For Kentucky income tax purposes, taxpayers may to deduct expenses that were paid with forgiven Paycheck Protection Program (PPP) loans under a new law approved by the general Assembly and signed by the governor. The law confirms that forgiveness of PPP loans does not create taxable income for state income tax purposes.
With these change, Kentucky taxpayers will see enhanced benefits of having taken out PPP loans that have now been forgiven.
When PPP loans were created under the federal CARES Act, it was expressly provided that, upon forgiveness, a borrower would not recognize federal income tax. This is a departure from the general rule that when a loan is not repaid forgiveness of the loan constitutes income. As noted in a previous SKO Insider, there was a question of whether states would afford similar treatment for state income tax purposes.
Receipt of PPP loans (and the potential forgiveness the debt) raised another issue at the federal and state levels for borrowers: whether the amounts paid with PPP loan proceeds could also be deducted on the borrower’s federal and state tax returns.
Let’s put this in context. Assume a company borrowed $100,000 under the PPP loan program. All of those funds were expended to cover ordinary and necessary business expenses that would otherwise be deductible including rent, mortgage insurance and compensatory payments. On that basis the PPP loan is eligible for 100% forgiveness. Let’s assume as well that our borrower received full forgiveness on February 15, 2021.
Under the original CARES Act, our borrower does not recognize $100,000 of income (for federal income tax purposes) because the PPP loan has been forgiven. This raises the following questions: (i) whether the debt forgiveness is also not recognized for state income tax purposes; and (ii) whether our borrower can deduct from its income the amounts spent using the PPP loan proceeds.
Assume our borrower paid an employee $1,000 of W-2 payroll. All else being equal, that $1,000 would give rise to a tax deduction for the employer. But since that $1,000 was paid with a forgivable PPP loan, which did not initially give rise to income, could that deduction take place? Initially, the IRS said “no” to the effect that if you pay an expense with a forgivable PPP loan, the borrower cannot as well deduct that expense. That determination was made by the Internal Revenue Service in Notice 2020-32, a decision which generated significant pushback from groups including the American Society of CPAs and certain members of Congress. Ultimately, in the Consolidated Appropriations Act effective December 27, 2020, Congress squarely addressed the issue and provided that the expenses funded with a PPP loan are deductible. The IRS followed with Revenue Ruling 2021-2 confirming this treatment. For further discussion on this topic, please see the SKO Insider titled Congress Reverses IRS – Expenses Paid with PPP Loan Proceeds Are Deductible (December 28, 2020).
But that left open the question of state tax treatment. However, the Kentucky General Assembly has now stepped in. Under HB 278, expenses funded with a forgiven PPP loan may be deducted on the borrower’s Kentucky income tax return, and (ii) forgiveness of a PPP loan will not, for purposes of Kentucky income, create taxable income.
Under Indiana law, the same treatment is in place
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