Federal Tax Attributes at the State Level
Not all states view federal tax attributes the same. Basis, carrybacks, carryforwards and related limitations do not necessarily follow federal rules.
November 12, 2009
At a time when every tax benefit can be critical to a firm’s survival, tax attributes such as net operating losses (NOL), tax credits and tax basis issues warrant special attention. Economic pressures may necessitate mergers to avoid bankruptcy in which issues of insolvency and cancellation of indebtedness become planning opportunities. In addition, ownership change issues can potentially limit or negate any savings anticipated from a merger or acquisition at both the federal and state level to differing degrees.
For federal tax purposes, there are several key tax attributes that become extremely important during a recessionary period. These include NOLs, capital losses, built-in gains, stock basis and cancellation of debt.
Net Operating Losses
The NOL created when expenses exceed income can generally be carried back or forward for federal purposes, subject to certain limitations. On a state level, however, the majority of states do not allow for losses to be carried back. Those states allowing for carryforward treatment may not necessarily follow the federal terms. Although some states allow a 20-year carryforward, many states allow for much shorter periods. Several states, like New Jersey and California have at some point completely suspended the use of NOL deductions or limited their use to only 50 percent of the loss incurred. Other states, like Rhode Island, limit the use of NOLs to the amount of federal NOL available, which in effect totally eliminates the state-level NOL if the loss is carried back for federal purposes.
Federal corporate tax law allows the carryback or carryforward of the excess of the losses from the sale or exchange of capital assets over gains from similar sales. Generally this loss can be carried back three years and forward five years. Capital losses vary significantly from state tax treatment to that of federal treatment. In addition to differing carryback and carryforward rules, the location of the capital asset at the time of sale or exchange becomes important. The nature of the assets is critical in determining whether the asset is a business asset or a nonbusiness asset which will dictate treatment by the states through either apportionment or allocation. Tangible and intangible assets have different tax ramifications in most states. For apportionment purposes, the inclusion in a unitary group may also be a factor in determining the availability of capital losses for state purposes, as well as the place of domicile of the company. The amount of the loss may also be an issue when state tax basis differs from federal tax basis, normally due to differing depreciation methods and limits. Each state may have its own nuances regarding the applicability and calculation of the loss in question.
During an ownership change, pre-acquisition losses will generally not be available to offset any built-in gains recognized as a result of a sale or disposition of an asset during the five-year period after the change in ownership. The fair market value of assets acquired must be determined at the date of the ownership change for comparison to the adjusted tax basis to determine gain or loss. The adjusted tax basis for federal purposes may differ from the state tax basis due to accelerated or bonus depreciation not generally allowed by states. This necessitates a state-by-state tax basis calculation of assets depending on the physical location at the time of the sale.
In these troubled times, it is not uncommon for corporations to be wrestling with the problem of worthless debt. This could include a subsidiary or commonly owned entity with poor performance and the threat of impending bankruptcy. For deductibility on the federal level, proof must be provided to establish that the debt is generally uncollectible. To determine worthlessness, the courts have considered the financial condition of the debtor, the value of any collateral securing the debt and the likelihood of legal action to enforce collection of the debt, among other factors. Once there is evidence that the debt is worthless, the period in which it became worthless must be established.
Wherever there is a bad debt, there is a resulting cancellation of debt income to consider by the creditor. This potential income recognition due to the cancellation of debt (COD) may be treated differently by the states. Although many states follow the federal rules for exclusion of COD income when insolvency occurs, this exclusion requires a number of adjustments to tax attributes which may or may not be allowed on the state level or may be subject to a different calculation. The tax attributes normally adjusted when COD income is not recognized include NOLs, minimum tax credits, general business credits, basis of property, capital loss carryovers, passive activity loss carryovers and foreign tax credit carryovers. Many of these adjustments may be limited at the state level or involve calculations based on different tax basis factors.
Although consideration of state tax attributes is seldom the most important factor of a business transaction, it can result in a significant financial impact. As every state has its own nuances in treating tax attributes, it is difficult to generalize about the effect on the business, but this impact should not be overlooked.
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Mary F. Bernard, CPA/MST is a tax principal and director of state and local tax services at Kahn, Litwin, Renza & Co., Ltd. in Providence, RI.