INSIGHT: The CARES Act Just May Have Increased Your State Taxes. Wait. What? Part 2 – Direct Changes to the Internal Revenue Code

In Part 1 of this two-part article series on areas where state conformity to (or decoupling from) the Coronavirus Aid, Relief, and Economic Security Act (Pub. L. No. 116-136) (CARES Act) will have a state income tax impact , I described some of the indirect impacts of the CARES Act signed by President Trump on March 27, 2020, that could result in increases to state taxes. The focus of that article was on the state income tax impacts of the employee retention tax credit (ERC) under Section 2301 of the CARES Act and the potential for state income tax disconnects on cancellation of indebtedness income (CODI) related to forgiven Paycheck Protection Program (PPP) loans under Sections 1102 and 1106(i) of the CARES Act.

This second article will turn to a few of the state income tax complexities due to direct amendments made by Congress in the CARES Act to the Internal Revenue Code described in the earlier article, the problems arise because of the myriad of ways by which the states that impose either a corporate or personal income tax conform to amendments to the I.R.C. (e.g., “rolling conformity,” “fixed date conformity” or “selective conformity”).

I touched on some of the I.R.C. conformity problems in the earlier article, and the same principles described in that article which apply to the particular states discussed there carryover and equally apply to the I.R.C. provisions described in this article. Instead of going over the same ground, I have attempted to address the conformity problems not only in general but also to state specific laws that I did not previously address. Some of the conformity principles identified in this article of course can be applied to the ERC and PPP CODI issues identified earlier and vice versa. To reiterate, my point here is not to criticize or sensationalize but simply to inform both taxpayers and tax policy makers about the state tax impact of the CARES Act changes and enable them to respond accordingly.

In addition to the indirect tax stimulus measures, such as the potential for tax-free treatment of PPP CODI and credits against federal employment taxes under the ERC, the CARES Act also included direct, powerful tax stimulus. First, it modified the business interest expense (BIE) limitations under I.R.C. Section 163(j). Next, it restored a net operating loss (NOL) carryback, extended it to five years, and temporarily lifted the 80% net income offset limitations for NOLs. Both of these actions effectively relaxed restrictions imposed by the Tax Cuts and Jobs Act (Pub. L. No. 115-97) (TCJA) which were enacted less than three years ago.

DIRECT STATE TAX COSTS OF THE CARES ACT [S2] [UC]

Changes to the BIE Limitations (Section 163(j))S2] [UC/LC]

Let’s start with the relaxation of the BIE limitations under Section 163(j). This TCJA provision amended and expanded the applicability of Section 163(j) from just focused on interest paid to foreign related parties to essentially all BIE. It does so by imposing a limitation on the amount of BIE that a taxpayer can deduct based on a percentage of the taxpayer’s “adjusted taxable income” (ATI). ATI, defined at Section 163(j)(8), is essentially a measurement of cashflow similar to the accounting principle of earnings before interest, taxes, depreciation, and amortization (EBITDA). A comparison of the I.R.C.’s ATI definition with a description of EBITDA published by the SEC on June 13, 2003, in its Frequently Asked Questions Regarding the Use of Non-GAAP Financial Measures: EBIT and EBITDA (June 13, 2003), demonstrates those similarities.

The CARES Act generally modifies the BIE limitation in two ways: First, in Section 2306(a) of the CARES Act, the BIE percentage limitation is increased from 30% to 50% of ATI for tax years beginning in 2019 and 2020 (see new clause Section 163(j)(10)(A)). Secondly, that section also adds new clause Section 163(j)(10)(B) which allows a taxpayer to elect to use its 2019 ATI in 2020 (presuming of course that a taxpayer might make the election if its 2020 tax year is a bad year from a taxable income perspective).

Nearly three years after the adoption of the TCJA, some states have still not conformed to the Section 163(j) BIE limitations. Thus, the “good news” for taxpayers filing in those states is that no limitations effectively exist on the deductibility of BIE (although these states may impose their own limitations (e.g., related-party interest addbacks) or may continue to conform to the “old” Section 163(j) limitations which disallowed interest expense paid to foreign related parties in most circumstances). California, as an example of a selective conformity state, is unaffected by these changes since it generally conforms to the I.R.C. as of Jan. 1, 2015, for franchise tax purposes. A good example of a different way a state might disconnect from the TCJA’s BIE limitations entirely is Georgia, which chose to conform to Section 163(j) as it was in effect prior to enactment of the TCJA. The state accomplished this through its amendment of the definition of “Internal Revenue Code” in Ga. Code Ann. Section 48-1-2(14) by specifically excepting Section 163(j) from the general updated conformity date as “… in effect before the 2017 enactment of federal Public Law 115-97 [TCJA] …”).

In those states which conformed to the TCJA’s BIE limitations, the questions raised by the CARES Act which must be answered are essentially two: (1) Will they conform to the increased BIE percentage limitation; and (2) Will they allow taxpayers to elect to use their ATI for 2019 instead of the (presumably) lower ATI anticipated for most taxpayers in 2020?

In rolling conformity states that never modified their law for the TCJA changes to Section 163(j), the answer should be relatively simple—the increase in the percentage limitation to 50% should carry over automatically, and if the taxpayer elects to use 2019 ATI in 2020, that should carry over for state purposes as well. In fixed date conformity states that incorporated the TCJA version of BIE limitation in Section 163(j), the question could be more complicated. Unless the state incorporates the new CARES Act relaxed provisions, taxpayers in those states would have to recompute the BIE limitation based upon the lower 30% ATI limitation and may not be able to use 2019 ATI in computing their 2020 BIE. Of course, there are a myriad of other complexities under Section 163(j) that apply at the state level such as:

• What if the members of the state combined group are different than the federal consolidated group?

• How are members of a federal consolidated group supposed to compute the BIE limitation in a separate return reporting state?

• Do taxpayers have to recompute the BIE percentage limitation to reflect federal/state group membership differences?

• Does the state provide any other adjustment in the BIE limitation calculation?

These issues and many others have been discussed in other articles, but the changes brought about by the CARES Act have just made those state conformity determinations and computations that much more complicated for taxpayers and their tax advisors, as well as for state tax authorities who have to apply and audit these positions. The point here is that taxpayers may find that if a state does not conform to the federal-relaxed BIE limitation rules under the CARES Act, they will face correspondingly reduced state tax deductions resulting in comparatively increased state tax liability compared to the post-CARES Act treatment of the same BIE items for federal income tax purposes. The take away, of course, is that while Congress may have provided taxpayers with some tax relief, the states in which they file may not have provided a similar, proportionate reduction in the BIE limitation.

New York—How just a few words create uncertainty

One example of this incredible state conformity complexity occurred through enactment of New York’s recent budget bill (Budget Bill) NY Laws 2020, ch. 58, (S 7508-B and A 9508-B), which was enacted shortly after the enactment of the CARES Act. Although not a major tax bill and only adding a few words to the existing New York Tax Law, Part WWW of the Budget Bill complicated New York State (NYS) and New York City (NYC) conformity to the I.R.C. after the CARES Act. Trying to navigate this complexity is akin to playing a game of multi-dimensional, multi-level chess that requires full consideration at each layer and each and every move by taxpayers and their tax advisors. Moreover, for individuals, different results can apply depending upon whether the taxpayer is a resident of NYC as well.

Let’s get to the easy part first—NYS corporate franchise tax, NYC corporate income tax, and NYC unincorporated business tax (UBT) conformity. As if this discussion weren’t complicated enough, readers are reminded that NYC currently has two corporate taxes with an income tax component—the General Corporation Tax (codified at N.Y.C. Admin. Code Section 11-602 to Section 11610) (GCT) and the Corporate Tax of 2015, commonly referred to as the Business Corporation Tax (codified at N.Y.C. Admin. Code Sections 11-651 to 11-660) (BCT). The primary difference between the two? The GCT currently applies only to S corporations while the BCT generally applies to all general corporations other than S corporations for taxable periods after Jan. 1, 2015. (Of course, both NYS and NYC have other, specialized income taxes for insurance companies, financial corporations, and transportation corporations that are not addressed by this article.)

One of the reasons for the apparent duplication of corporate tax law provisions is that NYC, but not NYS, has historically disregarded federal S corporation elections subjecting S corporations doing business in NYC to a direct entity-level tax as it they were treated as C corporations. Moreover, in 2015 when the New York Legislature undertook substantial tax reform, introducing mandatory combined reporting, effectively to exclude S corporations from an NYC combined report, the legislature seemingly kept the GCT intact and effectively had it apply only to federal S corporations subject to NYC tax. For simplicity purposes, since the primary focus of this article is on the impact of CARES Act law changes on C corporations, I’ll address the conformity issues under the BCT, although similar consequences should exist for S corporations under the NYC GCT.

These NYS and NYC business tax laws all fall into the category of a “rolling conformity” statute (i.e., as the I.R.C. changes, so does the state law). This can be seen in the statutory language in which the state’s tax base, defined as “entire net income,” “means total net income from all sources, which shall be presumably the same as the entire taxable income, which, except as hereinafter provided in this subdivision, (i) the taxpayer is required to report to the United States treasury department …” N.Y. Tax Law Section 208.9. The NYC has an identical provision in its business tax law. NYC BCT Section 11-652.8. Thus, when the CARES Act was adopted, the amendments to the Section 163(j) BIE limitations were immediately incorporated into the relevant NYS corporate, NYC BCT, and NYC UBT tax laws.

The Budget Bill, however, adopted just a few days after the adoption of the CARES Act changes all that but in subtly different ways for each of these NYS and NYC tax laws. Sections 1, 4, 5, and 6 of Part WWW of the Budget Bill contain identical, short statutory language adding a simple, seemingly harmless, cross reference to Section 163(j)(10)(A)(i) as added by Section 2306 of the CARES Act to the subtraction modification in the appropriate NYS or NYC business tax law.is provision amends the NYS corporate franchise tax law which determines the “entire net income” tax base (codified at N.Y. Tax Law Section 208(9)(b)) to read as follows:

Entire net income shall be determined without the exclusion, deduction or credit of:

… (26) For taxable years beginning in [2020], the amount of the increase in the federal interest deduction allowed pursuant to [I.R.C. Section ]163(j)(10)(A)(i) …”

So, what does this phrase effectively do? It disallows the CARES Act increase to the ATI percentage limitation from 30% to 50%. Unaffected was NYS and NYC business tax conformity to the taxpayer’s federal election to use 2019 ATI in 2020. Presumably, since it is not addressed by the Budget Bill, that federal election still applies. In essence, while a corporate taxpayer might be excluded from any BIE limitation in 2019 and 2020 for federal income tax purposes due to the increase in the percentage limitation from 30% to 50%, that same taxpayer may be subject to such a limitation in NYS or NYC because the much lower 30% percentage limitation still applies for NYS or NYC corporate tax purposes (as well as NYC UBT). Coupled with the possibility that the taxpayer’s combined reporting group membership may differ from that of its federal consolidated group, a NYS or NYC corporate taxpayer could face a very different and complicated BIE limitation.

Still with me? Now, if that weren’t complicated enough, the NYS personal income tax and NYC resident income tax treatment of the BIE limitation under Section 163(j) is even more complicated (and the legislature actually used fewer words to do it).

First, prior to enactment of the Budget Bill, just like their corporate income taxes, NYS and NYC personal income tax laws historically were treated as rolling conformity jurisdictions. The personal income tax laws still read that way, but keep in mind that NYC personal income tax only applies to residents. Nonresidents are not subject to the city tax because of a successful constitutional challenge by out-of-state taxpayers years ago when the New York Legislature excluded NYS residents from a NYC commuter tax but not out-of-state residents. That history is best described in the New York Court of Appeals decision in City of New York v. State.

N.Y. Tax Law Section 607(a) [NYS personal income tax law] specifically provides that “[a]ny reference in this article to the laws of the United States shall mean the provisions of the [I.R.C.] … and amendments thereto, and other provisions of the laws of the United States relating to federal income taxes, as the same may be or become effective at any time or from time to time for the taxable year. …” Identical language is provided in the NYC personal income tax law at N.Y.C. Admin. Code Section 11-1707.

Sections 2 and 3 of Part WWW of the Budget Bill seemingly changed all that for NYS and NYC personal income tax purposes for taxable years beginning before Jan. 1, 2022, by making any amendments to the I.R.C. enacted after March 1, 2020, inapplicable (i.e., for calendar year taxpayers, the 2020 and 2021 taxable years). Effectively, this simple provision makes each of the NYS and NYC personal income tax laws a fixed date conformity law at least through Jan. 1, 2022. Thus, it appears that none of the changes enacted by the CARES Act, including the amendments to the Section 163(j) BIE limitations, are incorporated into the NYS or NYC personal income tax laws. That means that not only does the increase in the BIE percentage limitation not apply (just like under the NYS and NYC corporate tax laws and the NYC UBT discussed above), but NYS and NYC personal income tax law likely doesn’t allow taxpayers to elect to use 2019 ATI to compute their 2020 BIE limitation.

Sounding like one of those late-night television commercials, but wait there’s more!, the NYS personal income tax law’s modification provision, N.Y. Tax Law Section 612(a), states that “New York adjusted gross income of a resident individual means his adjusted gross income as defined in the laws of the United States for the taxable year, with the modifications specified in this section [emphasis added].” Similarly, for resident partners or shareholders of an S corporation, N.Y. Tax Law Section 617 ties to the modifications provided in N.Y. Tax Law Section 612 for determining their distributive share of taxable income. Similar provisions apply for NYS non-residents (N.Y. Tax Law Section 631), for NYC residents (N.Y.C. Admin. Code Section 11-1712) and partners and S corporation shareholders (N.Y.C. Admin. Code Section 11-1717). So, the question becomes, are the CARES Act provisions incorporated or not for NYS or NYC partners and S corporation shareholders? Does the specific rule override the general rule that the CARES Act doesn’t apply in computing taxable income? Do the modifications provided for S corporations flow-through to the shareholders even though they seem to conflict with the corporate law changes? Unfortunately, the answers appear at best to be as clear as mud.

Readers of my earlier article should recognize that the same changes to NYS and NYC laws described here will carryover and apply similarly to the indirect tax impact described in the first part of this article published on June 30, 2020 in Bloomberg Tax, The CARES Act May Have Just Increased Your State Taxes. Wait. What?

NOLs Section 172

Section 2303 of the CARES Act reintroduced a carryback of federal NOLs for losses arising in 2018, 2019, and 2020 that was eliminated under the TCJA. It also extended the carryback period to five years. Finally, it suspended the 80% limitation on the amount of taxable income that could be offset by NOLs for taxable years beginning before Jan. 1, 2021. By filing for a claim or amending prior returns to include the NOL carryback, a taxpayer should be able to recover a quick cash refund of federal income taxes paid in prior years.

Taxpayers are likely to find few states following this CARES Act amendment regardless of whether the state is a rolling or fixed date conformity state, whether the federal tax base for determining state taxable income begins with adjusted gross income or federal taxable income (FTI), or whether the state starts its tax base by reference to Line 28 or Line 30 of the federal corporate income tax return (i.e., whether the federal tax base used is before or after NOLs and special deductions). The reason? Most states have long substituted their own NOL provisions for the federal NOL rules. We’ve even seen some states suspend their NOLs as a way to limit the adverse revenue effect on their state budgets, most notably California.

While the current carryforward period for federal income tax purposes is unlimited, most states have retained the pre-TCJA 20-year federal carryforward period, although many have even shorter periods. Historically, in times of economic distress, one of the first targets for raising revenue by the states is imposing percentage limitations on the amount of NOL that can offset state taxable income or suspending the NOL entirely for one or a number of years. In fact, on June 29, 2020, California Governor Newsom signed a budget trailer bill, 2020 Cal. Stat. ch. 8 (AB 85) adding new Cal. Rev. & Tax. Code Section 24416.23, which will suspend California’s NOLs for medium and large taxpayers for 2020, 2021, and 2022.

In nearly all cases, states have not provided for a NOL carryback or to the extent they do, have severely limited the amount of NOL that can be carried back to earlier years. The reasons for such a policy might not necessarily be obvious. First, unlike the federal government, every state (except Vermont) has a balanced budget requirement. Thinking about it, if a state were to allow a carryback, if enough taxpayers filed for one, the total amount payable to taxpayers could overwhelm the earlier budget from the closed year causing it to be “unbalanced” and in conflict with the state specific constitutional or statutory restrictions. Consequently, most states chose not to provide a carryback for their NOLs. Likewise, unlike the federal government, the states do not have the ability to print money (i.e., states have a much more limited capacity to issue debt). With those restrictions, states tend to be a bit more cautious in providing NOL deductions similar to those provided by the federal government.

Adding technical complexity, a statutes in one state (R.I. Gen. Laws Section 44-11-11(b)(3)) appears to limit the amount of state NOLs that can be used in a given year to not more than the amount of federal NOLs that are used in the same year. This rule creates an interesting conundrum: To the extent the taxpayer carries back a federal NOL, that action will necessarily limit the amount of state NOL it can use in later years, in some cases wiping them out entirely.

If taxpayers do carry back their federal NOLs to prior years for refunds, they may also have to report those changes for state tax purposes as well in each state in which they file returns, regardless of whether they receive a state benefit or not. Preparing those state returns will obviously be a costly exercise for taxpayers even though they may receive no actual state tax benefit. Worse still, carrying back NOLs to earlier years will affect the calculations of FTI in those earlier years and could result in clearly unintended state tax consequences because of the complicated manner by which states couple or decouple from FTI. For example, under Section 250(a)(2)(A), if a taxpayer’s combined deduction for global intangible low-taxed income (GILTI) under Section 951A and foreign-derived intangible income (FDII) exceeds its taxable income for the taxable year, the deductions for FDII and GILTI generally have to be reduced.

Most states don’t follow the federal NOL rules and substitute their own creating the possibility that a reduction in FTI caused by a carryback of a federal NOL could result in a reduction of the GILTI or FDII deduction if the state has one. Similarly, such a result could occur if the state conformed to a pre-TCJA federal deduction that was dependent upon the amount of FTI. The domestic production deduction under Section 199, which was repealed as part of the TCJA, is an example of such a provision. Section 199(a) generally limited the amount of that deduction to 9% of the lesser of: (1) the qualified production activities income (QPAI) of the taxpayer, or (2) the taxpayer’s FTI determined without regard to the Section 199 deduction for each taxable year.

Since the federal NOL carryback claims to taxable years in which the Section 199 deduction would still be available (i.e., 2017 taxable year and prior) will most likely affect those filed on a federal consolidated basis, the FTI limitation would appear to affect taxpayers joining in a state combined or consolidated return. Nevertheless, it is conceivable that a state’s conformity to the Section 199 domestic production deduction could require recomputing FTI in consideration of the federal NOL carryback as if a federal consolidated return had not been filed resulting in a different limitation for state tax purposes in the carryback years.

Thus, taxpayers taking a federal NOL carryback should be cognizant of the possibility that various state tax deductions may have to be recalculated and to the extent reduced, could result in increased state tax liabilities in those earlier years as long as the state statute of limitations for tax assessments remained open. Fortunately, in the author’s experience, there aren’t many of these provisions but as one may anticipate from both this article and the earlier one, taxpayers may have to go down the rabbit hole of state-by-state conformity to figure out whether the carryback of a federal NOL affects their earlier period state tax liability.

CONCLUSION

Together with my first article, the above are just a handful of the state tax conformity problems taxpayers and their advisors will face in considering how the direct and indirect tax provisions in the CARES Act will affect them. The author, taxpayers, and their advisors each know that the paramount attention of our state policy leaders is now focused on confronting the tragic and complex public health impact of the coronavirus on their citizens and the awful economic fallout the various shutdowns have had on all Americans. However, when they do have time to turn to state taxes, careful consideration of the state tax problems posed by the conformity of their state tax laws to the CARES Act and the federal tax decisions taxpayers make in response to them should not result in a surprise increase in their state tax burdens.

Read: Part 1—The CARES Act Just May Have Increased Your State Taxes. Wait. What?

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.

Author Information

Steven Wlodychak is a retired principal and contractor with Ernst & Young LLP in Washington, D.C. The views expressed are those of the author and do not necessarily represent the views of Ernst & Young LLP or those of the member firms of the global EY organization.