October 20, 2020
RE: Hawaii Tax Treatment of Various Federal COVID-19 Relief Programs and Payments
The purpose of this Tax Information Release (TIR) is to provide information about Hawaii tax treatment of the various COVID-19 relief programs and payments that the federal government has provided under the Coronavirus Aid, Relief, and Economic Security Act1 (CARES Act). This TIR supersedes TIR 2020-02.
FEDERAL INCOME TAX TREATMENT
Economic Impact Payments: Economic Impact Payments are not considered gross income and are therefore not subject to federal income tax. Section 2201 of the CARES Act provides payments to qualifying individual taxpayers of up to $2,400, depending on adjusted gross income and filing status. Qualifying taxpayers may also receive $500 per qualifying child.
Unemployment Compensation: Under existing law, unemployment compensation is included in gross income. The CARES Act does not provide for any special tax treatment for these amounts, thus, payments received under additional unemployment compensation are subject to federal income tax.
Pandemic Unemployment Assistance (PUA) under Section 2102 of the CARES Act provides up to $648 per week for those who ordinarily may not be eligible for unemployment benefits, such as business owners, self-employed persons, independent contractors, and others, that are out of business or whose services are significantly reduced as a direct result of the COVID-19 pandemic.
Federal Pandemic Unemployment Compensation (FPUC) under Section 2104 of the CARES Act also provides an additional $600 per week of unemployment compensation for employees who are eligible for unemployment benefits.
Rental and Mortgage Assistance Programs:
The State and counties have established programs where qualified individuals may receive housing assistance in the form of rental or mortgage payment assistance. The federal treatment of this type of assistance is ultimately determined by the Internal Revenue Service (IRS).
Small Business Loans:
The Paycheck Protection Program (PPP) under Section 1102 of the CARES Act provides forgivable loans to small businesses. The receipt of the loan funds, including PPP funds, are not subject to income tax. Regarding forgiveness of the PPP loans, Section 1106(i) of the CARES Act deems forgiven PPP debt, that would otherwise be included in gross income, to be excluded from gross income. Thus, loans forgiven under the PPP are not subject to federal income tax.
Economic Injury Disaster Loan Emergency Advances (EIDL Grant) are loan advances of up to $10,000 made to small businesses under Section 1110 of the CARES Act. The EIDL Grant does not need to be repaid. The CARES Act does not provide any special tax treatment for these amounts, thus, the EIDL Grant is included in gross income and is subject to federal income tax.
Economic Injury Disaster Loans (EIDL) provided under Section 7 of the Small Business Act2 allows for loans up to $2,000,000 in some cases. The receipt of the loan funds, including EIDL funds, are not subject to federal income tax. The CARES Act does not provide any special tax treatment for EIDLs.
Other Small Business Grants and Relief Programs:
The IRS has not provided guidance as to the federal tax treatment of any Hawaii specific programs, however, the guidance that was provided in IRS Notice 2020-32 (Notice) is instructive. In the Notice, the IRS concluded that ordinary and necessary business expenses could not be deducted to the extent that PPP loans were forgiven but excluded from gross income under the CARES Act. This conclusion follows the general rule that prevents a double tax benefit. Applying this rule to other forms of relief, if the amounts received by a business are includable in gross income, then the business may deduct ordinary and necessary business expenses that are paid with these amounts. Conversely, if the amounts received are not includable in gross income, the IRS' conclusion in the Notice will likely apply to disallow deductions for ordinary and necessary expenses paid with these amounts.
HAWAII INCOME TAX TREATMENT
Under existing law, Hawaii's income tax treatment is identical to the federal income tax treatment in most cases. Therefore, the Economic Impact Payments and loan proceeds from the BP. and EIDL programs are not subject to Hawaii income tax. Payments under the PUA and FPUC programs are subject to Hawaii income tax.
Regarding the forgiveness of PPP loans, in general, the forgiveness of a loan or cancellation of debt results in the amount that is forgiven being included in gross income. As discussed above, the CARES Act provides that forgiven PPP loan proceeds are not included in gross income for federal income tax purposes. Hawaii has also adopted this special treatment through enactment of Act 13, Session Laws of Hawaii 2020.
For Hawaii income tax purposes, the general rule preventing double benefits shall apply to amounts received from small business grants and relief programs. If the amounts received by a business are includable in gross income, the business may deduct ordinary and necessary business expenses that are paid with these amounts. Conversely, if the amounts received are not includable in gross income, the taxpayer may not take a deduction for ordinary and necessary expenses paid with these amounts.
Rental and mortgage assistance payments will not be subject to Hawaii income tax for the individual(s) to whom the assistance was provided, as the Department of Taxation views this type of assistance as nontaxable general welfare payments for the individual(s) that the assistance will benefit. For the landlords and mortgagees, the amounts received on behalf of the individuals receiving the assistance will be subject to Hawaii income tax as if the tenant paid rent and the mortgagor made the payment in the ordinary course of business.
GENERAL EXCISE TAX TREATMENT
Under existing law, unemployment compensation paid to employees and the receipt of loan funds, such as funds from PPP loans and EIDLs, are not subject to general excise tax (GET).
The general rule is that amounts received by a business that replace income are subject to GET. Thus, grants or other payments that replace or supplement income are normally subject to GET. However, in light of the severity of the economic impact of the COVID-19 pandemic, GET will not be imposed on payments received under PUA, loan amounts forgiven under PPP, and EIDL Grants. These amounts will be treated as exclusions from gross receipts and should not be reported on GET returns.
However, lease and rent payments received by residential and commercial landlords through the various COVID-19 assistance programs that benefit their tenants are subject to GET. Regardless of the source of the funds, the landlords are receiving income in exchange for use of residential or commercial real property by their tenants. Landlords are subject to GET on these amounts whether the payments are received from the tenants or directly from the agency that administers the relief program on behalf of the tenant.
A table summarizing State and federal tax treatment of CARES Act funds and IRS Notice 2020-32 can be found at the end of this release. Additional information is available by calling the Technical Section at (808) 587-1577, or by email at tax.technical.section@hawaii.gov.
ISAAC W. CHOY
Director of Taxation
| Description | Federal Income Tax | State Income Tax | State GE Tax |
|---|---|---|---|---|
INDIVIDUAL INCOME PROGRAMS | ||||
Economic Impact Payment | Payments made to qualifying individual taxpayers of up to $2,400, depending on adjusted gross income and filing status. Qualifying taxpayers may also receive $500 per qualifying child. | No | No | No |
Pandemic Unemployment Assistance (PUA) | Provides up to $648 per week for those who ordinarily may not be eligible for unemployment benefits, such as business owners, self-employed persons, independent contractors, and others, that are out of business or whose services are significantly reduced as a direct result of the COVID-19 pandemic. | Yes | Yes | No |
Federal Pandemic Unemployment Compensation (FPUC) | Additional $600 per week of unemployment compensation for employees who are eligible for unemployment benefits. | Yes | Yes | No |
Lease and rent payments | Lease and rent payments received by landlords either from tenants or directly from the administering agency on behalf of the tenant. | Yes | Yes | Yes |
SMALL BUSINESS PROGRAMS | ||||
Paycheck Protection Program (PPP) | Forgivable loans to small businesses. | No | No* | No |
Economic Injury Disaster Loan Emergency Advances (EIDL Grant) | Loan advances of up to $10,000 made to small businesses, which does not need to be repaid. | Yes | Yes | No |
Economic Injury Disaster Loans (EIDL) | Loans up to $2,000,000. | No | No | No |
Lease and rent payments | Lease and rent payments received by landlords either from tenants or directly from the administering agency on behalf of the tenant. | Yes | Yes | Yes |
*Act 13, Session Laws of Hawaii 2020. | ||||
PURPOSE
This notice provides guidance regarding the deductibility for Federal income tax purposes of certain otherwise deductible expenses incurred in a taxpayer's trade or business when the taxpayer receives a loan (covered loan) pursuant to the Paycheck Protection Program under section 7(a)(36) of the Small Business Act (15 U.S.C. 636(a)(36)). Specifically, this notice clarifies that no deduction is allowed under the Internal Revenue Code (Code) for an expense that is otherwise deductible if the payment of the expense results in forgiveness of a covered loan pursuant to section 1106(b) of the Coronavirus Aid, Relief, and Economic Security Act (CARES Act), Public Law 116-136, 134 Stat. 281, 286-93 (March 27, 2020) and the income associated with the forgiveness is excluded from gross income for purposes of the Code pursuant to section 1106(i) of the CARES Act.
BACKGROUND
I. Paycheck Protection Program
The Paycheck Protection Program was established by section 1102 of the CARES Act. Under the Paycheck Protection Program, a recipient of a covered loan may use the proceeds to pay (1) payroll costs, (2) certain employee benefits relating to healthcare, (3) interest on mortgage obligations, (4) rent, (5) utilities, and (6) interest on any other existing debt obligations. See section 7(a)(36)(F) of the Small Business Act (describing allowable uses of a covered loan). See also Q&A 2.r. in Part III of the interim final rule, Business Loan Program Temporary Changes; Paycheck Protection Program, Docket No. SBA-2020-0015, 85 Fed. Reg. 20811, 20814 (April 15, 2020).
Under section 1106(b) of the Cares Act, a recipient of a covered loan can receive forgiveness of indebtedness on the loan (covered loan forgiveness) in an amount equal to the sum of payments made for the following expenses during the 8-week “covered period” beginning on the covered loan's origination date (each, an eligible section 1106 expense): (1) payroll costs, (2) any payment of interest on any covered mortgage obligation, (3) any payment on any covered rent obligation, and (4) any covered utility payment. See section 1106(a) (defining the terms “covered period”, “covered mortgage obligation,” “covered rent obligation,” “covered utility payment,” and “payroll costs”), (b) (regarding eligibility for covered loan forgiveness), and (g) (regarding covered loan forgiveness decisions). However, section 1106(d) of the CARES Act provides that the amount of the covered loan forgiveness is reduced if, during the covered period, (1) the average number of full-time equivalent employees of the recipient is reduced as compared to the number of full-time employees in a specified base period, or (2) the salary or wages of certain employees is reduced by more than 25 percent as compared to the last full quarter before the covered period. In addition, pursuant to an interim final rule issued by the Small Business Administration, no more than 25 percent of the amount forgiven can be attributable to non-payroll costs. See Q&A 2.o. in Part III of the interim final rule, Business Loan Program Temporary Changes; Paycheck Protection Program, Docket No. SBA-2020-0015, 85 Fed. Reg. 20811, 20813-20814 (April 15, 2020).
Section 1106(i) of the CARES Act addresses certain Federal income tax consequences resulting from covered loan forgiveness. Specifically, that subsection provides that, for purposes of the Code, any amount that (but for that subsection) would be includible in gross income of the recipient by reason of forgiveness described in section 1106(b) “shall be excluded from gross income.” Thus, section 1106(i) of the CARES Act operates to exclude from the gross income of a recipient any category of income that may arise from covered loan forgiveness, regardless of whether such income would be (1) properly characterized as income from the discharge of indebtedness under section 61(a)(11) of the Code, or (2) otherwise includible in gross income under section 61 of the Code.
II. Deductibility of Eligible Section 1106 Expenses
Neither section 1106(i) of the CARES Act nor any other provision of the CARES Act addresses whether deductions otherwise allowable under the Code for payments of eligible section 1106 expenses by a recipient of a covered loan are allowed if the covered loan is subsequently forgiven under section 1106(b) of the CARES Act as a result of the payment of those expenses. This Notice addresses the effect of covered loan forgiveness on the deductibility of payments of eligible section 1106 expenses.
III. Summary of Relevant Law
Section 161 of the Code provides that, in computing taxable income under section 63 of the Code, there shall be allowed as deductions the items specified in part VI, subchapter B, chapter 1 of the Code (for example, sections 162 and 163). However, section 161 of the Code provides that the allowance of these deductions is subject to the exceptions provided in part IX, subchapter B, chapter 1 of the Code. These exceptions include section 265 of the Code. See also section 261.
In general, section 162 of the Code provides for a deduction for all ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business. Covered rent obligations, covered utility payments, and payroll costs consisting of wages and benefits paid to employees comprise typical trade or business expenses for which a deduction under section 162 of the Code generally is appropriate. Section 163(a) of the Code provides a deduction for certain interest paid or accrued during the taxable year on indebtedness, including interest paid or incurred on a mortgage obligation of a trade or business.
However, section 265(a)(1) of the Code and §1.265-1 of the Income Tax Regulations provide that no deduction is allowed to a taxpayer for any amount otherwise allowable as a deduction to such taxpayer that is allocable to one or more classes of income other than interest (whether or not any amount of income of that class or classes is received or accrued) wholly exempt from the taxes imposed by subtitle A of the Code. See generally section 265(a)(1); §1.265-1. The term “class of exempt income” means any class of income (whether or not any amount of income of such class is received or accrued) that is either wholly excluded from gross income under any provision of subtitle A of the Code or wholly exempt from the taxes imposed by subtitle A of the Code under the provisions of any other law. See §1.265-1(b)(1). The purpose of section 265 of the Code is to prevent a double tax benefit.
Section 265(a)(1) of the Code applies to otherwise deductible expenses incurred for the purpose of earning or otherwise producing tax-exempt income. It also applies where tax exempt income is earmarked for a specific purpose and deductions are incurred in carrying out that purpose. In such event, it is proper to conclude that some or all of the deductions are allocable to the tax-exempt income. See Christian v. United States, 201 F. Supp. 155 (E.D. La. 1962) (school teacher was denied deductions for expenses incurred for a literary research trip to England because the expenses were allocable to a tax-exempt gift and fellowship grant); Banks v. Commissioner, 17 T.C. 1386 (1952) (certain educational expenses paid by the Veterans' Administration that were exempt from income tax, were not deductible); Heffelfinger v. Commissioner, 5 T.C. 985 (1945), (Canadian income taxes on income exempt from U.S. tax are not deductible in computing U.S. taxable income); and Rev. Rul. 74-140, 1974-1 C.B. 50, (the portion of a state income tax paid by a taxpayer that is allocable to the cost-of-living allowance, a class of income wholly exempt under section 912, is nondeductible under section 265).
In Manocchio v. Commissioner, 78 T.C. 989 (1982), a taxpayer attended a flight-training course that maintained and improved skills required in the taxpayer's trade or business. As a veteran, the taxpayer was entitled to an educational assistance allowance from the Veterans' Administration pursuant to 38 U.S.C. section 1677 (1976) equal to 90 percent of the costs incurred. Because the payments received were exempt from taxation under 38 U.S.C. section 310(a) (1976), the taxpayer did not report them as income. The taxpayer did, however, deduct the entire cost of the flight training course, including the portion that had been reimbursed by the Veterans' Administration. In a reviewed opinion, the court held that the reimbursed flight-training expenses were nondeductible under section 265(a)(1) of the Code.
NON-DEDUCTIBILITY OF PAYMENTS TO THE EXTENT INCOME RESULTING FROM LOAN FORGIVENESS IS EXCLUDED UNDER SECTION 1106(i) OF THE CARES ACT
To the extent that section 1106(i) of the CARES Act operates to exclude from gross income the amount of a covered loan forgiven under section 1106(b) of the CARES Act, the application of section 1106(i) results in a “class of exempt income” under §1.265-1(b)(1) of the Regulations. Accordingly, section 265(a)(1) of the Code disallows any otherwise allowable deduction under any provision of the Code, including sections 162 and 163, for the amount of any payment of an eligible section 1106 expense to the extent of the resulting covered loan forgiveness (up to the aggregate amount forgiven) because such payment is allocable to tax-exempt income. Consistent with the purpose of section 265, this treatment prevents a double tax benefit.
This conclusion is consistent with prior guidance of the IRS that addresses the application of section 265(a) to otherwise deductible payments. In particular, Rev. Rul. 83-3, 1983-1 C.B. 72, provides that, where tax exempt income is earmarked for a specific purpose, and deductions are incurred in carrying out that purpose, section 265(a) applies because such deductions are allocable to the tax-exempt income. In accordance with the analysis set forth in Rev. Rul. 83-3, the direct link between (1) the amount of tax exempt covered loan forgiveness that a recipient receives pursuant to section 1106 of the CARES Act, and (2) an equivalent amount of the otherwise deductible payments made by a recipient for eligible section 1106 expenses, constitutes a sufficient connection for section 265(a) to apply to disallow deductions for such payments under any provision of the Code, including sections 162 and 163, to the extent of the income excluded under section 1106(i) of the CARES Act.
The deductibility of payments of eligible section 1106 expenses that result in loan forgiveness under section 1106(b) of the CARES Act is also subject to disallowance under case law and published rulings that deny deductions for otherwise deductible payments for which the taxpayer receives reimbursement. See, e.g., Burnett v. Commissioner, 356 F.2d 755, 759-60 (5th Cir. 1966); Wolfers v. Commissioner, 69 T.C. 975 (1978); Charles Baloian Co. v. Commissioner, 68 T.C. 620 (1977); Rev. Rul. 80-348, 1980-2 C.B. 31; Rev. Rul. 80-173, 1980-2 C.B. 60.
CONTACT INFORMATION
The principal authors of this notice are Sarah Daya and Patrick Clinton of the Office of Associate Chief Counsel (Income Tax & Accounting). For further information regarding the application of sections 161, 162, 163, and 261 please contact Ms. Daya at (202) 317-4891 (not a toll-free call); for further information regarding the application of section 265, please contact Mr. Clinton at (202) 317-7005 (not a toll-free call).