CARES Act May Create More Complexities for States

On March 27 President Trump signed into law a federal stimulus bill (the Coronavirus Aid, Relief, and Economic Security (CARES) Act, H.R. 748) designed to provide Americans relief from the economic impact of COVID-19. The CARES Act amends the federal interest expense deduction limitation in IRC section 163(j), enacted as part of the Tax Cuts and Jobs Act. Many states conform to the interest expense deduction limitation in section 163(j) and, as we discussed in our January article,¹ this state conformity can result in substantial complexities for taxpayers from a compliance perspective. In some states, the CARES Act amendments may complicate administration of section 163(j) even more.

At a high level, under section 163(j) a taxpayer’s deduction of business interest is generally limited to an amount equal to the business interest income for the year plus 30 percent of the adjusted taxable income for the year. The CARES Act changes the 30 percent limitation to 50 percent for tax years beginning in 2019 and 2020.² It also allows a taxpayer to elect to use its 2019 income to compute the interest expense deduction limitation for 2020.

From a state corporate income tax perspective, the states that conform to section 163(j) should allow this increased expense allowance, but only if the state law has rolling conformity to the IRC. In static conformity states (that is, states that conform to the IRC in effect on a specific date), the CARES Act amendments would not flow through to the state unless it updates its conformity to the IRC and applies the updated conformity retroactive to 2019. This presents a significant issue in static conformity states that conform to section 163(j). In those states, not only will taxpayers not get the benefit of the increased interest expense allowance unless the states update their laws for 2019 and 2020, but the nonconformity will cause even more of a compliance burden at the state level.

The issue is best illustrated with an example. Virginia is a static conformity state that conforms to the IRC as in effect December 31, 2019.³ Virginia conforms to section 163(j) but also allows a state deduction equal to 20 percent of the amount disallowed at the federal level under section 163(j).⁴ Guidance issued by the Virginia Department of Taxation provides that in administering the section 163(j) limitation, the limitation must be recomputed based on the separate-entity Virginia filer or based on the group that files a combined return (which is called a consolidated return) in Virginia.⁵ So, assuming Virginia does not update its conformity, the taxpayer would have to both recompute the federal limitation using the 30 percent limitation to determine the 20 percent expense allowance that Virginia will allow and then also recompute the state limitation on a separate-entity or Virginia filing group basis. Of course, the process will be complicated even further if the taxpayer elects to compute the federal section 163(j) limitation in 2020 based on 2019 income. Simply put, this is an administrative nightmare. Thankfully, Virginia updates its IRC conformity regularly, but to give taxpayers full relief on this issue, the legislature would have to update its conformity to the IRC effective retroactively to 2019.

While the section 163(j) amendments in the CARES Act do provide some relief for taxpayers at the federal and possibly the state level, they also result in more compliance difficulties at the state level. As a result of the CARES Act, multistate taxpayers may have to compute their section 163(j) limitations in several ways:

• the section 163(j) limitation as it applied under the IRC before the CARES Act amendments for states that do not conform to the IRC as amended by the CARES Act;

• recomputation of the former section 163(j) limitation based on the state taxpayer or filing group in states that do not conform to the IRC as amended by the CARES Act;

• the section 163(j) limitation as amended by the CARES Act and reported for federal purposes in states that conform to the IRC as amended by the CARES Act; and

• recomputation of the current section 163(j) limitation based on the state taxpayer or filing group in states that conform to the IRC as amended by the CARES Act.

Oh, and don’t forget, carryforward of disallowed interest expense amounts must be tracked state by state as well. It is certainly ironic that conformity to the IRC was intended for simplicity’s sake.

There are several static conformity states that conform to section 163(j), so it will be interesting to see how the taxing authorities respond to the section 163(j) amendments in the CARES Act. As we’ve said before, decoupling from section 163(j) avoids much complexity from a state tax perspective. If states needed a push to decouple from section 163(j) . . . this may be it.