Unmasking State Effects from the CARES Act
The Coronavirus Aid, Relief, and Economic Security Act (CARES Act) was signed into law on March 27, 2020, as an economic relief package to alleviate the financial strains of COVID-19. The CARES Act includes modifications to business tax provisions in the Internal Revenue Code (IRC). Currently (and in the future), these provisions present challenges for states to balance their tax relief via IRC conformity to these provisions versus revenue flows needed to avoid budget problems.
The tax treatment of the CARES Act provisions at the state level will depend on how each state conforms to the IRC. Lack of conformity with the IRC and inconsistencies between states create additional complexities and compliance burdens for taxpayers. Conformity with the IRC can be defined in three general categories:
- Rolling conformity automatically references the IRC currently in effect and will, therefore, conform to the CARES Act, unless the state passes decoupling legislation. Most states are rolling conformity; however, several states have already decoupled from certain CARES Act provisions.
- “Static” or fixed-date conformity refers to the IRC as of a specific date. Again, states may decouple from specific provisions as they update their conformity laws.
- Specific reference conformity to the IRC is done on a section-by-section basis, allowing the state to selectively choose how and what to conform to.
The following is an overview of key tax provisions within the CARES Act and how they may affect taxpayers at the state level.
Net Operating Loss (NOL)
The CARES Act suspends the 80 percent of taxable income limitation on federal NOLs under IRC Section 172(a) for tax years beginning in 2018, 2019, or 2020. The CARES Act also amends IRC §172(b) to permit a five-year NOL carryback for losses arising in tax years beginning after December 31, 2017, and before January 1, 2021. Most states don’t allow federal NOLs and provide their own specific NOL provisions. When determining any associated state effect, taxpayers should consider whether a state conforms to IRC §172.
Business Interest Expense
For tax years beginning in 2019 and 2020, the CARES Act increases the IRC §163(j) limitation on the deduction of business interest from 30 percent to 50 percent of adjusted taxable income, and taxpayers may elect to substitute their adjusted taxable income from their tax year 2019 for the 2020 tax year in applying this limit. For state tax purposes, taxpayers will need to consider not only if a state conforms to IRC §163(j) but also state-imposed, related-party interest expense disallowance rules and complications involved in determining the calculation on a separate or combined basis that may be different than federal.
Qualified Improvement Property (QIP)
The CARES Act includes a retroactive correction to treat QIP as 15-year property (formerly 39-year), thus making it eligible for 100 percent bonus depreciation under IRC §168(k). QIP required to use an alternative depreciation system has a 20-year class life. For state purposes, taxpayers must consider whether a state conforms to federal bonus depreciation and/or what adjustments may be needed due to property class life changes. This provision may add computation complexities and additional tracking issues. Further, adjusting the class life for QIP may require accounting method change filings.
Paycheck Protection Program (PPP)
The PPP allocated billions in loans to small businesses affected by the economic fallout of COVID-19. Under the terms of the program, the debt may be forgiven in whole or in part if the business meets specific requirements. The canceled debt is excluded federal taxable income, but the IRS does require taxpayers to reduce their business expense deductions paid using forgiven loan proceeds. The income exclusion isn’t provided by an IRC amendment, but rather by a congressional direction in an “off code” part of the CARES Act. Since the exclusion isn’t codified within the IRC, for state tax purposes, taxpayers must consider whether a state follows the exclusion based on specific state law, the state definition of taxable income, or if the cancellation of debt would fall under the normal exclusion within IRC §108.
Federal Employee Retention Credit
The CARES Act provides a temporary refundable employee retention credit for employers subject to business suspension or whose gross receipts have significantly declined due to COVID-19. Taxpayers that receive this federal credit will have a corresponding adjustment to the amount of deductible payroll taxes under IRC §280(a). Any reduction in payroll tax expense will increase a taxpayer’s federal income tax base and, depending on state conformity, could result in an increased tax base for state income tax purposes without a corresponding credit.
Payroll Tax Deferral
The CARES Act allows taxpayers to defer the employer’s portion of Social Security tax incurred during the period from March 27 to December 31, 2020, with half of deferral due by December 31, 2021, and the remainder paid by December 31, 2022. Similar to the employee retention credit, this creates a potential reduction in payroll tax expense. Timing on the payroll tax deduction for both federal and state tax purposes depends on if the taxpayer is cash basis, accrual basis, or has made the recurring item exception for payroll taxes.
In summation, the CARES Act was designed to provide fast and direct economic assistance to American taxpayers and help preserve jobs. However, these provisions will present a new round of state and federal conformity challenges for states, taxpayers, and practitioners. As a result, taxpayers will need to monitor state conformity and responses to the CARES Act tax provisions.
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