• The Covid relief bill grants borrowers in the Paycheck Protection Program their wish: tax-free forgiveness of the loan, along with the ability to deduct covered expenses.
• Whether states will permit those write-offs, along with tax-free forgiveness, remains up in the air. That means businesses may still face surprise taxes on their state tax returns.
• Small businesses may decide to go on extension when they file their 2020 taxes next year.

While the federal Covid relief bill addresses a key concern for small businesses with forgivable loans, these firms could still face a tax hit — this time on their state returns.

In addition to pledging stimulus checks to American households and providing a $300 boost to unemployment payments, the new Covid bill offers aid to ailing small businesses in the form of a second forgivable loan from the Paycheck Protection Program.

Generally, borrowers may be eligible for PPP loan forgiveness if at least 60% of the proceeds go toward payroll expenses. Partial loan forgiveness may be available to those who fall short of the threshold.

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Amounts that aren't wiped must be repaid and are subject to an interest rate of 1%.

Lawmakers also settled a long-standing issue in the relief bill: It allows PPP borrowers to claim tax deductions for the expenses they covered with forgiven loan proceeds — a move that the Treasury Department and IRS previously said would constitute "double dipping" because forgiveness is tax-free.

Small businesses shouldn't celebrate just yet.

Unresolved year-end tax planning problems are beginning to arise — including the fact that states may block PPP borrowers from claiming deductions on state tax returns or from having balances wiped free of taxes.

"There remains significant uncertainty," said Jared Walczak, vice president of state projects at the Tax Foundation. "Many states have yet to clarify what their position is."

Rolling vs. static conformity

When it comes to tax planning, the federal code is only one part of the story.

States will vary in their approach to the Internal Revenue Code, including whether they adopt changes to the federal law.

Some states, like New Jersey, follow their own rules on determining income. Others conform to the federal code on a so-called static or rolling basis.

Under static conformity, states adhere to the code as of a specific date. Under rolling conformity, they adopt changes to the tax code as they occur.

These differences can lead to discrepancies between how your income is defined on your federal income tax return versus your state return.

This also means states may take a different tack when interpreting the Covid relief measures, including potentially disallowing tax-free PPP forgiveness or blocking deductions tied to PPP.

Another motivating factor for states deciding not to follow the bill: their dented coffers due to the pandemic. State sales and income tax revenues have declined amid layoffs and businesses shutting their doors.

"If a state is really pushed on money, it's someplace they can go," said Ed Zollars, CPA and partner at Thomas, Zollars & Lynch in Phoenix and an instructor at Kaplan Financial Education.

"If you need to raise money, find something not to conform with on the federal side," he said.

A waiting game

Currently, California doesn't allow deductions for expenses paid with forgiven PPP loans, per state law. Businesses there will have to reduce their deductions on their state returns.

North Carolina excludes forgiven PPP loans from taxable income, but business owners can't deduct those covered expenses.

It remains to be seen how other states will proceed, which will throw a monkey wrench into year-end tax planning for small businesses.

It makes the situation more complicated for entrepreneurs, who will still need to pay estimated taxes even if they go on extension and wait for greater clarity from their state.

"We need states to tell us what they're going to do," said Dan Herron, CPA and principal at principal of Elemental Wealth Advisors in San Luis Obispo, California.

"Many people would rather hold onto the money and pay it later when they have an idea of how much they owe — that money is cash for their business," he said.