The Coronavirus Aid, Relief, and Economic Security Act (CARES Act) revised several federal tax provisions with the goal of increasing business liquidity. Among the CARES Act changes was the temporary lifting of limits on federal deductions for business interest expense in section 163(j). That section was enacted as part of the Tax Cuts and Jobs Act of 2017 and created a complicated formula for limiting federal business interest expense deductions. Section 163(j) imposed a limit on the deductibility of business interest expense equal to the sum of business interest income, 30% of “adjusted taxable income,” and “floor plan financing interest.” The federal law allowed business interest expenses limited under section 163(j) to be carried forward.
The CARES Act amends section 163(j) and increases the limit for federal business interest deduction for applicable years. The increase in the federal expense limits will help many businesses improve their cash flow. It will reduce current tax payments and may create net operating losses that can now be carried back five years for federal purposes and some states.
The federal interest deduction changes could have significant effects on state tax liabilities. As a general rule, reducing federal taxable or adjusted gross income will result in a reduction in state taxable income. There is the possibility that businesses could pursue significant state income tax refund claims for years open under the applicable statute of limitations. The ability of businesses to take advantage of the increased federal interest expense deductions will depend on state conformity rules.
State conformity with section 163(j) is complicated. Most of the 22 states with “rolling” business and corporate tax conformity will automatically adopt the CARES Act tax provisions. Some states, such as New York, have already decoupled from the CARES Act section 163(j) provision (retaining the 30% limit). Other rolling conformity states, such as Missouri and Connecticut, decoupled from section 163(j) when the TCJA was enacted and other rolling conformity states such as Tennessee have established additional or different rules governing the section 163(j) interest limitations. Some “fixed date” conforming states, such as California and Georgia, either never conformed to section 163(j) or conformed only to an earlier version of the law.
There is another important state tax issue presented by the revisions to section 163(j). The new 50% limit does not apply to partnerships in 2019. For that year, partnerships are still subject to the 30% percent limit. The 50% limit will apply to partnerships in 2020. Partners will be able to claim their share of the partnership deduction in 2020 plus an additional interest expense deduction that they would have otherwise been entitled to in 2019. The difference in the yearly limits could create cash flow issues for partnerships that make tax distributions to partners if they fail to consider the additional deductions partners will receive in 2020. Moreover, partnerships can elect out of the 50% business interest deduction limit. Partnerships face the same conformity issues discussed above. There may also be state tax implications arising from section 163(j) in states that impose entity level taxes.
Federal refund claims arising from the additional federal interest expense deduction may trigger additional state filing requirements. Federal refund claims also potentially open or extend state statutes of limitation.
The RSM State and Local Tax group can assist companies in assessing the potential state tax benefits presented by the increased federal business interest deduction limits. Businesses should be aware of the conformity rules that will govern the state tax opportunities. Partnerships should also consider the state tax ramifications of the section 163(j) changes.