821 Bakery Cafe advertises for customers that they are still open in Richmond, Va., March 18, 2020. (Parker Michels-Boyce/ For the Virginia Mercury)

Because COVID-19 hasn’t hit Virginia’s economy as hard as officials thought it might, Gov. Ralph Northam says policymakers will have an extra $730 million to work with as they finalize the next state budget.

Instead of building that revenue into a spending plan that includes raises for public employees and funding boosts for pandemic-rattled school systems, some business groups want the state to use its newfound flexibility to offer more tax relief to companies that took federal Paycheck Protection Program loans to get through the crisis.

“When small businesses see in the news that the state has this money, I think they’re going to be very vocal to their elected officials that this is something the state can do,” said Nicole Riley, Virginia’s state director of the National Federation of Independent Business.

About $12.6 billion in PPP loans flowed to thousands of Virginia businesses during the pandemic, with an average loan size of about $107,000. The goal was to give employers a cash infusion so they could keep paying workers even if business withered amid shutdowns and stay-at-home orders. As long as the money was spent on valid expenses like payroll, rent and utilities, the loans were forgiven. That’s where the tax issues come into play.

Even though the loans essentially turned into grants, Congress has decided the relief money shouldn’t count as taxable income and should be tax-deductible. Because Virginia and other states have to decide whether to conform their own tax policies to federal rules, state policymakers had to make their own decisions on how to treat PPP loans.

Virginia, which can’t print money and has a constitutional obligation to balance its budget, isn’t treating PPP money as entirely tax-exempt. That means some businesses might get a state tax bill for taking funds they thought were supposed to be a lifeline to keep people employed.

Forgiven PPP loans won’t be treated as taxable income, but Gov. Ralph Northam’s administration has argued expenses Virginia businesses covered with federal money shouldn’t be deducted from business income. In other words, a company with $500,000 in profits that took a $100,000 PPP loan wouldn’t be able to count PPP-covered expenses against its income to lower its taxable net profit to $400,000.

Making the PPP money deductible, according to Finance Secretary Aubrey Layne, creates a double benefit for loan recipients, letting businesses that were able to get free federal money use it to get a tax break that won’t be available to businesses that missed out on the PPP funds.

“These guys got a lot of help,” Layne said in an interview. “Other people got nothing.”

Conforming Virginia’s tax policy on PPP loans to the federal rules, Layne said, could mean a revenue hit of up to $500 million over the next two fiscal years.

Some have argued the state’s brightening budget outlook, despite still being $800 million below pre-pandemic forecasts, makes that an easier lift.

The Virginia Restaurant, Lodging and Travel Association sent a letter to General Assembly budget leaders Wednesday asking them to consider doing more to address the “the exceptionally challenging situation of the hospitality industry.”

“Without action, our members will face surprise tax bills at a time when they should be focusing on surviving the winter and the pandemic,” wrote VRLTA President Eric Terry.

Legislators in the state Senate and the House of Delegates have already been working on the issue, both seeking to offer some targeted tax relief to small businesses without going so far as to declare all PPP money tax-deductible.

The House passed legislation allowing deductions for up to $25,000 of PPP money. The Senate settled on a proposal allowing deductions of up to $100,000. The two chambers will likely have to work out the details in ad hoc conference committee meetings as the session nears its end later this month.

The House proposal, which only covers individual income taxes, would reduce state revenues by $36 million over the next two years, according to state fiscal analysts. The Senate version, which covers individual and corporate taxes, is estimated to have a $98 million impact.

In an email Wednesday, Del. Vivian Watts, D-Fairfax, the chairwoman of the House Finance Committee, said the new budget forecast might factor into the discussions.

“The revenue forecast may affect the amount of the deduction depending on competing needs to fully funding other programs to address the harsh impact of COVID-10 such as opening schools, replenishing the unemployment fund, rental assistance and Rebuild Virginia small business grants,” Watts said. “But as we negotiate, the House will continue to focus targeted relief to those businesses that need it the most.”

Supporters of the Senate’s relief plan have said making up to $100,000 deductible would cover roughly 75 percent of the Virginia businesses who received PPP funds. Proponents say it will help small businesses avoid a tax hit without giving massive breaks to big companies.

“They’re not the Amazons or the Krogers or any of these companies that everyone likes to throw around that did really well across the pandemic,” said Riley.

Some Republicans have argued the state shouldn’t be overly strict about money desperate businesses took to boost their odds for survival.

On Wednesday, Senate Republicans tried unsuccessfully to amend one of the bills to make the full amount of PPP loans deductible. Sen. Ryan McDougle, R-Hanover, characterized it as a matter of living up to the deal business owners thought they were getting when they took the money to avoid cutting jobs.

“Part of the reason that our economy is working well is that those employees continue to have jobs. They continue to have paychecks. They continue to have health insurance,” McDougle said.

That effort failed on a 17-22 vote.

Speaking on the Senate floor, Sen. Scott Surovell, D-Fairfax, said the PPP program was meant to be “pass-through” relief for workers, not a tax break for companies that got money “dropped out of the sky.”

“What we’re proposing I think is very targeted and much more thoughtful than what the federal government decided,” Surovell said.

Sen. Janet Howell, D-Fairfax, the chairwoman of the Senate Finance and Appropriations Committee, said the state is not “flush with money.”

“We are having to make very hard decisions,” Howell said. “And if this were to pass, they would be virtually impossible decisions.”

Layne said the Northam administration simply disagrees that tax policy is the correct route for COVID relief, because companies who got PPP loans don’t represent “all the people who got hit by the pandemic.”

“It had nothing to do with need,” he said. “It was whoever showed up the quickest and had relationships with banks.”