical care, public health, and other critical services that would further harm low- and moderate-income people and people of color who are already suffering disproportionately from COVID-19 and the economic downturn. Policymakers should consider whether their state can afford this tax break, and whether it’s the most cost-effective way to help businesses.

Decoupling from the new federal tax treatment of forgiven PPP loans doesn’t mean imposing a tax increase; it means declining to provide an additional tax break.