State implications of Sec. 163(j) under TCJA and CARES Act

Editor: Howard Wagner, CPA

The law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97, included a number of measures to increase the federal income tax base while reducing the federal corporate income tax rate. Typically, when federal legislation is enacted, the states review the federal provisions in conjunction with their revenue budget estimates and decide whether they will adopt the federal provisions or decouple. One of the base-broadening provisions in the TCJA was a limitation on the interest expense that a taxpayer could deduct for federal income tax purposes.

One key TCJA change was codified in Sec. 163(j), limiting a company’s interest expense deduction to 30% of adjusted taxable income (ATI), thereby disallowing a deduction for a portion of a business’s interest. To help address the effects of the COVID-19 pandemic, the Coronavirus Aid, Relief, and Economic Security (CARES) Act, P.L. 116-136, was enacted on March 27, 2020. The CARES Act raised the Sec. 163(j) ATI limitation of the TCJA from 30% to 50%. Additionally, it provided an option to use 2019 ATI to compute the 2020 limitation, since many companies may experience dramatic decreases in income for the 2020 tax year. These CARES Act changes apply to tax years beginning in 2019 and 2020 (CARES Act §2306(a)).

State conformity to the Code: Rolling vs. static conformity states

Roughly 23 states and the District of Columbia have rolling conformity to the Internal Revenue Code for corporate income taxes, where the state’s definition of taxable income is automatically updated to the currently enacted Code. In general, these states will follow the most recent changes provided in the CARES Act. States with rolling conformity include Illinois and Massachusetts. The remaining 22 states with a corporate income tax have either a static conformity date or selective conformity to specific federal provisions. In states with a static IRC conformity date, each state follows the Code as of a specific date and requires a legislative update for federal changes to be applied in the state. States with static conformity include California with an IRC conformity date of Jan. 1, 2015, and Florida with a date of Jan. 1, 2019. In the third and smallest group are those with selective conformity, such as Arkansas or Mississippi, which conform only to certain provisions of the Code. As a result, much like in static conformity states, federal changes are not automatically adopted in these states either.

Do state adjustments from Sec. 163(j) under the TCJA automatically apply to Sec. 163(j) provisions under the CARES Act?

Following the enactment of the TCJA, many states decoupled entirely from the 30% ATI limitation of Sec. 163(j); Connecticut and Indiana are two examples. Additionally, other states provided a state modification to adjust the federal interest expense deduction — for example, Virginia, which allows a 20% state subtraction modification for federally disallowed interest expense. Depending on a state’s conformity method and its decoupling or modification adjustments, taxpayers could need to prepare five different interest expense deduction amounts for state income tax purposes:

• State-specific interest rules (Mississippi, e.g.);
• Interest expense under the pre-TCJA rules (e.g., California and Indiana);
• The TCJA’s 30% Sec. 163(j) limitation (Florida);
• The CARES Act’s 50% Sec. 163(j) limitation (Illinois); and
• State-specific modifications to the TCJA or CARES Act for Sec. 163(j) (Virginia).

It is also important to consider that previously allowed state interest expense deductions taken in 2018 tax years in states that decoupled from Sec. 163(j), such as California and Indiana, that were limited for federal purposes and carried forward, would need to make a state addition adjustment in the year the carryforward is claimed on the company’s federal tax return. The federal changes to the Sec. 163(j) rules added complexity for state income tax returns in the 2019, 2020, and future tax years. In addition to these state-specific Sec. 163(j) adjustments, taxpayers that have intercompany interest expense also need to layer on those state modifications, as a number of states disallow interest expense deductions for payments to related parties.

New York and Wisconsin CARES Act conformity

Many state legislative sessions have been suspended in 2020 due to the COVID-19 pandemic. As legislatures return to session, we expect that states’ approaches to CARES Act conformity may follow those in New York and Wisconsin. The following paragraph will demonstrate approaches states may take, using New York and Wisconsin as examples, to CARES Act conformity.

New York is a rolling conformity state that previously conformed to the federal Sec. 163(j) limitation under the TCJA (i.e., interest expense was limited to 30% of ATI). Therefore, New York had no state return modification related to interest expense. On April 3, 2020, New York passed a response to the CARES Act within its budget act (New York 2020—2021 Budget Act (including S.B. 7509-B/A.B. 9509-B, S.B. 7508B/A.B. 9508-B, and S.B. 7506B/A.B. 9506B)). The state specifically decoupled from the CARES Act provision increasing the interest expense limitation from 30% to 50% of federal ATI. As a result, for New York purposes, interest expense continues to be limited to 30% of federal ATI for tax years ending in 2019 and 2020. The same decoupling applies for New York City corporation and unincorporated business taxes.

Wisconsin is a static conformity state that previously decoupled from the Sec. 163(j) limitation under the TCJA (i.e., interest was not limited and was fully deductible in the year incurred). Therefore, Wisconsin had a favorable state tax return adjustment to deduct any interest that had been disallowed at the federal level. On April 15, 2020, Wisconsin enacted WI Act 185, which adopted a number of provisions from the CARES Act. Among those were the exclusion from income for cancellation of loans under the Paycheck Protection Program and the change to treat qualified improvement property as 15-year property for depreciation purposes. Wisconsin’s bill was silent regarding the CARES Act’s 50% ATI limitation for interest expense. As a result, Wisconsin (as a static conformity state with no legislation stating otherwise) will not conform to the 50% Sec. 163(j) limitation. Further, because Wisconsin previously decoupled from the 30% Sec. 163(j) limitation, taxpayers will continue to deduct interest expense as computed prior to the 30% or 50% Sec. 163(j) limitations.

When the legislatures come back

The TCJA included a number of measures to increase the federal income tax base while reducing the federal corporate income tax rate. One base-broadening provision in the TCJA was the 30% ATI limitation under Sec. 163(j). With the passage of the CARES Act, this limitation was increased to 50%, thereby reducing the federal taxable income base for 2019 and 2020 tax years. As a result, states that had adopted or decoupled from the Sec. 163(j) provisions may now be reviewing the new budgetary impacts of the reduced federal taxable income base, in light of new revenue constraints that are present in 2020. Many state legislatures have suspended their 2020 sessions and have not yet addressed conformity to the CARES Act. It is anticipated that, as legislatures meet in the second half of 2020, states’ approaches to CARES Act conformity will be driven by budget estimates and whether they can follow the reduction to the federal taxable income base while still balancing their budgets. In addition to CARES Act conformity decisions, states may also consider other revenue-raising provisions such as the suspension of state net operating loss deductions.

EditorNotes

Howard Wagner, CPA, is a partner with Crowe LLP in Louisville, Ky.

For additional information about these items, contact Mr. Wagner at 502-420-4567 or howard.wagner@crowe.com.

Contributors are members of or associated with Crowe LLP.