The Coronavirus Aid, Relief, and Economic Security (CARES) Act, signed into law on March 27, is providing critical relief to individuals and businesses that have been economically impacted by the COVID-19 pandemic. In addition to providing financial assistance to individuals and loans to businesses, the CARES Act made several structural adjustments to the tax code to facilitate a smoother economic recovery.
Because states, to varying degrees, use the Internal Revenue Code (IRC) as the starting point for their own taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. codes, some of the CARES Act’s largely temporary tax changes will flow through to states. Normally, conforming with the most up-to-date version of the IRC is routine business without much fanfare, which is why many states conform on a rolling basis.
However, most states are experiencing severe revenue shortfalls amid the pandemic. Stay-at-home orders, business closures, and social distancing guidelines have had a significant negative impact on consumption and employment, and, in turn, sales and income tax revenues. While some states may have difficulty finding the revenue to conform to all the federal tax changes made by the CARES Act, states should take stock of the unintended consequences that would occur should they decouple, including added state tax complexity and a reduction in net value, for in-state taxpayers, of the federal relief being provided.
As policymakers continue evaluating their evolving revenue and spending options, the importance of enacting policies that enhance business liquidity must remain at the forefront.
When considering conformity legislation, states should make every effort to conform to the CARES Act’s tax relief provisions, with priority given to those that were designed to restore much-needed liquidity to struggling businesses. In particular, provisions related to net operating losses, business interest deductibility, the Paycheck Protection Program, and the cost recovery treatment of qualified improvement property offer critical cash flow assistance to struggling businesses and provide immediate economic relief in a structurally sound manner. Conforming with the provisions described below will facilitate a smoother economic recovery, ensuring as many employers as possible can remain in business and rehire the millions of Americans who have lost their jobs in recent months.
Net Operating Loss (NOL) Carrybacks and Carryforwards
Under the CARES Act, businesses that incur net operating losses this year—or did so in 2018 or 2019—can deduct those losses against up to five years’ worth of past profitability. This means that if a business is unable to turn a profit this year, it can file an amended return for prior years and receive a near-immediate refund of some of its past income taxes paid. The CARES Act allows NOL carrybacks for 2018 and 2019 as well as 2020 because 2018 and 2019 are the only years in recent history in which carrybacks were disallowed. (To help offset the cost of other reforms, the 2017 federal tax reform law repealed the longstanding two-year carryback provision that existed prior to 2018.) Offering NOL carrybacks is one of the most valuable tax policy decisions states can make to help struggling businesses during these unprecedented economic times.
In addition, the Tax Cuts and Jobs Act’s (TCJA) NOL carryforward limitation—which prevents taxpayers from using NOLs to offset more than 80 percent of taxable income in any given year—has been suspended for tax years 2018, 2019, and 2020. Under the CARES Act, for the specified years, NOLs may be carried forward with no limit on the extent to which they offset a business’s tax liability. This provision will allow businesses that have recently incurred losses to deduct a greater share of those losses immediately when they otherwise would have to carry more of those losses forward to future years.
Finally, the TCJA limited the amount by which active owners of pass-through businesses may use NOLs to offset non-business income to no more than $250,000 for single filers and $500,000 for joint filers. The CARES Act removes the excess business loss limitation for 2020 (as well as for the previous two years in which it was in effect, 2018 and 2019). Since, by definition, the business income of a pass-through businessA pass-through business is a sole proprietorship, partnership, or S corporation that is not subject to the corporate income tax; instead, this business reports its income on the individual income tax returns of the owners and is taxed at individual income tax rates. owner “passes through” to his or her individual income tax return, it makes sense that all income be treated equally for purposes of taxation and that the business owner not be penalized for having income from other sources, such as another job or interest income.
By temporarily loosening the TCJA’s NOL restrictions, the CARES Act restores liquidity to the businesses that need it most, ensuring more firms will be able to continue operations, rehire their employees, and return to profitability (and pay taxes on those profits) after the public health crisis abates.
It is important to note, however, that even when the economy is not in a state of crisis, NOL deductions are an important structural component of any income tax, whether federal, state, or even local. By definition, business income taxes are designed to tax a business’s net income, or profits. An income tax does this most neutrally when it attempts to capture a business’s average profitability over time rather than a mere snapshot of the business’s income in any given year. When stingy NOL policies prevent business owners from fully deducting their losses from taxable incomeTaxable income is the amount of income subject to tax, after deductions and exemptions. For both individuals and corporations, taxable income differs from—and is less than—gross income. , a taxpayer whose profits fluctuate from year to year will end up paying higher effective tax rates than a taxpayer whose year-to-year profits are more stable, even if the two taxpayers earn the same amount of net income over time.
Business Interest Deduction
Another important structural feature in federal and state tax codes is the deduction for business interest expenses. Ideally, when businesses take out loans and pay interest on those loans, those interest payments, like other business expenses, ought to be fully deductible when calculating taxable income. However, one of the “pay-fors” in the TCJA was a provision under Section 163(j) that limited interest deductibility to 30 percent of earnings before interest, taxes, depreciation, and amortization (EBITDA) for the first four years and to 30 percent of earnings before interest and taxes (EBIT) starting in 2022. For tax years 2019 and 2020, the CARES Act lifts this cap to 50 percent of EBITDA.
Although the restriction on the net interest deduction was intended in part to reduce a disparity in the treatment of debt versus equity financing, it also increases the cost of capital investment. The CARES Act provision raising the 163(j) cap is designed to help businesses that have to take out loans due to COVID-19, ensuring they will be able to deduct from taxable income a greater share of their total expenses.
Paycheck Protection Program
The CARES Act’s Paycheck Protection Program (PPP) was designed to help employers avoid laying off their employees during the pandemic. Specifically, the PPP provides 100 percent federally backed loans to help small businesses continue making payroll, rent, mortgage, and utility payments, among others, during the crisis.
Under the PPP, loan forgiveness is available to qualifying loan recipients that retain their employees and sufficiently avoid pay cuts during the pandemic. Under normal federal income tax law, when a loan is forgiven, the amount of canceled indebtedness is considered income for purposes of taxation. However, taxing forgiven PPP loans would reduce the value of the benefit Congress chose to provide, so under the CARES Act, PPP loans are excluded from income and will not be subject to income taxes at the federal level.
However, at the state level, there remains a great deal of uncertainty as to whether states will carry this exclusion into their own tax codes due to the CARES Act’s amendment of the definition of “gross incomeFor individuals, gross income is the total pre-tax earnings from wages, tips, investments, interest, and other forms of income and is also referred to as “gross pay.” For businesses, gross income is total revenue minus cost of goods sold and is also known as “gross profit” or “gross margin.” ” being made from outside the tax code rather than directly to the IRC. As a result, even in a state that conforms to the CARES Act’s changes to the IRC on a rolling or static basis, conformity alone will not necessarily bring in this ancillary provision.
States do, however, typically bring in any Treasury Department guidance from the year of the IRC to which they conform, and they often rely on the current calculation of federal adjusted gross income as their own starting point even without specifically conforming to all the provisions in federal law which inform that calculation. As such, it is likely that many states will indeed bring in the income exclusion, but since conformity alone does not guarantee such an exclusion, it would make sense for every state with an income tax to clarify its intended policy regarding the taxation of forgiven PPP loans.
It is also important to note that, unlike other CARES Act provisions, conforming to the federal income exclusion for PPP loan forgiveness will not reduce state revenue (since states had not counted on the existence of this income), so it is easier for states to offer this same relief at the state level. States that do not conform to the CARES Act—either because they remain conformed to a prior year’s version of the IRC or because they are choosing to decouple from various provisions—ought to be careful in how they address this provision so as to avoid accidentally taxing forgiven loans.
Separately, while the CARES Act specifies that forgiven PPP loans will not be taxed as income at the federal level, current Treasury Department guidance has clarified that taxpayers who receive loan forgiveness under the PPP will not be eligible to deduct certain payroll, rent, and other expenses from income if those expenses were covered by a forgiven PPP loan. The worst possible outcome, then, would be for a state to conform to the expense addback while simultaneously decoupling from the income exclusion, as this would result in states double-taxing forgiven PPP loans (both taxing the forgiven amounts as income and disallowing the associated expenses). This would undermine the federal benefit a business receives from retaining its employees under the PPP program’s rules and is contrary to the bipartisan spirit in which the CARES Act sought to minimize financial hardship for taxpayers during these unprecedented economic conditions.
“Retail Glitch” Fix
Finally, the CARES Act made an important technical correction to the cost recoveryCost recovery is the ability of businesses to recover (deduct) the costs of their investments. It plays an important role in defining a business’ tax base and can impact investment decisions. When businesses cannot fully deduct capital expenditures, they spend less on capital, which reduces worker’s productivity and wages. treatment of qualified improvement property (QIP), fixing a clerical error in the TCJA—known as the “retail glitch”—which prevented certain investments from qualifying for 100 percent bonus depreciation. The error increased the after-tax cost of investing in interior improvements and remodeling, such as the installation of new flooring, lighting, and sprinkler systems, subjecting those types of property to a much longer-than-intended cost recovery period.
After the TCJA was enacted, many states conformed to the TCJA’s pro-growth full expensing provisions under IRC Section 168(k), but in so doing, brought the “retail glitch” into their own tax codes. States should therefore prioritize conforming to this CARES Act correction, removing the error’s unintended negative impact on retailers, restaurants, movie theaters, and other businesses that rely heavily on interior investments (many of which are facing severe financial difficulty during this time). Conforming to this change will allow businesses to deduct those investments in the year they are made instead of incrementally over years or even decades.
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