States 'decouple' from federal tax law

By Andrew L. Bareham, CPA
Clifton Gunderson LLP
Member, MACPA State Tax Committee

On March 9, 2002, President Bush signed the Job Creation and Workers Assistance Act of 2002 (the "act"). The act is a scaled-down version of what was proposed immediately after the Sept. 11 terrorist attacks. The primary focus of the act is to stimulate the economy by providing tax breaks to businesses and to extend unemployment benefits. The primary tax breaks under the act are the allowance of bonus depreciation deductions for investing in new property and an increase from two years to five years in the carryback period of net operating losses.

Bonus depreciation

A major cornerstone of the act allows businesses to take an additional first-year depreciation deduction equal to 30 percent of the adjusted basis of qualified property. This "bonus" depreciation is allowable for both regular and alternative minimum tax (AMT) purposes and is in addition to Section 179 expensing. Qualified property includes:

property with a recovery period of 20 years or less;
most computer software unless the software must be amortized;
water utility property; and
qualified leasehold improvements.

This provision is effective for property acquired after Sept. 10, 2001 and before Sept. 11, 2004. It requires that the basis of the property be reduced by the bonus depreciation when calculating depreciation in future years. Included in this provision is an additional first-year depreciation deduction for automobiles. For years 2001 and 2002, prior legislation allowed only $3,060 in first-year depreciation. The new law increases the first-year limitation by $4,600 to $7,660. The depreciation deduction in subsequent years is limited to prior law amounts.

Increase in net operating loss carryback period

The new legislation temporarily extends the net operating loss (NOL) carryback period from two to five years. If a business has an NOL arising in a tax year ending in 2001 or 2002, those losses can be carried back to the fifth preceding tax year. For example, if you are a calendar-year taxpayer with a 2001 NOL, you can carry the loss back to 1996. If you are subject to AMT, the new legislation allows an NOL deduction in arriving at alternative minimum taxable income (AMTI) of 100 percent of AMTI. Currently, you can reduce your AMTI by only 90 percent of AMTI.

You may elect to disregard this one-time opportunity and instead carry an NOL back under the prior two-year rule. However, this election is irrevocable once made. Businesses can still elect to waive their NOL carryback and instead carry the NOL forward.

States respond to federal act by decoupling from federal tax law

Generally, state tax laws conform to federal tax law, meaning the provisions of the act potentially could have a significant impact on state revenues. The Center on Budget and Policy Priorities estimates that as a result of the act, state revenues (including Washington, D.C., and New York City) will be reduced approximately $14 billion over the next three years. This increases the damage to state budgets already on the ropes from last year's recession and the repercussions of Sept. 11. Enactment of the act in mid-year when nearly every state is facing a substantial budget shortfall sets up what could be a dire situation for state treasuries.

At the time Congress passed this new law, most states followed federal rules for state income tax purposes or conformed to federal law enacted as of a specific date. In other words, the state tax laws were coupled with federal law. Following the passage of the act, a number of states have decoupled from federal law or are considering doing so to offset the expected revenue loss.

Though this is a possible solution to the state tax revenue loss, decoupling creates a series of compliance and audit problems for taxpayers in future years. By not conforming with the bonus depreciation, taxpayers will have to deal with the complexities of having two different depreciation deductions for as long as they are depreciating the property. The assets subject to the bonus depreciation will have a different basis for federal and state purposes that will complicate the disposition of these assets. Taxpayers also will need to maintain separate federal and state NOL schedules.

Mid-Atlantic states react to federal tax law changes

Outlined below is the current status of how states in the Mid-Atlantic region are treating the bonus depreciation and NOL carryback period.

Maryland: Under legislation signed by Gov. Parris N. Glendening on May 16, 2002 and applicable to all taxable years beginning after 2001, Maryland corporate and personal income taxes are decoupled from the federal income tax for a taxable year in which there are any amendments to the Internal Revenue Code, unless the state comptroller estimates an impact on state revenues of less than $5 million.

Specifically, Maryland corporate and personal income taxes are decoupled from two provisions of the act: (1) the 30 percent bonus depreciation for property in the first year placed in service; and (2) the extended five-year net operating loss (NOL) carryback period, applicable to any taxable year to which those provisions apply.
Delaware: As of May 3, 2002, there is no legislation pending to "decouple" from the Internal Revenue Code.
District of Columbia: For District of Columbia corporate income and personal income tax purposes, an "emergency act" decouples the District from the provision that allows businesses to claim an additional income tax deduction for depreciation. The emergency act prohibits District taxpayers from deducting the bonus depreciation when computing their District corporate income or personal income tax. The emergency act is effective April 24, 2002, for a 90-day period expiring on July 23, 2002. The District does not allow NOL carrybacks.
New Jersey: On May 30, 2002, the Business Tax Reform Act (S.B. 1556) was introduced in the New Jersey Senate and referred to the Senate Budget and Appropriations Committee. The legislation, as introduced, contains provisions to decouple the New Jersey corporation business (income) tax from the bonus depreciation deduction of the ACT. New Jersey does not allow NOL carrybacks.
North Carolina: The North Carolina Department of Revenue has advised taxpayers that it is unclear whether the Legislature will adopt the retroactive "bonus" depreciation. The North Carolina Legislature convened May 28, 2002. The Department has decided to process original returns claiming the 30 percent "bonus" depreciation as if North Carolina law includes the provisions of the stimulus bill. If the Legislature decides not to incorporate the retroactive depreciation provision, taxpayers would be required to file amended returns and pay additional tax and interest. If a taxpayer files an amended return claiming the "bonus" depreciation, the Department will not process the return until the issue is resolved legislatively.

The NOL provision only affects individual income taxpayers because North Carolina does not follow federal NOL rules for corporate income tax purposes. The state has advised individuals to delay filing amended returns with NOL carrybacks until the Legislature determines whether it will adopt the additional carryback period. The Department will not process NOL carryback returns until the matter is solved legislatively.
Pennsylvania: The Pennsylvania Department of Revenue has reminded taxpayers and practitioners that for personal income tax purposes, the bonus depreciation is not allowed. However, because of the way the tax code is written, the Revenue Department needs legislation to decouple the Pennsylvania rules for C corporations. Because Pennsylvania is facing a $1 billion budget deficit, it is expected that a provision will be inserted in the tax bill that will be introduced in June. Pennsylvania does not allow NOL carrybacks.
Virginia: Earlier this year, Virginia enacted legislation to switch from an automatic conformity state to conform to the Internal Revenue Code as of Dec. 31, 2001. This means Virginia will not allow the bonus depreciation or increased NOL carryback period.
West Virginia: New laws were enacted that conform the state's personal income tax and corporate income tax acts to federal tax law changes. The state's enactment of these conformity statutes keeps the state coupled with the federal changes, including the bonus depreciation and NOL carryback period.

Other states react

At press time, all but five states have elected not to conform to provisions of the Job Creation and Worker Assistance Act of 2002.

To assist tax practitioners with determining how states are reacting to the act, the Federation of Tax Administrators has added a new section to its Web site. The FTA Web site provides links to each of the states that have taken action following passage of the ACT.

The Web site is located at http://www.taxadmin.org/fta/rate/decoupling.html.

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