The COVID-19 pandemic has caused a monumental fiscal crisis not seen in the U.S. since the Great Depression. In response, the federal government passed the Coronavirus Aid, Relief, and Economic Security (CARES) Act, a tax and spending bill intended to provide much-needed economic relief. To date, the CARES Act is the largest stimulus package ever enacted in the nation’s history. While much of the initial attention of the CARES Act focused on the stimulus checks and Payroll Protection Program (PPP), the Act also contains three significant modifications to the Internal Revenue Code (IRC), namely:
1. Increasing the business interest expense limitation under IRC Section 163(j) from 30% of adjusted taxable income to 50% for taxable years 2019 and 2020;
2. Extending the carryback period for net operating losses (NOLs) arising in taxable years 2018, 2019, and 2020 to the 5 prior tax years; and
3. Permitting 100% bonus depreciation for eligible Qualified Improvement Property placed in service by a taxpayer between January 1, 2018 and December 31, 2022.
As state legislatures start returning with the opening of the country’s economy, the taxing authorities need to consider how to respond to the stimulus and rule changes of the CARES Act. Unlike the federal government, states do not have the ability to print money. State budgets rules require the passage of balanced budgets and do not allow for deficit carryforwards. This significantly hampers states’ abilities to respond to the crisis. Accordingly, states need to be strategic to maximize their relief efforts while ensuring their states remain financially solvent. The question is how.
Stimulus Checks and the Payroll Protection Program
The aim of the stimulus payments and the PPP is to keep funds flowing to both lower income and working class individuals. It allows citizens to pay bills and buy essentials. States have an interesting dilemma over whether to assert tax on these funds. Federal tax refunds and debt forgiveness are typically subject to state income taxes and therefore, without a legislative pronouncement, the $1,200 checks (really an advancement of a refundable credit) and PPP loan forgiveness will be taxable by the states. Thus far, only a few states have indicated that they will not tax these funds, leaving most individuals on the hook for tax.
Business Interest Expense Limitation
Pre-CARES Act, states fell into 2 categories regarding IRC Section 163(j) - those that conformed and those that did not. For the states that did not previously conform, they may seek to revisit this policy. Limiting an interest deduction for a specific subset of highly leveraged firms is likely preferable to cutting funding for critical state services at this time. States are more concerned with the welfare of its residents, than the negative impact that a limited interest deduction might have on a small group of businesses.
Conversely, states that previously conformed to 163(j) might consider decoupling from the CARES Act’s changes. Many businesses undoubtedly need cash in these desperate times and will possibly incur additional debt to manage the shortfalls caused by the pandemic. Expanding the interest expense deduction would help a number of those companies. Ultimately, states need to weigh the benefit of decreasing the deduction limitation versus the taxes generated by decoupling for use in other widespread relief efforts.
Net Operating Losses
Two years before the CARES Act, the federal government modified NOL carryback and computation rules, which have been law for some time. As a result, many states that previously did not have their own NOL provisions decoupled from the federal rules in one way or another. A significant number of states eliminated NOL carrybacks entirely due to the difficultly in properly allocating the losses to the specific state jurisdiction as apportionments change year to year. Accordingly, it is unlikely that the federal changes to the NOL rules will cause any adjustment to the current state NOL provisions.
Qualified Improvement Property
Bonus depreciation has long been a matter of contention for state tax regimes. The vast majority of states begin their tax levy computations by using federal taxable income containing the bonus depreciation expense. Over the years, states have oscillated between conforming to federal bonus depreciation and decoupling from it. However, in more recent years even states with rolling conformity to the Internal Revenue Code have generally required an addback modification for the bonus depreciation thereby reducing the additional depreciation expense. This is almost certain to continue as a matter of state policy because the tax revenue raised from the decoupling is too significant and desperately needed to fund current state programs.
Currently, only the state of New York has comprehensively addressed the provisions of the Act and its response was rather bifurcated. For corporate tax purposes, including New York City corporate and unincorporated taxes, the only CARES Act change for which New York decouples is the increased interest expense deduction limitation under 163(j). However, for personal income tax purposes the state has transformed into a fixed conformity date state of March 1, 2020, effectively decoupling from all CARES Act provisions. As other states begin to evaluate the fiscal stability of their economies, the CARES Act will receive close scrutiny in getting states back up and running again.
To learn more about the state implications of the CARES Act on you or your business and what else state taxing authorities are doing in response to COVID-19, please contact your Friedman tax advisor, or Alan Goldenberg, Principal, State and Local Taxation and Tax Controversy, at 212-897-6421 or via email at email@example.com.