State net operating loss (NOL) rules generally differ from federal NOL rules, and state NOL rules often differ from one another. This lack of consistency can lead to confusion about a taxpayer’s ability to utilize NOLs.
Federal NOL Regime
Sec. 172(b)(1)(A) allows taxpayers to carry NOLs back 2 and forward 20 years, unless a taxpayer elects to waive the carryback period, in which case NOLs will only be carried forward. Legislation enacted in 2009 allows most corporate taxpayers to elect to carry back 2008 or 2009 NOLs up to five years and provides a five-year carryback for 2008 NOLs generated by eligible small business taxpayers.
State NOL Regime
The computation of state taxable income generally begins with either federal taxable income before NOL and special deductions (from line 28, Form 1120, U.S. Corporation Income Tax Return) or federal taxable income after NOL and special deductions (from line 30, Form 1120). The applicable federal starting point is modified to reflect certain addition and subtraction adjustments, such as the addback of expenses not deductible and the subtraction of income not taxable at the state level. Taxpayers should consider a number of common NOL variations.
In general, states require a taxpayer to have nexus (i.e., be subject to tax) in the state in the year a loss is generated in order to carry over a loss to a subsequent tax year. While most states utilize loss year apportionment limitations as a way to require nexus in a loss year, other states generally provide that a taxpayer must have nexus in a loss year to claim an NOL carryover. For example, Maryland regulations provide that a taxpayer cannot use an NOL generated when a corporation is not subject to Maryland income tax law as a deduction to offset Maryland income (MD Code Regs. §03.04.03.07(A)(5)). A similar rule applies in Rhode Island (RI Gen. Laws §44-11-11(b)).
New York law takes the “subject to tax” restriction one step further and provides that a taxpayer must be subject to the same article of the New York tax law in both the loss year and the carryover year to claim an NOL deduction (see, e.g., NY Tax Law §208(9)(f)(2)). Accordingly, if a taxpayer is subject to the Article 32 bank franchise tax based on income in the year an NOL is generated and the Article 9-A corporate franchise tax on income in the year it seeks to claim an NOL carryover, no deduction is permitted. In contrast, Virginia, which does not have its own NOL provisions but relies on federal NOL provisions in computing state taxable income, does not require nexus in the loss year; thus, Virginia taxpayers may “import” NOLs from pre-nexus years.
In determining state taxable income, states require a number of addition and subtraction modifications to federal taxable income. State-specific modifications may result in significant differences between federal and state taxable income, such as where a state “decouples” from bonus depreciation provisions or from the cancellation of debt income elective deferral provisions. As a result, while taxpayers may have an NOL for federal purposes in a given tax year, they may have taxable income at the state level in that year. Even if the state-specific adjustments do not cause a taxpayer to be in a net income position for state purposes, the dollar amount of an NOL may be significantly less at the state level than at the federal level.
Most states limit the amount of loss that a taxpayer can carry over based on the taxpayer’s level of in-state activity in the loss year. Taxpayers that realize a significant shift in operations in a specific state over time by increasing or decreasing levels of activity may need to consider the impact of such shifts on their deferred tax asset values attributable to state NOL carryovers. For example, if a taxpayer ceases operations in a specific state, it may need to fully reserve the deferred tax asset attributable to the NOL carryover in that state.
On a similar note, taxpayers may need to consider the impact of loss carryovers on different categories of income. For example, New York requires taxpayers with business and investment income in the year to which they carry an NOL to apportion the NOL carryover between the business and the investment income. The regulations set forth specific guidance for apportioning the loss between the different categories of income (20 NYCRR §3-8.8).
Given the balanced budget mandates under which most states operate, states generally limit the number of years that a taxpayer may carry an NOL forward or back. More than 30 states prohibit the use of NOL carrybacks of any amount. States that allow carrybacks often have state-specific provisions that prescribe a carryback period, which can result in nonconformity to extended carryback and carryover periods allowed at the federal level. For example, the five-year carryback period for 2008 or 2009 NOLs does not apply in most states as a result of state statutes that specify the carryover period. In addition, even if a state conforms to the Sec. 172 carryover provisions, a lag in the Code conformity date may result in nonconformity to an extended NOL carryover period.
Some states limit the amount of NOL deduction claimed in any year to a specific dollar amount. For example, of the states that allow carrybacks, the following limit the amount that a taxpayer may carry back as follows: Delaware ($30,000), Idaho ($100,000), New York ($10,000), Utah ($1 million), and West Virginia ($300,000). Pennsylvania, which does not allow NOL carrybacks, caps the amount of NOL deducted in a tax year beginning after December 31, 2009, to the greater of 20% of taxable income or $3 million. Some states cap the NOL deduction to the amount of NOL claimed in computing federal taxable income. For example, New York limits the NOL deduction in any tax year to the amount of NOL deducted in computing federal taxable income (NY Tax Law §208(f)(3)). The limitation is computed on an “as if” basis—as if the federal tax liability were subject to the state NOL carryback limitation noted above.
The impact of different return filing methodologies for federal and state purposes may create a challenging issue for taxpayers. For example, taxpayers that file returns on a separate basis at the state level while filing consolidated returns for federal purposes will need to track state NOLs separately to ensure accurate recordkeeping of tax attributes. Also, if a taxpayer used a state-specific NOL to compute a deferred tax asset in a year in which an NOL was generated, it may need to reassess the deferred tax asset if the state subsequently adopts combined filing.
Some states facing a fiscal crisis have suspended NOL deductions for a period of time. For example, in 2008 California suspended NOL deductions for tax years beginning on or after January 1, 2008, and before January 1, 2010, for taxpayers with taxable income of $500,000 or more (CA Rev. & Tax. Code §24416.9). Another common limitation on the use of the federal NOL deduction at the state level is the prohibition from using federal NOLs to offset state addition modifications. For example, while Maryland allows a current-year federal NOL to offset current-year state modifications, if total addition modifications exceed total subtraction modifications in the year an NOL is generated, a taxpayer must recapture excess addition modifications in the year the NOL deduction is claimed. See the 2009 instructions for Form 500, Maryland Corporation Income Tax Return, p. 2.
Editor: Annette B. Smith, CPA
Annette Smith is a partner with PricewaterhouseCoopers LLP, Washington National Tax Services, in Washington, DC.
For additional information about these items, contact Ms. Smith at (202) 414-1048 or firstname.lastname@example.org.