Editor: Greg A. Fairbanks, J.D., LL.M.
Analyzing state conformity to the Internal Revenue Code (IRC) always has been a challenge to corporate income taxpayers tracking the issue on a multistate basis, due to historically different state approaches on this issue. But the confluence of tax reform and the pandemic in the past four years has made this challenge especially daunting.
In late 2017, the law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97, made numerous significant changes to the IRC that directly affected state and local taxes. In March 2020, the Coronavirus Aid, Relief, and Economic Security (CARES) Act, P.L. 116-136, was quickly enacted to provide tax relief in response to the COVID-19 pandemic. The CARES Act included temporary, and in some cases permanent, changes to some of the key TCJA provisions. Subsequent major federal laws such as the Consolidated Appropriations Act, 2021 (CAA), P. L. 116-260; the American Rescue Plan Act of 2021 (ARPA), P.L. 117-2; and the Inflation Reduction Act of 2022, P. L. 117-169, were enacted, albeit with somewhat less dramatic impacts on state and local taxes.
In response to these provisions, states have taken a variety of approaches concerning federal conformity, and they have adopted a considerable amount of legislation and interpretive guidance. Given the numerous approaches taken and the ability of each state to develop its own position on what constitutes a feasible corporate tax structure, the policies adopted by the states are far from uniform, tend to be very complex, and in some cases vary in a particular state from year to year. This item reviews the most significant provisions of the TCJA and CARES Act affecting state corporate tax regimes and discusses state conformity issues that should be addressed by corporate taxpayers.
State conformity approaches
As a threshold question, taxpayers must consider how a state generally conforms to the IRC. To the extent the IRC changes, state conformity varies based on the manner in which each state’s laws interact with the IRC. Rolling conformity states such as Illinois, New Jersey, New York, and Pennsylvania automatically adopt the IRC as currently in place. Static conformity states such as Florida, Georgia, North Carolina, and Virginia adopt the IRC as of a certain date and generally enact legislation each year to advance their IRC conformity. A few states such as Arkansas, Colorado, and Oregon follow a selective conformity or distinctive approach by adopting only selective portions of the IRC, with the state tax code conforming to, or decoupling from, specific IRC provisions.
Rolling conformity states generally automatically adopted the TCJA and CARES Act, but in many cases, states evaluated and eventually decoupled from certain aspects of these laws. Likewise, while most static conformity states have advanced their IRC conformity date past the TCJA and CARES Act enactment dates, these states have not wholly followed the TCJA and CARES Act provisions. For those states that decide to conform to the TCJA and CARES Act, doing so does not guarantee that such laws apply for all years in which such provisions were in effect. For example, in April 2022, Kentucky enacted legislation that advanced its IRC conformity date from Dec. 31, 2018, to Dec. 31, 2021, for tax years beginning on or after Jan. 1, 2022 (Ky. Ch. 212 (H.B. 8), Laws 2022). As a result, Kentucky generally adopts the CARES Act beginning with the 2022 tax year, which means that the temporary changes to the TCJA made under the CARES Act generally do not apply.
A few states continue to follow a version of the IRC prior to the CARES Act or even prior to the TCJA. California adopts the IRC as of Jan. 1, 2015, and Texas adopts the IRC as of Jan. 1, 2007, so these states do not conform to most provisions in the TCJA or CARES Act. Minnesota and New Hampshire both adopt the IRC as in effect on Dec. 31, 2018, prior to the CARES Act. Michigan adopts the IRC as in effect on Jan. 1, 2018, but taxpayers may elect to use the current IRC that incorporates the TCJA and CARES Act.
Major conformity issues
Four of the most significant state conformity issues resulting from the TCJA and CARES Act relate to the treatment of: (1) bonus depreciation; (2) the Sec. 163(j) business interest expense deduction limitation; (3) the Sec. 179 cost recovery deduction; and (4) net operating losses (NOLs).
Bonus depreciation deduction:
The TCJA amended Sec. 168(k) to provide 100% bonus depreciation for property placed in service after Sept. 27, 2017, and before Jan. 1, 2023. The bonus depreciation rate then phases down for the next five years as follows: 80% in 2023, 60% in 2024, 40% in 2025, 20% in 2026, and 0% beginning with the 2027 tax year. The CARES Act included a retroactive technical correction to make qualified improvement property (QIP) eligible for the TCJA’s 100% bonus depreciation provision.
Given the significant effect on the tax base in the year in which taxpayers purchase qualifying property, many states do not conform to the TCJA’s 100% bonus depreciation, either by rejecting the concept out of hand or applying their own state-specific depreciation method. For those states that do follow the federal approach, the phaseout of 100% bonus depreciation beginning in 2023 will be an issue to watch. These states will need to decide whether to continue to follow federal law and phase out bonus depreciation or decouple from federal law and retain a full bonus depreciation policy.
Oklahoma addressed this issue in 2022 by enacting legislation providing taxpayers with the option of immediate and full expensing for qualified property and QIP for tax years beginning after Dec. 31, 2021 (Okla. H.B. 3418, Laws
. Other states that wish to maintain front-loaded deductions may follow a similar approach.
Interest deduction limitation:
Under Sec. 163(j), the TCJA generally limits the deduction for net business interest expense in excess of interest income to 30% of adjusted taxable income (ATI) plus floor plan financing interest for tax years beginning in 2018 and thereafter. The CARES Act temporarily increased the ATI percentage threshold from 30% to 50% for tax years beginning in 2019 and 2020 and allowed taxpayers to elect to use their 2019 ATI for purposes of calculating their allowable interest expense deduction in 2020.
As for the state tax implications of Sec. 163(j), some states have decoupled from Sec. 163(j) and allow a 100% business interest deduction. Other states conformed to the TCJA’s 30% limitation but did not conform to the temporary 50% limitation under the CARES Act. A third group of states conformed to the CARES Act and temporarily increased the limitation to 50%. As a result, a state’s Sec. 163(j) limitation and carryforward to future years may differ from the federal limitation, in some cases dramatically. Separate calculations may be required in separate company reporting states and those states where the filing group differs from the federal consolidated group.
Taxpayers also must consider relatedparty addback rules and their interplay with the Sec. 163(j) limitation. In some situations, a related-party addback may substantially reduce or eliminate the available interest expense deduction. Taxpayers need to determine how to calculate the interest deduction when both provisions apply to interest that is paid. A few states have enacted legislation or issued guidance on the related-party addback issue. In states such as Alabama, Illinois, New Jersey, and Pennsylvania, the Sec. 163(j) limitation is applied before considering the state related-party interest limitations.
Massachusetts, however, follows a different approach (Mass. Dep’t of Rev., Technical Information Release 19-17 (Dec. 18, 2019)). The addback adjustments to a member’s separately determined Massachusetts business interest expense must be made at the separate-entity level on a pre-apportioned basis. Where an addback is required, the Massachusetts business interest expense deduction is determined after first reducing the current-year business interest expense by the amount of the required addback. Any amount of business interest expense that is disallowed due to a Massachusetts addback may not be deducted in the current year or carried forward.
Sec. 179 cost recovery deduction:
Under Sec. 179, taxpayers may deduct the cost of certain property as an expense when the property is placed in service. For tax years beginning after 2017, the TCJA increased the maximum Sec. 179 expense deduction from $500,000 to $1 million, and the phaseout threshold was increased from $2 million to $2.5 million. These amounts are indexed for inflation for tax years beginning after 2018. The deduction applies to tangible personal property such as machinery and equipment purchased for use in a trade or business and, if the taxpayer elects, qualified real property.
While many states conform to the increased expensing limitation, there are notable exceptions, including California, Kentucky, Maryland, New Jersey, and North Carolina. If a state conforms to the current version of Sec. 179 with the increased limitations, taxpayers are more likely to use this provision because the potential deduction is much greater. For this reason, the deduction becomes more attractive for larger businesses in the year in which the asset is purchased.
In 2022, Arkansas enacted legislation changing its conformity to Sec. 179 (Ark. Act 2 (S.B. 1), 2022 Third Extra. Session). For tax years beginning on or after Jan. 1, 2022, Arkansas adopts Sec. 179 as in effect on Jan. 1, 2022, for purposes of computing state tax liability for property purchased in tax years beginning after 2021. Prior to this legislation, Arkansas had adopted Sec. 179 as in effect on Jan. 1, 2009, for property purchased in tax years beginning after 2013. This legislation should benefit taxpayers in Arkansas because it substantially increases the available Sec. 179 deduction by conforming to current federal law.
Under Sec. 172, the TCJA limits the deductibility of NOLs generated in tax years beginning after Dec. 31, 2017, to 80% of taxable income, with no carryback and an unlimited carryforward. Federal NOLs generated prior to 2018 remain subject to a two-year carryback and a 20-year carryforward. The CARES Act temporarily suspended the 80% limitation to allow federal NOLs to be fully deductible for tax years beginning in 2018, 2019, or 2020 and allows the carryback of any NOL generated in one of these tax years for up to five years.
State conformity to the federal NOL provisions is particularly inconsistent and follows a variety of approaches. Some states use taxable income before the federal NOL deduction to determine state taxable income and then provide a different state-specific NOL. Other states initially include the federal NOL in the tax base but require the federal NOL to be added back, with a state-specific NOL subtraction.
A large number of states, even those that generally conform to federal NOL concepts, disallow NOL carrybacks and do not always conform to federal carryforward provisions. In light of the temporary and permanent federal NOL changes, state NOL attributes are likely to become even further removed from their federal NOL counterparts. In many cases, these differences may lead to situations in which taxpayers may have surprisingly large state tax liabilities, even in tax years in which federal tax liability is low or nonexistent due to the application of federal NOLs.
Other conformity issues
In addition to the four major IRC conformity issues discussed above, other tricky state conformity issues are worth considering as a result of the TCJA and the CARES Act, including those involving global intangible low-taxed income (GILTI), foreign-derived intangible income (FDII), and the tax treatment of grants.
GILTI and FDII: For tax years beginning after Dec. 31, 2017, the TCJA imposes additional taxes on income classified as GILTI (Secs. 951A and 250) . GILTI is a shareholder’s net controlled foreign corporation income minus the shareholder’s net deemed tangible income return. A 50% deduction for this income is provided. In addition, a special deduction of 37.5% of FDII is allowed for federal purposes (Sec. 250). FDII represents a corporation’s intangible income from serving foreign markets.
GILTI and FDII are complex topics, and there is little state uniformity in this area. Because these concepts have been in place since the advent of the TCJA, states have had the opportunity to address and release guidance regarding the state tax treatment of these items for some time. Yet the treatment of these issues remains unclear in some states, particularly with respect to whether the FDII deduction is available in cases in which GILTI is excluded from the income tax base. Further, in the relative minority of states in which GILTI is not offset by a foreign income or dividends-received deduction and is included in state taxable income, there is little state guidance on the proper representation of GILTI in the sales factor for apportionment purposes.
CARES Act grants: Amounts received pursuant to government grants often are subject to federal income tax unless specifically exempted. However, as a means to provide relief to businesses and individuals and to inspire economic growth, the CARES Act, CAA, and ARPA exempt many COVID-19–related grants from the federal income tax. While at first blush it may seem that such treatment should carry over to the states, taxpayers still need to determine whether a state follows this federal treatment, based on its conformity to the IRC.
Some states have enacted legislation or issued guidance excluding federal COVID-19–related grants from income. To the extent that a state includes these grants in the tax base, taxpayers must then consider whether, and if so, how, to reflect the amounts received in the sales factor. Conversely, taxpayers that have received state COVID-19–related grants should consider how such grants may be treated for federal income tax purposes.
Continuing importance of state conformity determinations
Despite the fact that the recent wave of major tax reform legislation directly impacting states began five years ago, the issue of state conformity to federal tax law has not dissipated and must be carefully considered. States take a variety of approaches in conforming to federal law and frequently decouple from significant IRC provisions. As a result, IRC conformity should be considered for each state, and major topics such as bonus depreciation and the Sec. 163(j) business interest expense deduction limitation must be closely examined. While differences in state conformity have resulted in significant additional burdens from a tax compliance perspective, there may be potential opportunities in revisiting positions taken in prior tax years that may still be open under the statute of limitation, given continually shifting guidance.
Greg A. Fairbanks, J.D., LL.M., is a tax managing director with Grant Thornton LLP in Washington, D.C. Contributors are members of or associated with Grant Thornton LLP. For additional information about these items, contact Mr. Fairbanks at 202-521-1503 or firstname.lastname@example.org.