California aligning with fed PPP loan treatment

On April 29, 2021, California Gov. Gavin Newsom signed Assembly Bill 80 (“A.B. 80”) providing greater conformity to federal law regarding the deductibility of expenses paid using forgiven Paycheck Protection Program (PPP) loans.¹ Under A.B. 80, deductions for expenses paid using PPP loan proceeds are allowed even when the loan is forgiven provided the taxpayer is not an “ineligible entity.” Under the legislation, an “ineligible entity” is a taxpayer that either: (i) is a publicly-traded company; or (ii) does not experience a 25% reduction in gross receipts in an applicable quarter of 2020 as compared to the same quarter in 2019.²

Background

The PPP was created as part of the Coronavirus Aid, Relief, and Economic Security Act (CARES Act), which provides forgivable business loans when the recipient meets certain eligibility criteria.³ Under the PPP, qualifying borrowers can apply to have some (or all) of their loan forgiven to the extent it was used for certain expenses such as rent, utilities, mortgage payments, and employee payroll. Under the express terms of the CARES Act, forgiven loan amounts are excluded from the borrower’s gross income.⁴

Shortly after enactment of the CARES Act, the Internal Revenue Service (IRS) issued Notice 2020-32 providing that deductions for business expenses otherwise allowable under the Internal Revenue Code (IRC) (e.g., deductions under IRC Secs. 162 and 163) will be disallowed to the extent PPP loan proceeds are ultimately forgiven.⁵ Later in 2020, the IRS issued Revenue Ruling 2020-27 further explaining that taxpayers cannot deduct expenses paid with PPP loan proceeds if the taxpayer “reasonably expects” forgiveness of the covered loan regardless of the year when forgiveness occurs.

In response to the IRS’s guidance, Congress enacted the Consolidated Appropriations Act, 2021 (CAA) on Dec. 27, 2020, to allow greater deductibility of expenses paid with forgiven PPP loan proceeds.⁶ This federal response more broadly allows for the deductibility of expenses paid with forgiven PPP loan proceeds.

On Sept. 9, 2020, which was after the IRS released Notice 2020-32 but before the CAA was signed, California enacted legislation, A.B. 1577, addressing the treatment of PPP loans for tax years beginning on and after Jan. 1, 2020.⁷ Consistent with IRS Notice 2020-32, this legislation generally provided that forgiven PPP loan amounts would be excluded from the borrower’s gross income, but that associated deductions would not be allowed for expenses paid with forgiven PPP loans. Specifically, A.B. 1577 added new corporate and income tax statutes providing that “[a]ny credit or deduction otherwise allowed under this part for any amount paid or incurred by the taxpayer upon which this exclusion is based shall be reduced by the amount of the exclusion allowed under this section.”⁸

A.B. 80’s treatment of expenses paid with forgiven loan proceeds

A.B. 80 amends California law to operate more consistently with the federal CAA regarding the permissibility of deductions for expenses paid with forgiven PPP loan proceeds. Rather than deny deductions for expenses paid with forgiven PPP loan proceeds as A.B. 1577 attempted to do, A.B. 80 generally allows for the deductibility of such expenses in years beginning on or after Jan. 1, 2019, provided the taxpayer is not an “ineligible entity.”⁹ The legislation defines an “ineligible entity” as any publicly-traded company, or any entity that does not meet the 25% reduction in gross receipts requirements of 15 U.S.C. Sec. 636(a)(37)(A)(iv)(I)(bb).¹⁰ Generally, to satisfy the gross receipts requirement, a taxpayer must have experienced a 25% or greater reduction in quarterly gross receipts for the first, second or third quarters of 2020 as compared to the same quarter of 2019.¹¹

A.B. 80’s gross income exclusion also extends to any Economic Injury Disaster Loan (EIDL) advance grants received under the CARES Act and the CAA.¹²

Commentary

Though enacted later than many taxpayers would have liked, A.B. 80 provides much needed guidance clarifying California’s treatment of deductions for expenses paid with forgiven PPP loan proceeds. For taxpayers other than ineligible entities, A.B. 80’s partial conformity to the federal treatment of expenses paid with forgiven PPP loan proceeds is welcome news that generally alleviates an otherwise burdensome federal conformity issue. It is worth noting that A.B. 80 is not a complete conformity bill, and there are some key distinctions to be made from the federal treatment of PPP loans. In particular, California’s definition of an “ineligible entity” borrows its 25% diminution in gross receipts test from the qualification (i.e. eligibility) criteria for receiving a second draw PPP loan for federal income tax purposes under the CAA.¹³ Although this requirement only applied to second draw PPP loans for federal income tax purposes, it appears to be incorporated as a general limitation for California purposes when determining whether a taxpayer is classified as an “ineligible entity” under A.B. 80.

Due to the timing of A.B. 80, some California taxpayers may have either filed their 2020 returns prior to its enactment, or made an extension payment based on the provisions of A.B. 1577 which had previously denied the deductibility of expenses paid with forgiven PPP loan proceeds. For this reason, taxpayers that have already filed or paid tax following the provisions of A.B. 1577 may consider the need to amend their California return and/or recompute their claimed deductions for expenses paid with PPP loan proceeds that were forgiven. Furthermore, to the extent a taxpayer is an “ineligible entity,” it may be faced with difficult questions regarding how to treat deductions for expenses paid in 2020 that later become disallowed upon loan forgiveness occurring in a different tax year (e.g., the expense occurs in 2020 but becomes disallowed upon PPP loan forgiveness occurring in 2021). Careful consideration will need to be given to these issues, as well as the need for documentation to support that the 25% diminution in gross receipts requirement of A.B. 80 has been satisfied to avoid being classified as an “ineligible entity.”

1 Ch. 17 (A.B. 80), Laws 2021.
2 Under the Consolidated Appropriations Act, 2021, as referenced in A.B. 80, gross receipts from the fourth quarter of 2020 may be compared to the fourth quarter of 2019 “only with respect to an application submitted on or after Jan. 1, 2021.” See 15 U.S.C. § 636(a)(37)(A)(iv)(I)(bb).
3 P.L. 116-136.
4 See P.L. 116-136, § 1105(i).
5 IRC Sec. 265 disallows deductions related to tax-exempt income. A disallowance of the deductions effectively neutralized the benefit of the tax-exempt nature of the PPP loan forgiveness.
6 P.L. 116-260.
7 Ch. 39 (A.B. 1577), Laws 2020.
8 CAL. REV. & TAX. CODE §§ 17131.8(b); 24308.6(b), as added by A.B. 1577.
9 Note that the statutes originally applied to taxable years beginning on and after January 1, 2020. However, they were amended to apply to taxable years beginning on or after January 1, 2019. According to the legislative analysis, this date was changed to ensure that all fiscal year filers are captured. Assembly Floor Analysis for A.B. 80, California Assembly, April 15, 2021.
10 CAL. REV. & TAX. CODE §§ 17131.8(g)(3); 24308.6(g)(3). 15 U.S.C. Sec. 636(a)(37)(A)(iv)(I)(bb) was added by Section 311 of Division N of the CAA.
11 See 15 U.S.C. § 636(a)(37)(A)(iv)(I)(bb). The fourth quarter of 2020 and 2019 only becomes a measure in this test if taxpayers submit their PPP loan application on or after January 1, 2021.
12 CAL. REV. & TAX. CODE §§ 17131.8(b); 24308.6(b), as amended by A.B. 80.
13 Specifically, A.B. 80 defines an “ineligible entity” in part as a taxpayer that “does not meet the reduction from the gross receipts requirements of Section 636(a)(37)(A)(iv)(bb) of Title 15 of the United States Code, as added by Section 311 of Division N of the Consolidated Appropriations Act, 2021 (Public Law 116-260).” See CAL. REV. & TAX. CODE §§ 17131.8(g)(3)(B); 24308.6(g)(3)(B). Note that the citation to the federal law presumably should be 15 U.S.C. Sec. 636(a)(37)(A)(iv)(I)(bb).

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