State net operating loss (NOL) rules generally differ from federal NOL rules, and state NOL rules often differ from one another. This is especially true with respect to carrybacks of NOLs—which, unlike for federal returns, the majority of states do not allow—and carryforwards. This lack of consistency can lead to confusion about a taxpayer’s ability to use NOLs.
FEDERAL NOL REGIME
IRC § 172(b)(1)(A) allows taxpayers to carry NOLs back two and forward 20 years, unless a taxpayer elects to waive the carryback period, in which case NOLs will only be carried forward. Legislation enacted in 2009 allows most corporate taxpayers to elect to carry back 2008 or 2009 NOLs up to five years.
STATE NOL COMPUTATION AND APPLICATION DIFFERENCES
Computing state taxable income generally begins with either federal taxable income before NOL and special deductions (from line 28 of the 2009 Form 1120, U.S. Corporation Income Tax Return) or federal taxable income after NOL and special deductions (from line 30). The applicable federal starting point is modified to reflect certain addition and subtraction adjustments, such as the add-back of expenses not deductible and the subtraction of income not taxable at the state level.
Taxpayers should consider a number of common NOL variations. In general, states require a taxpayer to have nexus (that is, be subject to tax) in the state in the year a loss is generated to carry over that loss to a subsequent tax year. Some states specifically require nexus in a loss year to claim an NOL carryover. For example, Maryland regulations provide that a taxpayer cannot use an NOL generated when a corporation is not subject to Maryland income tax law as a deduction to offset Maryland income in a carryover year (Md. Code Regs. § 03.04.03.07(A)(5)). A similar rule applies in Rhode Island (R.I. Gen. Laws § 44-11-11(b)). Most states require nexus implicitly, by limiting carryforward or carryback amounts by taxpayers’ income apportionment factor in the loss year between or among themselves and one or more other states. For example, Georgia requires a corporation doing business within and outside Georgia to compute the NOL carryover deduction based on the corporation’s apportionment formula in the loss year (Ga. Code Ann. § 48-7-21). Iowa applies a similar rule (Iowa Code § 422.35(11)(g)).
New York law takes the “subject to tax” restriction one step further and provides that a taxpayer must be subject to the same article of the New York tax law in both the loss year and the carryover year to claim an NOL deduction (N.Y. Tax Law § 208(9)(f)(2)). Accordingly, if a taxpayer is subject to the Article 32 bank franchise tax based on income in the year an NOL is generated and the Article 9-A corporate franchise tax on income in the year it seeks to claim an NOL carryover, no deduction is permitted. In contrast, Virginia, which does not have its own NOL provisions but relies on federal NOL provisions in computing state taxable income, does not require nexus in the loss year; thus, Virginia taxpayers may “import” NOLs from non-nexus years.
In determining state taxable income, states require a number of addition and subtraction modifications to federal taxable income. State-specific modifications may result in significant differences between federal and state taxable income, such as where a state “decouples” from bonus depreciation provisions or from the cancellation-of-debt income elective deferral provisions. As a result, while taxpayers may have an NOL for federal purposes in a given tax year, they may have taxable income at the state level in that year. Even if the state-specific adjustments do not cause a taxpayer to be in a net income position for state purposes, they may significantly reduce the NOL from the federal amount.
Most states limit the amount of loss that a taxpayer can carry over based on the taxpayer’s level of in-state activity in the loss year. Taxpayers that significantly shift their operations to increase or decrease their activity in a state may need to consider the impact on their deferred tax asset values attributable to state NOL carryovers. For example, if a taxpayer ceases operations in a state, it may need to fully reserve the deferred tax asset attributable to the NOL carryover in that state.
In addition, taxpayers may need to consider state restrictions on types of income to which loss carryovers may be applied. For example, New York requires taxpayers with business and investment income in the year to which they carry an NOL to apportion the carryover between business and investment income. New York regulations set forth specific guidance for this apportionment (20 NYCRR § 3-8.8).
CARRYOVER PERIOD DIFFERENCES
Given the balanced-budget mandates under which most states operate, states generally limit the number of years that a taxpayer may carry an NOL forward or back. More than 30 states prohibit NOL carrybacks entirely. States that allow carrybacks often prescribe a carryback period that may not conform to federal periods. For example, the federal five-year carryback period for 2008 or 2009 NOLs does not apply in most states. In addition, even if a state conforms to the federal section 172 carryover provisions, a lag in the Code conformity date may result in nonconformity to an extended NOL carryover period.
Another consideration is the state treatment of a federal election to forgo an NOL carryback. While most states do not allow carrybacks, those that do may require a taxpayer to make a state-specific election to forgo a carryback independent of the federal election. For example, Oklahoma allows taxpayers to make an election to forgo the carryback period (Okla. Admin. Code § 2358(A)(3)). In contrast, Missouri law provides that a taxpayer is bound by its federal election to carry back or carry forward losses (Mo. Rev. Stat. § 143.121(2)(d)).
CAPS AND CONSOLIDATED RETURNS
Some states limit the NOL deduction claimed in any year to a specific dollar amount. For example, of the states that allow carrybacks, the following limit the amount that a taxpayer may carry back: Delaware ($30,000), Idaho ($100,000), New York ($10,000), Utah ($1 million) and West Virginia ($300,000). Pennsylvania, which does not allow NOL carrybacks, caps the amount of NOL deducted in a tax year beginning after Dec. 31, 2009, to the greater of 20% of taxable income or $3 million. Some states cap the NOL deduction to the amount of NOL claimed in computing federal taxable income, modified by special limitations. For example, New York limits the NOL deduction in any tax year to the amount of NOL that could have been deducted in computing federal taxable income if it had been subject to the state NOL carryback limitation noted above (N.Y. Tax Law § 208(f)(3)).
Taxpayers that file returns on a separate basis at the state level while filing consolidated returns for federal purposes will need to track state NOLs separately to ensure accurate recordkeeping of tax attributes. Also, if a taxpayer used a state-specific NOL to compute a deferred tax asset in a year in which an NOL was generated, it may need to reassess the deferred tax asset if the state subsequently adopts combined filing.
Some states facing a fiscal crisis have temporarily suspended NOL deductions. For example, in 2008 California suspended NOL deductions for tax years beginning on or after Jan. 1, 2008, and before Jan. 1, 2010, for taxpayers with taxable income of $500,000 or more (Calif. Rev. & Tax. Code § 24416.9). Another common limitation prohibits using federal NOLs to offset state addition modifications. For example, while Maryland allows a current-year federal NOL to offset current-year state modifications, if total addition modifications exceed total subtraction modifications in the year an NOL is generated, a taxpayer must recapture excess addition modifications in the year the NOL deduction is claimed. See the 2009 instructions for Form 500, Maryland Corporation Income Tax Return, page 2.
(Editor’s note: A version of this article appeared in the July 2010 issue of The Tax Adviser.)
By Karen Nakamura, CPA ( email@example.com); Jason R. Thompson, Esq., LL.M. (firstname.lastname@example.org); and Tara Ferris, Esq., LL.M., (email@example.com) all of PricewaterhouseCoopers, Washington, D.C.
To comment on this article or to suggest an idea for another article, contact Paul Bonner, senior editor, at firstname.lastname@example.org or 919-402-4434.
More from the JofA: