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IRC Section 163(j) and the Impact of the TCJA/CARES Act on States

by Alex Thacher

The federal Tax Cuts and Jobs Act (TCJA) imposed a limitation on the deduction for business interest expense (BIE) for tax years beginning after December 31, 2017. Section 163(j) of the Internal Revenue Code (IRC) limits the deduction for business interest to the sum of business interest income, 30% of adjusted taxable income (ATI), and the taxpayer’s floor plan financing interest for the tax year per the TCJA. This provision has been temporarily modified by the Coronavirus Aid, Relief, and Economic Security Act (CARES Act) for tax years beginning in 2019 or 2020.

With the CARES Act, the IRC § 163(j) BIE limitation has increased from 30% to 50% ATI for tax years beginning in 2019 or 2020. In addition, the CARES Act also allows taxpayers to elect to substitute 2019 ATI for 2020 ATI and permits taxpayers to elect out of the ATI limitation increase.

Almost every state with an income tax relies on the rules and regulations from the IRC and generally follows the regulations put in place based on when or how it conforms to the IRC. There are three main types of conformity: rolling, fixed date and selective. Depending on how the state conforms to the IRC and/or IRC § 163(j), state adjustments may have to be made and/or separate 163(j) calculations may be needed for certain separate or even combined state returns.

Details

As mentioned above, there are three main ways that a state can conform to the IRC. The first, “rolling” conformity, means that as the IRC is updated, the state will conform to the updates. Therefore, in general, a rolling conformity state will adopt all the changes based on the TCJA and the CARES Act and will not require separate state modifications.  

The second, “fixed date” conformity, means that the state conforms to the IRC as of a specific date and all changes made to the IRC after that date do not apply to the state income calculation. For example, California conforms to the IRC as of January 1, 2015, so updates made through the TCJA and CARES Act would not apply unless specifically adopted by the state. 

The third, “selective” conformity, means that the state doesn’t follow the IRC as of a certain date and instead specifically adopts certain sections that it chooses. 

We all recall the difficulties that came with tax reform through the TCJA and how we had to determine state adjustments based on the conformity rules. Unfortunately, the CARES Act makes the situation a bit more complex, especially for the fixed date conformity states. For example, Arizona conforms to the IRC as of January 1, 2020.  Therefore, it incorporates the TCJA changes but not the changes made by the CARES Act. 

Recall that for federal return purposes for IRC § 163(j), the CARES Act allows taxpayers to compute the BIE limitation based on 50% of ATI for tax year 2019 (even though the CARES Act was not enacted until 2020).  Arizona does not conform to the CARES Act, so for its 2019 state return, the 30% limitation will need to be used. Whereas in other states such as California, which doesn’t conform to either the TCJA or the CARES Act, neither the 30% nor 50% limitation will apply. The pre-TCJA 163(j) calculation method would need to be considered for whether or not a state adjustment would be required for California purposes.

In addition, there are considerations for separate filing states that conform to IRC § 163(j), as the federal IRC § 163(j) limitation is calculated on a consolidated basis. Some of these separate states and even combined states have issued separate guidance to address how to recalculate IRC § 163(j) specific to that state.  Below we’ll look at two state examples, Tennessee and Michigan.

Tennessee

Tennessee, a separate filing state, has recently issued several notices regarding the calculation of BIE limitations and carryforward of disallowed BIE. Tennessee conforms to IRC § 163(j) as amended by the TCJA and CARES Act for years beginning January 1, 2018, through December 31, 2019. It decouples from IRC § 163(j) for tax years beginning on or after January 1, 2020. 

For the tax years in which Tennessee conforms to IRC § 163(j), the taxpayer’s part of a consolidated federal return should allocate the allowed BIE deduction based on an entity’s pro-rata share of interest expense subject to limitation based on guidance in Notice 19-18.  If any disallowed BIE carryforward exists, the carryforward would also be carried forward on a pro-rata basis for the 2018 and 2019 tax years. Disallowed BIE carryforwards from tax years 2018 and 2019, for tax years beginning on or after January 1, 2020, may be deducted the same as for federal income tax purposes based on guidance in Notice 20-16.

Michigan

Michigan is a consolidated filing state. On June 8, 2020, the Michigan Department of Treasury issued a notice, Corporate Income Tax Treatment of the IRC 163(j) Business Interest Limitation, addressing the computation of the BIE limitation pursuant to IRC § 163(j) for Michigan Corporate Income Tax (CIT) purposes.

Facts

  • Michigan conforms to the current IRC and has not decoupled from the BIE limitation of IRC § 163(j).
  • If The corporate income tax starting point is a taxpayer’s federal taxable income, which includes the BIE as limited by IRC § 163(j).

Separate vs. Consolidated Federal Return Matters for Michigan

  • A CIT taxpayer or unitary business group (UBG) member that files a separate federal return has no further adjustments to make to report federal taxable income on its Michigan return.
  • A CIT taxpayer or UBG member that filed a federal consolidated return will have to make a state-specific adjustment for IRC § 163(j).

Michigan (CIT) Recalculation of IRC § 163(j)

  • For CIT purposes, IRC § 163(j) is to be calculated on a separate-entity basis for each member of a UBG, instead of applying the limitation at a consolidated level. The separate company federal taxable income of each member of the group, including the separate company IRC § 163(j) limitation is then aggregated to determine combined group income.
  • For purposes of the CIT, separate company IRC § 163(j) limitation, pro forma adjusted taxable income should be computed without regard to bonus depreciation.
  • Intercompany interest expense is subject to the IRC § 163(j) limitation and is only eliminated to the extent it is deductible in a year.
  • A UBG member cannot use the carry-forward or disallowed BIE or unused limit of another UBG member.

In addition to the reduction in the lifetime exclusion, Biden has also proposed eliminating the basis “step-up” to fair market value at death, which allows for a deferral of gain until the beneficiaries ultimately sell an asset. We do not know, under his proposal, whether the original basis would simply be carried over or if there would be tax due at death on the capital gains or during lifetime at the time a gift is made. This will completely change the approach to estate planning and wealth transfer, and a careful review of your current plan could result in a great deal of tax savings over your lifetime.

Insights

Preparers and taxpayers need to be aware of the conformities of each state, as they differ on a state-by-state basis regarding IRC § 163(j) and the many changes that came with the TCJA and the CARES Act. The guidance provided by Tennessee and the example of Michigan as described above are some of the many different adjustments that can occur within a state. These can get very complex depending on the taxpayer’s facts, especially if there are multiple entities.

As of today, many states still need to address the treatment of IRC § 163(j), global intangible low-taxed income (GILTI) and foreign-derived intangible income (FDII) under their state tax laws.

September 23, 2020

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Alex Thacher - Partner, Tax - San Jose, CA | Armanino
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