The Coronavirus Aid, Relief and Economic Security (CARES) Act provides two measures of relief to taxpayers, but taxpayers amending federal income tax returns should be aware these benefits may not reach their state income tax returns.
First, the CARES Act temporarily repeals the 80% of taxable income limitation on net operating loss (NOL) utilization, which was previously established by the Tax Cuts and Jobs Act (TCJA). Additionally, taxpayers can carry back NOLs arising in 2018, 2019, and 2020 to the five preceding taxable years.
Second, the CARES Act increases the interest expense limitation under Internal Revenue Code (IRC) Section 163(j) from 30% to 50% for tax years 2019 and 2020. Taxpayers who have chosen to amend federal income tax returns to take advantage of the relaxed NOL usage rules should be aware that these tax benefits may not reach their state income tax returns.[1] Similarly, the increased interest expense limitation for federal income tax purposes does not automatically increase interest expense limitation for state income tax purposes.
Under the TCJA, enacted in 2017, NOLs cannot be carried back to previous tax years but can be carried forward for an indefinite period of time.[2] Additionally, the TCJA limited the amount of NOLs available for use to 80% of taxable income. The CARES Act, signed into law on March 27, 2020, temporarily suspended restrictions on NOL usage. Section 2203 of the CARES Act allows NOLs generated in tax years beginning after December 31, 2017 and before January 1, 2020 to be carried back to the five preceding tax years.
Further, the CARES Act removes the 80% limitation set by the TCJA, and allows taxpayers to fully offset taxable income for tax years 2018, 2019, and 2020. Lastly, the CARES Act increases the interest expense limitation under IRC Section 163(j) from 30% to 50% for tax years 2019 and 2020.
Taxpayers who were previously limited in using their NOLs can amend prior year federal returns and claim refund(s). Further, the expanded interest expense limitation may generate additional NOLs in tax years 2019 and 2020 that can now be carried back to prior tax years. The filing of an amended federal return triggers an obligation to file an amended state tax return. Taxpayers should take caution in filing amended state returns as states have varying rules for NOL usage.
State NOL rules can be divided into one of four categories:
Taxpayers who amend their federal returns to take advantage of the NOL availability under the CARES Act will not be able to see those same advantages in states that do not conform to federal NOL statutes. Further, taxpayers may see relief from NOL availability for carryback or suspended 80% limitation in fixed conformity states, depending on subsequent legislation or guidance from state revenue agencies. Additionally, some states limit the amount of available state NOLs as those reported on an original federal return.
Therefore, to the extent NOL carryforward balances are reduced by carrying back NOLs on amended federal returns, taxpayers will not be able to use those NOLs on state returns. Lastly, taxpayers may realize tax benefits in rolling IRC conformity states that should automatically conform to the NOL rules enacted by the CARES Act. Although, these states could enact legislation to specifically decouple from Section 2203 of the CARES Act.
State conformity to IRC Section 163(j) depends on the relevant state’s methodology for conformity to the IRC. Generally, states fall into fixed conformity, rolling conformity, or selective conformity. A selective conformity state is a state that identifies certain provisions of the IRC to which it will conform or decouple. A fixed state conforms to the IRC as of a certain date. Therefore, to the extent the fixed date of conformity is prior to enactment of the CARES Act, the 50% interest expense limitation will not apply. Rolling conformity states conform to the IRC automatically. Thus, rolling conformity states automatically adopt the 50% interest expense limitation. If these states wish to defer from the 50% limitation, they will need to enact legislation to decouple from that and the other specific measures of the CARES Act.
New York has already decoupled from the 50% interest expense limitation and Minnesota introduced House Bill 3389, which would amend the state’s tax code to decouple from the additional interest expense deduction. In states that decouple from the 50% interest expense limitation, taxpayers will be required to add back the difference in interest expense allowed by the state as compared to the federal government.
Taxpayers should be mindful of the differences between federal and state tax rules in computation of NOLs and interest expense deductions. Morgan Lewis state tax lawyers will continue to monitor state legislation for conformity to the CARES Act. Taxpayers should consult with Morgan Lewis advisors to work through the various issues that will arise not only from the CARES Act, but from additional relief legislation that is expected to come out of Washington, DC.
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If you have any questions or would like more information on the issues discussed in this LawFlash, please contact any of the following Morgan Lewis lawyers:
New York
Cosimo A. Zavaglia
Philadelphia
Justin D. Cupples
[1] For federal tax implications of the CARES Act, see our LawFlash, $2 Trillion Stimulus Bill Brings Major Tax Changes (Mar. 27, 2020).
[2] IRC § 172.