On March 27, 2020, President Trump signed into law the Coronavirus Aid, Relief, and Economic Security Act, P.L. 116-136 (CARES Act), which provides over $2 trillion in economic relief in response to the coronavirus (COVID-19) pandemic. The CARES Act also modifies sections of the Internal Revenue Code of 1986, as amended (IRC).1 Certain IRC modifications relax limitations on deductions, which were enacted as part of the Tax Cuts and Jobs Act, P.L. 115-97 (TCJA).
Because nearly every state with a corporate or personal income tax relies on the IRC in some manner to determine its tax base, the CARES Act amendments to the IRC will have important implications for state and local (collectively, state) corporate income tax reporting purposes and may result in future responses by state tax administrators and legislatures alike, some of which could have retroactive effect.
This Tax Alert highlights the significant changes to the IRC made by the CARES Act and broadly analyzes how these changes could affect state corporate income taxes generally (i.e., state income taxes imposed on C corporations and other legal entities that are taxed as regular corporations for federal income tax purposes). It does not address the state income or other business tax consequences of the law on any other type of taxpayer, including individuals and pass-through entities (such as partnerships, limited liability companies or S corporations). Unless otherwise stated, it is not intended to provide a detailed analysis of the tax law implications in a particular state. Readers are cautioned that the impact of the CARES Act on state corporate income taxpayers as described in this Tax Alert may not necessarily be the same impact that applies to other types of state taxpayers.
Select CARES Act provisions of significance for state corporate income tax purposes
From a state corporate income tax perspective, the following CARES Act modifications to the federal income tax law are of particular interest. For a general overview of federal corporate income tax implications of the CARES Act, see Tax Alert 2020-9011 and Tax Alert 2020-9012.
Temporary and permanent changes to NOL rules under IRC Section 172
The CARES Act temporarily suspends the 80% taxable income limitation on the use of a net operating loss (NOL) deduction against taxable income incurred for tax years beginning after December 31, 2017, and before January 1, 2021 (i.e., the 2018, 2019 and 2020 tax years for a calendar year-end taxpayer).2 Additionally, taxpayers may elect to:
- Carry back five years any NOL arising in a tax year beginning after December 31, 2017, and before January 1, 2021 and
- Exclude an IRC Section 965 transition tax year from the five-year NOL carryback period
Taxpayers may not use the NOL carryback to directly reduce the amount of IRC Section 965 transition tax incurred in a transition year. Taxpayers may still carry NOLs forward if they decide against carrying them back.
The carryback or carryforward of an NOL may affect a taxpayer’s (1) allowable IRC Section 250 deduction (both against foreign-derived intangible income (FDII) and global intangible low-taxed income (GILTI)); (2) allowable foreign tax credits (FTCs); (3) base erosion anti-abuse tax (BEAT) liability, and (4) in some cases, the taxpayer’s IRC Section 965 transition tax liability.
Temporary changes to IRC Section 163(j) limitation
The CARES Act generally allows taxpayers to increase the 30% of adjusted taxable income (ATI) limitation on the business interest expense deduction to 50% of ATI for tax years beginning after December 31, 2018, and before January 1, 2021.3 Taxpayers, however, may elect not to apply the higher 50% limitation. In addition, taxpayers may elect to use their ATI for the 2019 tax year (in lieu of their ATI for the 2020 tax year) in calculating their IRC Section 163(j) limitation for the 2020 tax year. If the additional deduction yields negative tax consequences for another tax provision, such as the IRC Section 59A BEAT, taxpayers may decide not to elect the increased IRC Section 163(j) limitation.
State corporate income tax implications of the CARES Act
The modifications to the IRC by the CARES Act will affect the corporate income taxes imposed by state governments. Generally, most state corporate income tax systems use some measure of income determined under the IRC, including federal taxable income (FTI) or adjusted gross income, as a starting point for state corporate income tax computations. The immediate impact of changes under the CARES Act to the calculation of FTI will depend on how each state conforms and incorporates changes to the IRC. Some will instantly conform to these federal changes. Others will not be affected by the amendments until the state’s legislature enacts new law to conform, such as by advancing the state’s IRC conformity date to incorporate the changes brought about by the CARES Act (i.e., advancing the IRC conformity date to a date on or later than March 27, 2020).
States generally conform to the IRC in one of several ways: (1) they automatically tie to the federal tax law as it changes (known as “rolling” conformity); (2) they tie to the federal tax law as of a specific date (known as “fixed” conformity); or (3) they pick and choose different federal tax law provisions and dates to which they will conform (known as “selective” conformity). Most states then generally define state taxable income as either FTI or adjusted gross income, as determined under the IRC, plus or minus certain additions or subtractions, such as adding back federal depreciation and substituting a state method of depreciation. A few states select sections of the IRC to which they will conform and then modify some of those provisions to meet their own tax policy objectives, meaning that the state’s taxable income is computed independent of the FTI computations.
State implications of changes to IRC Section 172
Most states do not conform to federal changes to NOL rules because they either use FTI before the NOL deduction to determine state taxable income or require the addback of the federal NOL and substitute their own NOL provisions. Furthermore, most states have long disallowed carrybacks of NOLs — perhaps because to allow NOL carrybacks would upset state budgetary determinations in earlier years. For these reasons, the CARES Act amendments to the federal NOL deduction will likely not have a significant impact in most states because only a handful follow the federal NOL directly (e.g., Maryland4) or otherwise subject their own NOLs to utilization limitations derived from IRC Section 172 (e.g., Indiana5), unless those states enact amendments to their tax laws to decouple from the new federal rules.
The more meaningful state impact emerges indirectly from the carryback of an NOL, which may affect other components of FTI to which states conform. The amount of an NOL deduction impacts a corporation’s allowable IRC Section 250 deduction against FDII and GILTI. In states that conform to one or both components of the IRC Section 250 deduction, the carryback of a federal NOL may also change state taxable income. This scenario raises nuanced concerns about the impact of the CARES Act in states that conform to the IRC Section 250 deduction but decouple from IRC Section 172. For example, it is unclear whether a state might recompute the IRC Section 250 deduction for state corporate income tax purposes, excluding the effect of any federal NOL carryback deduction.
Finally, and perhaps least intuitively, the carryback of an NOL may change state taxable income as a result of changes to total federal income tax. For example, corporations may, on an amended return, change their strategic decisions with respect to available BEAT elections to forgo deductions for all federal income tax purposes.6 Such elections can affect FTI and, therefore, state taxable income. Corporations should evaluate state tax consequences of these federal tax decisions in measuring the associated cost or benefit.
State implications of changes to IRC Section 163(j)
States generally will conform to the CARES Act changes to IRC Section 163(j), absent state legislative decoupling, because the business interest expense deduction limitation is part of the computation of a deduction used to determine FTI. How the CARES Act changes affect a specific state income tax law will depend on how that state conforms to the IRC and, in particular, IRC Section 163(j). A “rolling” conformity state generally will automatically conform to the amendments to IRC Section 163(j) unless the state decouples from the provision. A “fixed” conformity state generally will not apply the CARES Act changes until the state updates its IRC conformity date to a date on or after the enactment date of the CARES Act (i.e., March 27, 2020), while a “selective” conformity state generally will also have to incorporate the CARES Act changes for them to apply.
Since the TCJA’s enactment, several states have enacted laws specifically decoupling their income tax law from IRC Section 163(j). For example, Connecticut decouples from IRC Section 163(j) for purposes of calculating Connecticut taxable income.7 State taxing authorities have also responded to the TCJA’s business interest expense deduction limitation rules by publishing guidance regarding the application of IRC Section 163(j) in the context of their state’s corporate tax scheme. For example, Virginia’s Department of Taxation recently finalized such guidance.8 This guidance addresses several subtle federal-state conformity issues, including when corporate taxpayers will need to recompute ATI for Virginia purposes.9 These guidelines also note that Virginia law allows an additional deduction for 20% of the amount of business interest expense disallowed under IRC Section 163(j) for federal income tax purposes. Consequently, while taxpayers are allowed a larger deduction for Virginia income tax purposes in the year the interest expense was paid or accrued, they may need to reconcile in future tax years the accelerated Virginia business interest expense deductions with the federal deductions.10
Still, many states that generally conform to the TCJA’s provisions have yet to address — either through taxpayer guidance or lawmaking — the application of IRC Section 163(j) under their state tax laws. Important questions persist in light of the proposed Treasury Regulations11 and now the significant changes brought about by the CARES Act. For example:
- Uncertainty exists regarding state conformity to federal elections available under IRC Section 163(j). This uncertainty extends to the new federal election under the CARES Act to use a taxpayer’s 2019 ATI in calculating its 2020 IRC Section 163(j) limitation.
- It is unclear how or whether the federal consolidated return concepts incorporated into IRC Section 163(j) and the proposed Treasury Regulations, which allow for single-entity treatment for the members of a federal consolidated group, will apply to those same members in the states.
- States may not follow the carryover provisions for disallowed interest expense tax attributes because some states do not conform to IRC Sections 381 and 382, thereby raising the possibility of further federal-state disconnects in applying IRC Section 163(j) and the proposed Treasury Regulations.
- Many states impose related-party interest expense disallowance rules, which may intersect and conflict with the IRC Section 163(j) limitation on business interest expense deductions as applied by the states, creating ambiguity and uncertainty.
The CARES Act therefore means more favorable interest expense deductions in conforming states but at the cost of increased administrative complexity for both corporations and state taxing authorities. This is not a one-time reporting concern. Federal consolidated group members may be required to make stock basis and earnings and profits (E&P) adjustments to reflect the federal utilization of IRC Section 163(j) attributes among the members of that consolidated group. Taxpayers should recognize that most states, even some combined reporting states, do not permit these types of adjustments, which can result in significant differences in the federal and state tax treatment of future distributions and stock sales.
State tax policy and other considerations
As the CARES Act was enacted during the first quarter of the 2020 calendar year, state tax impacts of conformity, particularly in the rolling conformity states, may present time-sensitive compliance and reporting concerns. Most calendar year-end corporations will soon prepare estimated tax payments, and not all states currently provide an extension of time to file forms or pay tax due on April 15, 2020. For the latest in state responses to the COVID-19 pandemic as of the date of this Tax Alert, see Tax Alert 2020-0744 (EY endeavors to update this Tax Alert for state tax responses as they occur).
In determining their response to the COVID-19 pandemic, state legislatures will have to address their own budgetary impact, including any impact of conformity to the CARES Act. States in which the legislature adjourned before enactment of the CARES Act will require a special or emergency session to respond to the new federal law. Taxpayers have significant opportunity to participate in this state tax policy process — for instance, through a board of trade or legislative committees of professional associations, such as a state CPA society. EY will follow state regular and special legislative sessions and will provide periodic updates on these developments as they occur.
The CARES Act also arrives at a time when businesses may anticipate economic losses due to effects of the COVID-19 pandemic. Corporations should evaluate their state tax profile now to avoid situations in which any current-year state NOLs could become “trapped” (e.g., assigned to states in which the taxpayer does not ordinarily have business activity because workers are telecommuting from states in which they do not ordinarily work) or interest expense deductions could become unusable in future tax years. Analysis of business organizational structure and other strategic evaluations, such as obligor (versus guarantor) debt terms, can illuminate risks and opportunities surrounding limitations on NOLs and business interest expense deductions.