State Tax Conformity: The CARES Act and Beyond

COVID-19 has had an immense impact on state and local governments’ fiscal capacities.¹ States and localities must now work to maintain the tax revenues necessary to fund critical services while trying to prevent taxation from overwhelming their residents and the businesses that serve them — many of whom which are also struggling because of the effects of the global pandemic. Solutions to this problem must be multiple,² and are the focus of Project SAFE (State Action in Fiscal Emergencies), an academic effort to help states weather the fiscal economic crisis by providing policy recommendations backed by research.³

One way that states can help themselves is by ensuring that their fiscal stability is not undermined by acts of Congress — such as federal tax changes. States have long conformed to the federal tax code as the starting point for their income taxes. The practice of piggybacking on the federal tax code — or “delegating up”⁴ — has long been a feature of state taxation that has provided states with benefits, but also subjected them to significant revenue volatility.⁵

Entering 2020, states were still struggling with whether and how to respond to the federal Tax Cuts and Jobs Act of 2017.⁶ States now also have to consider whether and how to respond to the tax changes made by the Coronavirus Aid, Relief, and Economic Security (CARES) Act and any potential future legislation making changes to the federal tax code in response to the pandemic.

The article will first evaluate several ways in which the CARES Act may have affected states’ corporate income taxes and how states might respond to protect their tax bases. The broader focus of this analysis, however, is on thinking holistically about the relevant considerations for states as they evaluate their conformity positions more broadly. The economic effects of this crisis are sure to continue for some time, and states will face additional revenue shocks as Congress responds to the pandemic with relief provided through the tax code. States should think now about whether they should change their approaches to conformity during this turbulent time.

Conformity and the CARES Act

The CARES Act provisions with the greatest impact on states’ corporate income taxes are its adjustments to the business interest deduction, the net operating loss rules, and the TCJA’s full depreciation allowance. Each change provides tax relief for businesses, but their adoption by states would reduce revenue and further endanger states’ fiscal stability. Ideally, states would evaluate whether and how to conform to these changes and make decisions about their approach. Unfortunately, though, many states will automatically conform to those changes because of past legislatures’ decisions.

Roughly half of states with corporate income taxes conform to the federal tax code on a rolling or dynamic basis, meaning that they automatically incorporate most changes made at the federal level.⁷ The other half conform on a static or fixed basis, which means that they would need to take affirmative action to adopt the CARES Act changes. These default positions are very important, especially given that many state legislatures have already concluded their regular sessions under their standard legislative schedules or because of COVID-19.⁸

Rolling conformity states will most likely have already incorporated CARES Act changes, unless they previously opted out of the federal provisions. These states may want to evaluate another approach. New York, for example, recently changed its default of rolling conformity to static conformity for a limited time.⁹ New York state’s recent budget act provides that the state will conform to the federal tax code as of March 1, 2020, for tax years beginning before January 1, 2022.¹⁰ That modification to state law means that the Legislature will have to evaluate any federal tax changes made after that date and determine whether and to what extent to the state should adopt them. This approach seems eminently reasonable because it will allow New York the flexibility to adopt any federal changes that it deems advisable while not subjecting state finances to congressional whims.

Whether states will ultimately want to provide tax relief in the form of relaxed business interest deduction limitations, expanded NOL utilization, or expanded expensing will depend on a judgment about the costs and benefits of those provisions. In the midst of this pandemic, though, it is worth scrutinizing those tax breaks further. Every additional dollar in tax relief helps the recipient but harms the state fisc and, by extension, the services that the state provides.

Conformity and the Modified Business Interest Limit

The TCJA introduced section 163(j), which limited business interest deductions to 30 percent of a taxpayer’s adjusted taxable income.¹¹ The CARES Act loosened that limitation in a couple of ways. First, it raised the threshold percentage from 30 percent to 50 percent. Second, for purposes of tax reporting for 2020, the bill modified section 163(j) by allowing taxpayers to use their 2019 — rather than 2020 — adjusted taxable income for making their limitation calculations.¹²

The TCJA’s business interest limitation was enacted in conjunction with its full-expensing allowance in section 168(k). And while neither the conference report nor the JCT Bluebook explained why that provision was enacted, the U.S. Senate Finance Committee did discuss that limitation in a section on cost recovery.¹³ Some therefore view the business interest limitation as a sort of quid pro quo for full expensing — a way of discouraging “excessive debt financing” of assets that could be fully expensed.¹⁴

But the business interest limitation of section 163(j) is neither directly tied to nor fully able to accounts for section 168(k). Section 163(j) limits interest deductions, but it does not prevent businesses from deducting interest on debts incurred to purchased assets that are fully expensed under section 168(k). That is highly problematic as a matter of tax policy.¹⁵ Section 163(j) is even further limited because it does not apply to all taxpayers. Businesses whose average annual gross receipts over an applicable three-year period do not exceed $25 million are exempt from the limits.¹⁶ Thus, it is reasonable for states to evaluate the business interest limitation independently from their depreciation allowances post after the TCJA and CARES Act.

Pre-CARES Act, states were in two camps: those that conformed to section 163(j), and those that did not — which means that they allowed interest deductions without the section 163(j) limitation. Conformity with the CARES Act for those groups would obviously mean two different things. Conformity would be an expansion of the interest deduction for previously conforming states, and a contraction for the others.

States that did not previously conform to section 163(j) and limit business interest deductions might want to consider that change at this time. Quite simply, the calculus for states is very different now than it was even a few months ago. Limiting an interest deduction for a limited subset of highly leveraged firms is likely preferable to cutting funding for critical state services at this time. States must be concerned with overall welfare rather than focusing only the negative impact that a limited interest deduction might have on particular firms.

States that previously conformed to section 163(j) should also consider decoupling from the CARES Act’s changes. Many businesses undoubtedly need cash in these desperate times, and many will also need to incur additional debt to manage the shortfalls caused by the pandemic. An expanded deduction would undoubtedly help those companies, and some have argued for CARES Act conformity on that ground.¹⁷ The problem with expanding the state business interest deduction to aid struggling firms is two-fold. First, states are not in the a position to provide stimulus funding to firms during this pandemic. The federal government, unbounded by a balanced budget requirement, must take the lead on stimulus. Second, there is little fit between an expansion of the interest deduction and providing relief to firms that are struggling due tobecause of COVID-19.

The interest limitation of section 163(j) applies only to a select group of firms, and an expansion of that limit would reverse the modest inroads that the TCJA made into the debt preference in the U.S. Tax Code. States making that choice would be providing a targeted tax cut to an unknown group of taxpayers to the detriment of the known community in the state. No change in the tax laws can be viewed in isolation from the state’s overall mission and goals.

In light of these considerations, I would suggest that states not conform to the CARES Act changes to the business interest limitation, and that states that had previously decoupled from section 163(j) consider adopting that provision now. Perhaps a different approach would be preferable under an ideal business tax or in an ideal time, but states have the luxury of neither during this pandemic.

NOL Expansion

Before the TCJA, the federal tax code allowed taxpayers to carryback NOLs back for two tax years and to carry them forward for 20 years. The TCJA eliminated taxpayers’ ability to carry back their NOLs but allowed an unlimited carryforward.¹⁸ The act also limited taxpayers’ use of NOLs in any given year to 80 percent of their taxable income.¹⁹ These provisions served to both raise revenue to offset the TCJA’s revenue reductions and to prevent taxpayers from using losses incurred in post-TCJA years to offset income earned under the old 35 percent corporate tax rate.

The CARES Act modified these rules again. Under the new law, corporations are allowed to carry back losses incurred in tax years ending after December 31, 2017, and before January 1, 2021, for five years.²⁰ The TCJA’s 80 percent limitation is also suspended for tax years beginning before January 1, 2021.²¹ The CARES Act did not eliminate the TCJA’s indefinite carryforward.

If one is solely focused on getting taxpayers cash in any way possible, these expansions obviously work — for some. The NOL expansion allows taxpayers to carry back losses unburdened by an 80 percent limit. In a world where the tax year is used just for administrative convenience, an unlimited carryback may also make sense. A taxpayer who earns a profit in Year year One 1 and loses it in Year Two 2 has, on net, earned nothing. A carryback recognizes the oddities that result because of from the necessity of adopting reporting periods for tax purposes.

Again, however, states have more to consider than simply getting companies cash in any way possible. As with the aforementioned net interest limitation modification, simply pointing out that some companies would benefit from expanded  net operating loss utilization use does not suffice to justify this policy change. States should again consider the overall cost and distributional aspects of that expansion and whether the state could help its residents and businesses better through other means. States, again, cannot be in charge of stimulus funding during this pandemic.Firms must look to the federal government for that support.

It is worth noting that most states already decouple from the federal NOL rules in one way or another and that most do not allow any NOL carryback.²² NOL carrybacks at the state level raise difficult issues regarding the amount and source of the losses for taxpayers operating in multiple states. Either the calculations are either imprecise or the administrative burden is incredibly high.²³ States that use state-specific calculations for precision purposes already use NOL calculations independent from the federal amounts, so conformity becomes a matter of state tax and economic policy rather than one of harmonization with the federal government.

Tax policy should also matter, of course, and an unlimited NOL provision might actually make more sense at the state level than at the federal level if states’ tax rates have remained unchanged. But states have other policy considerations — as evidenced by their current NOL practices — and they operate far from a world where their tax codes reflect good tax policy at every turn. For example, every state with an income tax conforms to the federal step-up in basis at death, and every state offers targeted tax breaks for particular industries or taxpayers. It is just reality that state tax bases are far from complete across the board. Those deviations are often justified for political or economic reasons, which is a necessary part of state governance. In the NOL context, states have erred on the side of more limited NOL utilization use than that is allowed under federal law, so the question is whether they should change course now.

I obviously cannot consider each idiosyncrasy in states’ budgets or tax bases, but it does seem clear that conformity as pure stimulus would be overbroad. The CARES Act’s NOL expansions apply to losses incurred well before this pandemic, so the changes are not tied to pandemic losses. NOL expansions would also obviously work to get cash into the hands of affected corporations. But that doesn’t mean that conformity makes sense for states as a method of relief. Every taxpayer would benefit in the form of additional funds, but that was true before the pandemic as well. States have to prioritize, and they likely cannot afford this type of non-targeted relief.

Accelerated Depreciation

As noted, expanding the section 168(k) bonus depreciation to a 100 percent allowance was one of the major TCJA tax reforms. As has been well documented, the TCJA left out one asset class unintentionally — qualified improvement property — with the effect that many taxpayers in the retail industry were denied 100 percent expensing for their capital expenditures.²⁴ The CARES Act corrected that prior omission and included that property among the categories of property eligible for 100 percent bonus depreciation under section 168(k).²⁵

States that have adopted rolling conformity and that have not previously elected out of bonus depreciation under section 168(k) will automatically make this change as well. Obviously, static conformity states would need to act to do so. The case for conformity here, as a matter of tax policy, might be especially strong for states that have broadly adopted 100 percent expensing. The TCJA’s omission of qualified improvement property from that expansion seems to have been unintentional and created an odd distortion in the federal tax code that disadvantaged some types of property as compared to others. Conformity would merely be clean-up work for a hastily enacted TCJA.

But state conformity would also come at a cost. Judged from the current status quo, expanded section 168(k) would represent a targeted tax break for a very limited subset of the population. Its adoption as a matter of stimulus or as a matter of good tax policy raises the same issues as discussed earlier. And if you believe that states made a mistake in conforming to full expensing to begin with, conforming to the CARES Act expansion would only expand that error.

Ultimately, I am sympathetic to the notion of full expensing and the goals of those who would move the income tax system toward a cash-flow-based tax. But in a world that falls short of that goal, expanding full expensing is not likely the optimal approach at this time.²⁶ The more compelling argument is likely that states should slow down their depreciation allowances, not speed them up. At the very least, states should look closely at the revenue costs of conforming to the CARES Act expansion, the distributional effects of that change, and what services they would have to cut to offset those changes in revenue if they were to conform. It may be that expanding expensing is of little cost. Or it might be that conformity would further defund essential public services at a time when the state and its residents could ill afford it.

Conformity Practice in General

The overarching message of this article is that states should carefully consider all proposed changes to their revenue streams during this difficult time. The impact of the coronavirus has been felt far and wide, so those arguing for tax changes must do more than point out that those amendments would provide tax relief for some taxpayers. States must be more strategic and thoughtful to maximize the effects of all of their residents’ tax dollars and to best pursue their public missions. Unlike the federal government, states generally cannot deficit spend to buy themselves time until a recovery. They must lean on the federal government to use its greater resource availability.

Just like before the pandemic, states should be very intentional about tax reform. They should identify the revenue and distributional effects of the proposed change and identify its purpose (for example, stimulus, tax policy, etc.). They should determine how close of a fit there is between the purpose and effect of the proposed amendment, and examine its systemic effects.

With these considerations in mind, it would make sense for rolling conformity states to shift to static conformity — at least for a short period like New York. That approach would give state lawmakers more control over their budgets while not foreclosing conformity. If states are unwilling to make that change, they should consider provisions like that enacted in Maryland, which prevents the state from automatically conforming to any federal tax change that results in anticipated revenue changes exceeding a set threshold.²⁷ It doesn’t make sense for state legislatures to use their limited time to discuss changes that are truly de minimis. A conformity provision that has had a revenue threshold might be useful.²⁸

Longer term, it is worth states taking a closer look at whether and how they conform to the federal tax code. Those involved in state taxation and finance have long appreciated that conformity causes revenue volatility for states. But the process by which Congress enacted the TCJA and the growing political tensions at the federal level suggest that the tax code may be especially unstable now. States may need to rethink their default positions in light of changed circumstances. States should also be aware that the federal government will need to make significant adjustments as this pandemic continues and after it is resolved. Evaluating conformity practices will help states to ensure that they can control their revenue streams to the maximum extent possible.

Looking Beyond the CARES Act

This article has focused on state conformity with the CARES Act’s corporate tax provisions and broadly suggested that states not conform to those changes. Every state revenue reduction is a likely decrease reduction in critical state services at a time when we can least afford them. Businesses and states must look to the federal government — and its borrowing capacity — to help provide relief.

States must also go farther than simply treading water regarding their tax systems. They should consider changes that would affirmatively raise taxes on their most fortunate residents. Whether that comes in the form of new taxes, like partial wealth taxes;²⁹ modifications to existing taxes, like progressive property taxes;³⁰ or strategic conformity or decoupling from the TCJA,³¹ states will need to raise revenue to maintain their residents’ health and safety and to ensure their own futures as thriving political and economic units. Evaluating state conformity practice is a necessary but insufficient task as states pursue those goals during this difficult time.