Rebecca Roman and Sasha Timakova are students at the University of Chicago Law School.
In this installment of Classroom Corner, the authors argue that Illinois and other rolling conformity states should amend their tax codes to decouple from the IRC section 461(l) deferral of loss limitations.
Copyright 2020 Rebecca Roman and Sasha Timakova.
All rights reserved.
I. State Budget Crises in the Wake of COVID-19
While the full economic impact of the COVID-19 pandemic remains unclear, the outlook for states is grim. States have had to increase spending on public health and Medicaid while making the difficult decisions to shut down large parts of their economies. The mandatory business closures and stay-at-home orders paralyzed the American economy in a way for which no state could have been prepared.
The aftermath of these public health measures has affected both state income and sales tax revenues, which are most states’ largest revenue sources.1 Income taxes started falling off in March and have continued their downward progression.2 Shutdowns have spurred mass layoffs, with the national unemployment rate approaching 15 percent.3 This steep decline in business activity will lead to less consumer spending, and therefore less sales tax revenue.4
The combination of reduced economic activity, increased unemployment, and increased enrollment in state safety-net programs is severely affecting state budgets. Illinois was in desperate financial straits even before the economy came to a halt in March. Already facing a $1.7 billion budget shortfall, the deficit progression for this year alone has increased by $1 billion.5 The Illinois Department of Revenue estimates a further budget shortfall of $4.6 billion, for a total anticipated shortfall of $7.4 billion for fiscal year 2021.6 Further, Illinois already had the lowest credit rating in the nation and was well below the average funding level, with less than 40 percent of the funds needed to meet its current expenses and obligations.7 The impact of COVID-19 will only exacerbate these problems.
Fiscally constrained states like Illinois are in especially difficult positions, as Treasury Secretary Steven Mnuchin has said that states that were in financial trouble before the COVID-19 pandemic should not be rescued by the federal government.8 President Trump echoed this sentiment in a tweet, asking why taxpayers should bail out what he called “poorly run states.”9 In addition to a clear lack of executive support, the recently passed Coronavirus Aid, Relief and Economic Security (CARES) Act10 (P.L. 116-136), while providing more than $4.9 billion in direct aid to Illinois, is expected to cause state income tax revenue to decline. In particular, section 2304 of the CARES Act amends IRC section 461(l) to give a tax break to noncorporate taxpayers (i.e., passthrough business entities such as partnerships and S corporations) by allowing them to deduct 100 percent of losses for tax years 2018-2020.11
States like Illinois that are in rolling conformity with the IRC automatically adopt changes to the federal tax statutes. These states will experience even greater tax revenue losses unless they decouple from the amended provisions through legislative action. This article argues that Illinois and other rolling conformity states should amend their tax codes to decouple from the section 461(l) deferral of loss limitations.
II. Changes to the Limitation on Business Losses for Noncorporate Taxpayers
Among other changes, the CARES Act amended several significant tax provisions affecting both individuals and businesses. Specifically, section 2304 deferred application of the excess business loss limitation imposed by the Tax Cuts and Jobs Act of 201712 in section 461(l) until 2021.13 This change allows noncorporate taxpayers to offset their business losses for tax years 2018, 2019, and 2020 against any nonbusiness income for those years, potentially deducting 100 percent of these business losses.
For context, the TCJA created section 461(l) to limit the business losses that noncorporate taxpayers could deduct.14 Section 461(l) denied these noncorporate taxpayers deductions for “excess business losses,” defined as the deductions of a taxpayer from all trades or businesses that exceed any gain from the taxpayer’s trades or businesses, plus $250,000 ($500,000 if filed jointly).15 Loss carryovers allow businesses to either deduct current-year losses against future profits (carryforwards) or deduct current-year losses against profits made during past years (carrybacks).16 The disallowed excess business losses would be treated as net operating losses that could be carried over to subsequent tax years.17 The Joint Committee on Taxation estimates that CARES Act section 2304, which removed this loss limitation, will cost the federal government over $135 billion in tax revenue.18
What does this have to do with Illinois? Illinois is a rolling conformity state. States in rolling conformity with the IRC automatically implement federal tax changes as they are enacted, unless the state specifically decouples by amending the state tax code.19 In 2017 Illinois automatically adopted the TCJA changes from which it had not decoupled, including the limits to excess business losses from added provision 461(l).20 Similarly, without legislative action, Illinois will automatically conform with the CARES Act changes and will lose hundreds of millions of dollars in state tax revenue.
There are several CARES Act provisions from which Illinois could decouple to maintain tax revenue during these difficult times.21 We focus on section 461(l) because the change would be simple, and the payoff would be substantial. If Illinois does not decouple from section 461(l), we estimate the state stands to lose over $800 million in state income tax revenue.22 This estimate is based on Illinois’s current income tax rate of 4.95 percent. However, Illinois voters will consider a constitutional amendment on the November ballot to replace Illinois’s flat income tax rate with a graduated, progressive income tax structure. If the amendment passes, state income tax rates will range from 4.75 to 7.99 percent.23 Under this new progressive structure, Illinois could lose out on over $1 billion in income tax revenue from the section 461 (l) changes.24
On the other hand, if Illinois adopts this progressive tax structure, loss carryforwards will become more valuable than carrybacks because the tax rate will be higher for most noncorporate taxpayers in the future. Nonetheless, rolling conformity states whose tax rates have decreased in recent years will be heavily affected by the delayed loss limitations as carrybacks will become more valuable to taxpayers in those states. For example, in 2019 Colorado decreased the state income tax rate from 4.63 to 4.5 percent,25 meaning now, businesses with losses in 2018 will be able to retroactively deduct losses for the higher rate of 4.63 cents on the dollar.
III. Policy Implications
Congress passed the CARES Act to respond to the COVID-19 outbreak and “its impact on the economy, public health, state and local governments, individuals, and businesses.”26 While characterized as a relief bill, the CARES Act is expected to have a stimulative effect on the economy by giving individuals and businesses liquid cash that they can spend immediately.27
For fiscally constrained states, decoupling from section 461(l) and other CARES Act changes will allow states to keep much needed revenue from income taxes while still aligning with the act’s explicit purpose to provide relief and what we could call the “implicit purpose” to stimulate the economy.
A. Economic Impact
The expected impact of section 461(l) on the federal income tax burden of noncorporate taxpayers is substantial. Even if the state decouples, section 461(l), as amended by the CARES Act, will provide noncorporate Illinois businesses with almost $5.19 billion in federal tax relief.
Before the pandemic, fiscal planning, budgeting, and tax preparations had been based on the assumption of an 80 percent NOL limitation.28 Because the section 461(l) change applies retroactively, businesses are getting federal relief from taxes that they had intended to pay; in fact, these changes provide relief from taxes that businesses already paid. Therefore, decoupling from section 461(l) will not upset expectations of the businesses that will be affected, but will merely realign the tax code with the pre-March 2020 baseline of state and local taxes they knew they would owe. In contrast, not decoupling would upset expectations of Illinois lawmakers who passed a budget based on the pre-CARES Act revenue code. In sum, the dollar estimate associated with decoupling does not come from Illinois collecting additional taxes, but rather, it is a way for the state to hold onto tax dollars it desperately needs and has already allocated.
For similar reasons, decoupling from section 461 will not detract from the simulative effect of the CARES Act. The CARES Act is a federal bill designed to decrease federal tax burdens. The major effect on businesses will be the refund stemming from losses recouped at the 37 percent rate, not the low state income tax rates of rolling conformity states that were incidentally roped into this change.
Ultimately, decoupling from section 461(l) as amended by the CARES Act will still allow for significant federal income tax relief, without upending expectations about state and local tax structures that individuals and firms would have had before March.
B. Broader Policy Implications
Aside from the economic reasons to decouple from section 461, the provision is poorly tailored to achieve policy goals Congress may have considered. It is a common misconception that “noncorporate” is synonymous with “small business.” In 2016 almost half of all passthrough income was attributed to businesses making $500,000, with 33 percent coming from businesses making $1 million or more. Passthrough income is concentrated among high-income taxpayers, and a large portion of the tax revenue that states collect comes from these higher-profit businesses. If the goal is to help small businesses, there are more targeted ways to do so than indirectly returning money to high-income passthrough entities based on operating losses from previous years.
Large refunds may encourage these noncorporate taxpayers to innovate and hire more employees. Allowing unlimited deduction claims for all excess losses in 2020 may encourage these businesses to take risks. However, section 2304 takes this farther by applying these changes to previous tax years and allowing businesses to claim losses beyond $250,000 ($500,000 if filing jointly) for risks they took before COVID-19. If the goal is to encourage prospective risk taking to boost the economy during the uncertainty of COVID-19, then allowing businesses to retroactively offset risks that they have already taken in the past does not align with this purpose either.
Many states in difficult financial positions like Illinois will not be able to meet their budgetary obligations. Failing to decouple from section 461(l) to postpone limitations on excess business losses will allow high-income noncorporate taxpayers to retroactively offset all of their losses from 2018 and 2019 and seek refunds that could cost Illinois up to $1 billion in tax revenue — a loss Illinois cannot afford.
APPENDIX
Amending the Tax Code
This would not be the first time Illinois sought to decouple (at least in part) from section 461(l). After the TCJA was signed into law, Illinois automatically adopted the section 461(l) business loss limitations imposed on noncorporate taxpayers. It later amended its tax code to allow trusts and estates to deduct excess business losses from income, effectively decoupling from the trusts and estates provisions of section 461(l).29 The General Assembly effectuated this change by providing that adjusted gross income for trusts would be increased by the amount of excess business losses “disallowed as a deduction” under IRC section 461(l)(1)(B).30
Decoupling from section 461(l) as it relates to individuals would be similarly simple. We propose to amend 35 Ill. Comp. Stat. Ann. 5/203 “Base Income Defined” to add a new clause, section (a)(2)(II), which would read:
(a) Individuals.
(1) In general. In the case of an individual, base income means an amount equal to the taxpayer’s adjusted gross income for the taxable year as modified by paragraph (2).
(2) Modifications. The adjusted gross income referred to in paragraph (1) shall be modified by adding thereto the sum of the following amounts:
. . .
(II) For taxable years beginning after December 31, 2017, and before January 1, 2026, the amount of excess business loss of the taxpayer allowed as a deduction by Section 461(l)(1)(B) of the Internal Revenue Code.
FOOTNOTES
1 See Urban-Brookings Tax Policy Center, “The State of State (and Local) Tax Policy.” In Illinois, for example, about 46 percent of the revenue collected by the Department of Revenue comes from state income taxes, and about 33 percent comes from sales taxes. See Illinois DOR, “Annual Report Fiscal Year 2019.”
2 See National Conference of State Legislatures, “Coronavirus (COVID-19): Revised State Revenue Projections” (May 29, 2020). Further, states have followed the IRS in delaying income tax return filing deadlines from April 15 to July 15. States generally collect 13 to 15 percent of annual personal income tax revenues in April, but with the deadline pushed to July, payments are arriving later and will likely lead to cash shortages. See Urban Institute, “State Tax Revenues Began to Decline in March 2020, More Declines on The Horizon” (Mar. 2020).
3 See Lance Lambert, “Over 40 Million Americans Have Filed for Unemployment During the Pandemic — Real Jobless Rate Over 23.9%,” Fortune, May 28, 2020 (arguing that the real unemployment rate is closer to 23.9 percent).
4 A report by the Illinois Policy Institute estimates the state’s economic activity has dropped more than 7.4 percent in the first quarter of 2020, costing the state about $183 million a day. The report also found that the state’s unemployment rate is nearly 18 percent (about 1.5 times higher than during the Great Recession). See Orphe Divounguy, Bryce Hill, and Jon Josko, “Illinois’ Economy Shrinking by More Than $183M Per Day as State Approaches 1M New Jobless Claims,” Illinois Policy Institute (May 7, 2020).
5 See Illinois Department of Commerce, “Gov. Pritzker Provides Updated Revenue Projections Amid COVID-19 Crisis,” Apr. 15, 2020; See also Tina Sfondeles, “COVID-19 Numbers Crunch Packs One-Two Punch: Pritzker Sees $2.7B Budget Jab Now, $6.2B Later,” Chicago Sun Times, Apr. 15, 2020. These estimates were based on Illinois’s current state income tax structure. See id.
6 See Sfondeles, supra note 5.
7 See Vincent Caruso, “Report: Illinois Pension Debt Soars To $137B, Despite Record Taxpayer Contributions,” Illinois Policy Institute (Nov. 14, 2019).
8 See Saleha Mohsin, “Mnuchin Says No Bailout for States with Badly Managed Budgets,” Bloomberg, Apr. 28, 2020.
9 Donald Trump (@realDonaldTrump), Twitter (Apr 27, 2020, 10:41 AM).
10 Coronavirus Aid, Relief, and Economic Security Act, H.R. 748, 116th Cong. (2d Sess. 2020).
11 See id. section 2304.
12 Tax Cuts and Jobs Act (Pub. L. No. 115-97) (2017).
13 H.R. 748 section 2304.
14 See TCJA section 11012.
15 Id.
16 See Alicia Tuovila, “Loss Carryforward,” Investopedia (updated July 14, 2018); and Adam Hayes, “Loss Carryback,” Investopedia (updated May 14, 2020).
17 See TCJA section 11012.
18 See Joint Commission on Taxation, JCX-11R-20, “Estimated Revenue Effects of the Revenue Provisions Contained in an Amendment to the CARES Act” (Apr. 23, 2020).
19 See 35 Ill. Comp. Stat. Ann. 5/102-103.
20 However, in the case of a trust or estate, Illinois decoupled from the federal NOL provision, and therefore excess business loss is permanently disallowed to a trust or estate. See 35 Ill. Comp. Stat. Ann. 5/203(c)(2)(Z).
21 See , e.g., BDO, “New York Becomes First State to Decouple From Key Business Tax Provisions of the CARES Act,” (Apr. 2020).
22 The estimated loss of federal income tax is $135 billion. Illinois comprises about 3.8 percent of the U.S. population, so a rough estimate based on population would mean a benefit to Illinois of $5.19 billion of the total U.S. estimate. We assume that noncorporate taxpayers will effectively be in a 29.6 percent federal tax bracket because 26 U.S.C. section 199A allows noncorporate taxpayers to deduct 20 percent of qualified business income (1-(1-0.2) x (1-0.37)). In Illinois, passthrough entities would be taxed on their business income at the individual income tax rate of 4.95 percent. At this tax rate, Illinois could stand to lose over $760 million in tax revenue; $135 billion (full cost to U.S.) x .03844 (Illinois population /U.S. population) ~ $5.19 billion (what Illinois would be responsible for at the 29.6 percent tax rate). 0.0495/0.296 (Illinois income tax rate/effective federal tax rate) = .16723. $5.19 billion x .16723 = ~ $867,860,399.
23 J. Res. Const. Amend. 1, 101st General Assembly (Il. 2020).
24 Losses for 2020 could be deducted at the current 4.95 percent tax rate, but subsequent years would allow deductions at up to a 7.99 percent rate. This would total about $1.2 billion in lost tax revenue over three years.
25 See CCH Tax Group, “Colorado Budget Surplus Triggers Income Tax Rate Reduction,” Wolters Kluwer, Nov. 27, 2019.
26 See Congressional Research Service, “Summary: H.R.748” (Mar. 27, 2020).
27 See Kelsey Snell, “What’s Inside the Senate’s $2 Trillion Coronavirus Aid Package,” NPR, Mar. 26, 2020 (quoting Senate Majority Leader Mitch McConnell, R-Ky., saying, “This isn’t even a stimulus package. It is emergency relief. Emergency relief. That’s what this is.”). For an assessment of the CARES Act’s expected stimulative effect on the U.S. economy, see Alexander Arnon et al., “Short-Run Economic Effects of the CARES Act,” Wharton School of the University of Pennsylvania (Apr. 8, 2020).
28 See 26 U.S.C. section 461(l) (2019).
29 See 35 Ill. Comp. Stat. Ann. 5/203(c)(2)(Z).
30 See id.
END FOOTNOTES