Recent developments involving limitations to state NOL usage

Editor: Greg A. Fairbanks, J.D., LL.M.

As businesses continue to recover from the pandemic, many have experienced dramatic economic difficulties that may ultimately manifest as operating losses. From a federal perspective, the law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97, in 2017 and the Coronavirus Aid, Relief, and Economic Security (CARES) Act, P.L. 116-136, in 2020 significantly changed the historic treatment of net operating losses (NOLs) for federal income tax purposes. The TCJA provisions, specifically, limit allowable NOL deductions to 80% of federal taxable income and lift the previously imposed 20-year limitation on carryovers. While the TCJA provisions disallow NOL carrybacks, the CARES Act temporarily and retroactively allows NOLs incurred in tax years beginning in 2018, 2019, or 2020 to be carried back five years or carried forward indefinitely, at the taxpayer’s election. From a federal standpoint, the CARES Act change was intended to grant taxpayers a degree of relief from the economic difficulties created by the pandemic.

As states have historically employed myriad ways to account for operating losses on a current basis, as well as unique carryover and carryback provisions, tracking the ability to utilize operating losses at a state level has long been a complex and time-consuming endeavor. Over the past two years, as states have reckoned with their own financial difficulties and decided whether and how to conform to the many significant tax provisions included in the TCJA and the CARES Act, NOL treatment has certainly not escaped notice. Some states, in efforts to address budgetary woes and maximize revenue, have acted to limit taxpayers’ ability to offset taxable income with recognized losses. This item focuses on legislative developments in California, Illinois, and Kansas, as well as judicial decisions in Pennsylvania and New Jersey, that highlight imposed limitations on NOL usage.

Legislative changes

Using legislation to craft policy, California, Illinois, and Kansas have recently enacted state-specific limitations on NOL usage.

California: In June 2020, California enacted legislation expected to raise $9.2 billion in taxes over a three-year period, in part by amending the California Revenue and Taxation Code to suspend the use of NOLs for most taxpayers for tax years beginning in 2020, 2021, and 2022 (Ch. 8 (A.B. 85), enacted June 29, 2020). This is not the first time California has acted to restrict the use of NOLs. California suspended NOLs from 2008 to 2011, during and after the Great Recession (Cal. Rev. & Tax. Code §§17276.21 and 24416.21). Specifically, the 2020 legislation adds provisions for both corporate and personal income tax purposes that together suspend the use of NOLs for most California taxpayers for tax years beginning in 2020, 2021, and 2022 unless they can qualify for limited small business exceptions. The NOL suspension does not apply if a corporate taxpayer has less than $1 million of income subject to tax for the tax year (Cal. Rev. & Tax. Code §24416.23(c)). Also, to compensate for the suspension, to the extent that the NOL utilization is denied by Cal. Rev. & Tax. Code Section 24416.23, a corollary extension of the NOL carryover period is provided for each year of disallowance (Cal. Rev. & Tax. Code §24416.23(b)). Similar rules apply for personal income tax purposes (Cal. Rev. & Tax. Code §§17276(b) and (c)).

Illinois: Illinois enacted a fiscal 2022 budget bill that includes a temporary limitation of its NOL carryover deduction (P.A. 102-0016 (S.B. 2017), Laws 2021). Specifically, the legislation limits C corporations to a deduction of $100,000 of NOL carryforwards for each tax year ending on or after Dec. 31, 2021, and prior to Dec. 31, 2024. Like California, this is not Illinois’s first foray into restricting NOL usage as a means to raise tax revenue and close its budget gap. Previously, a similar limitation applied for tax years generally ending in 2012 and 2013. If a corporation is affected by the limitation in a given year, that year will not be included in determining the 12-year carryforward period in which previously generated NOLs must be used.

Kansas: Kansas legislation enacted in 2021 changes the state’s treatment of NOLs so that losses incurred in tax years prior to Jan. 1, 2018, generally follow the federal treatment, except that the carryforward period is limited to 10 years (Kan. S.B. 50, Laws 2021). This change, which was included with other corporate income tax modifications as part of a significant bill imposing a sales tax collection and remittance requirement for remote sellers and marketplace facilitators, is the result of over three years of legislative efforts to respond to the increases in Kansas taxes due to federal income tax changes resulting from the TCJA. For NOLs incurred after Dec. 31, 2017, Kansas NOL deductions will follow the federal treatment, but may only be carried forward. Therefore, while Kansas NOLs incurred after Dec. 31, 2017, may now be carried forward indefinitely, the federal 80% limitation added by the TCJA and the CARES Act’s temporary suspension of this limitation for NOLs carried forward to 2019 and 2020 will apply for Kansas income tax purposes. By disallowing NOLs from being carried back and adopting the 80% TCJA limitation, Kansas’s legislation, like the legislation enacted by California and Illinois, imposes limits on taxpayers’ ability to use NOLs.

Judicial decisions

Courts in both Pennsylvania and New Jersey have recently considered disputes regarding the appropriate usage of losses to offset income in computing the corporate income tax.

Pennsylvania: It is important to recognize that challenges to Pennsylvania’s concept of an operating loss attribute, the net loss carryover (NLC), have resulted in several significant judicial decisions in recent years. Pennsylvania law generally allows corporate taxpayers to carry forward unused prior net losses to reduce the amount of taxable income subject to Pennsylvania corporate net income tax (CNIT) in future years. However, legislation enacted during an economic recession in the 1990s temporarily suspended the deduction before reintroducing it with a fixed-dollar limitation on the amount of net loss a taxpayer could claim. Subsequently, the Legislature amended the legislation to allow taxpayers to claim the greater of a fixed-dollar amount or a relatively small percentage of taxable income.

In 2017, the Pennsylvania Supreme Court addressed the constitutionality of the limitation and struck down the fixed-dollar limitation provision of the NLC statute as applied to the challenging taxpayer during the 2007 tax year (Nextel Communications of the Mid-Atlantic, Inc. v. Pennsylvania, 171 A.3d 682 (Pa. 2017)). In fashioning a remedy, the court severed the fixed-dollar cap from the NLC provision while retaining the percentage limitation. Subsequently, the Pennsylvania Department of Revenue issued a bulletin clarifying its policy to apply the remedy only on a prospective basis, to tax years beginning on or after Jan. 1, 2017 (Corporation Tax Bulletin 2018-02, Net Operating Loss Deduction (NOL): Application of Nextel Communications v. Commonwealth (May 10, 2018)).

In addressing the most recent challenge to the NLC statute during 2021, an intermediate appellate court, the Commonwealth Court of Pennsylvania, found that a taxpayer was not entitled to a refund of CNIT paid for the 2014 tax year when the taxpayer’s use of NLCs was limited by the state’s percentage limitation for net loss deductions (Alcatel-Lucent USA Inc. v. Pennsylvania, No. 803 F.R. 2017 (Pa. Commw. Ct. 9/13/21)). In denying the refund, a three-judge panel found that the Pennsylvania Supreme Court’s decision in Nextel does not require a retroactive elimination of the percentage limitation based on the taxpayer’s income. Instead, the court ruled that prospective application of Nextel to the taxpayer’s facts did not violate the Uniformity and Remedies clauses of the Pennsylvania Constitution, or the Due Process and Equal Protection clauses of the U.S. Constitution. Thus, Pennsylvania was free to apply its NLC percentage limitation. The next chapter in the NLC interpretive saga is likely to come soon, with the Pennsylvania Supreme Court currently considering an appeal of General Motors Corp. v. Pennsylvania, 222 A.3d 454 (Pa. Commw. Ct. 2019), in which the applicability of Pennsylvania’s flat-dollar limitation to the taxpayer is at issue.

New Jersey: Addressing an attempt by the New Jersey Division of Taxation to disallow the usage of NOLs, the New Jersey Tax Court recently found that the division may not disallow NOLs generated in closed tax years and carried forward to an open tax year under an audit examination (R.O.P. Aviation, Inc. v. Director, Division of Taxation, No. 01323-2018 (N.J. Tax Ct. 5/27/21)). Specifically, the N.J. Tax Court found the division’s adjustment of NOL carryforwards created in closed years was tantamount to the adjustment of income reported in those years, thus constituting an impermissible “audit” for closed years outside the state’s four-year statute of limitation. The decision confirms that the division cannot adjust NOLs generated in tax periods falling outside the four-year statute of limitation and carried forward to offset income in open tax years that are audited. Further, it clarifies that NOLs from tax years that are otherwise closed cannot be disallowed even when they impact the computation of income for open years. The division may still appeal this determination.

Limitations on NOL usage will continue

The recent legislative changes and court decisions in California, Illinois, Kansas, New Jersey, and Pennsylvania highlight states’ continuing efforts to limit the use of NOLs in efforts to raise revenue and balance their budgets in these challenging times. As the economic effects of the pandemic continue to evolve, there is little reason to believe that the states will become more beneficent with respect to the application of state operating loss attributes. Instead, a spotlight is likely to remain on the ever-changing landscape of NOL treatment for state income tax purposes, and these recent developments merely evidence a need to remain vigilant. Taxpayers in loss positions should continue to identify and evaluate the impact of these and other amendments to their anticipated usage of state NOLs for both cash flow and tax provision purposes.

EditorNotes

Greg A. Fairbanks, J.D., LL.M., is a tax managing director with Grant Thornton LLP in Washington, D.C.

For additional information about these items, contact Mr. Fairbanks at 202-521-1503 or greg.fairbanks@us.gt.com.

Contributors are members of or associated with Grant Thornton LLP.