Handle With Care: Navigating the State Tax Pitfalls for Corporate Taxpayers Claiming NOL Deductions Under the CARES Act

The temporarily expanded availability of net operating loss deductions (NOL) under the CARES Act comes as welcome news to businesses in the wake of the economic hardships resulting from the COVID-19 pandemic. How claiming this federal tax relief will impact state tax returns depends on a variety of factors and could, in some cases, trigger additional filing requirements.

In response to economic hardship created by the COVID-19 pandemic, the federal government enacted the Coronavirus Aid, Relief, and Economic Security Act (CARES Act) to provide relief to taxpayers. As part of this relief, the CARES Act temporarily loosened the restrictions on the utilization of NOLs, which applied to tax years beginning on or after 2018 under the Tax Cuts and Jobs Act.

Specifically, the CARES Act allows federal taxpayers to:

• utilize NOLs to offset income without the 80% limitation in taxable years beginning prior to January 1, 2021; and
• carryback NOLs generated in taxable years beginning on or after January 1, 2018 and ending on or before December 31, 2020 (i.e., 2018, 2019, and 2020 tax years) to fully offset taxable income in the five prior tax years.

The federal impact of the NOL carryback provision is significant because it allows taxpayers to reduce taxable income that was taxed at the pre-2018 35% tax rate. As many taxpayers move toward amending their federal tax returns to take advantage of the benefits and potential refunds under the CARES Act, there are a number of state and local tax considerations to keep in mind.

While the changes to the NOL rules under the CARES Act will likely result in significant federal income tax savings for many taxpayers, the state tax ramifications depend on a variety of factors. Determining the availability of an NOL deduction in a particular state requires understanding the jurisdiction’s conformity to the Internal Revenue Code (Code) as well as each state’s laws addressing NOLs.

In some cases, the interaction between NOL carryovers and income inclusions for global intangible low-taxed income (GILTI) could result in a tax increase at the state level. Add to this the issues that arise as a result of the taxpayer filing on a federal consolidated basis while filing in states on separate or combined basis and the risk for errors increase significantly.

Accordingly, taxpayers filing amended federal tax returns to take advantage of the CARES Act NOL provisions could also trigger additional state tax filing requirements, which vary by jurisdiction and could result in significant penalties.

State Conformity to the Internal Revenue Code

The approach each state takes in adopting the Code is determinative in whether it will follow the temporary changes to the federal NOL rules under the CARES Act. States generally adopt the Code on either a static conformity or a rolling conformity basis. Static conformity states adopt the Code as of a specific date. Such states are automatically precluded from adopting the changes under the CARES Act unless the state enacts legislation aligning its tax code with the current federal tax laws. Rolling conformity states, on the other hand, automatically conform to the Code as new provisions are enacted. Barring specific action from these states, they will follow the CARES Act.

However, the analysis does not end with state conformity. Even if a state conforms with the current version of the Code, it may choose not to follow (decouple) from a specific federal provision. The majority of the states, both static and rolling, do not allow NOL carrybacks. Further, of the states that do permit carrybacks, many have limitations on either the carryback period or the dollar amount that can be utilized. As a result, few states will allow a full five-year carryback as permitted by the CARES Act. States that disallow or partially allow NOL carrybacks will likely require taxpayers to add back to state income amounts deducted for NOL carrybacks at the federal level.

GILTI Considerations

Carrying back a federal NOL to years 2018 and 2019 could potentially reduce the amount of a taxpayer’s allowable deduction for GILTI inclusions and foreign-derived intangible income (FDII). A taxpayer must have taxable income (inclusive of any NOL deduction) to be eligible to claim a Sec. 250 deduction. Under Sec. 250(a)(2), if a taxpayer’s GILTI and FDII, exceeds taxable income (including NOLs), the amount of such Sec. 250 deduction available to the taxpayer will be reduced. If a taxpayer’s NOL carryback were to reduce taxable income to zero, then there would be no Sec. 250 deduction available. In states that adopt the GILTI provisions and the rules under Sec. 250 but not the NOL provisions of the CARES Act, a federal NOL carryback could result in additional tax at the state level because the state return will have a reduced GILTI deduction with no corresponding NOL deduction.

State Tax Filing Requirements

Although taxpayers may not receive any benefits at the state level, many states still require that federal changes on an amended tax return be reported to the state, whether by notifying the state of the federal changes, or by filing amended state returns. Failure to comply may result in penalties. To further complicate matters, states may have amended their specific NOL carryback rules during the federal five-year carryback period, thus requiring different treatment of the carryback in different years. Additionally, the filing of an amended state return in itself poses a risk, as it could extend or reopen the statute of limitations in that tax year. In certain instances, amending a state return may actually result in liability for additional state taxes.

The Takeaway

While the federal CARES Act provides significant benefits to taxpayers, it also presents various risks at the state level. Because each state is unique with regard to their specific rules on conformity to the Code, NOL carrybacks, and the tax treatment of GILTI, we strongly recommend that taxpayers reach out to the Andersen SALT team to determine the optimal filing position.