As we hear about the increase in bankruptcies and debt restructuring, corporations often assume that the state income tax treatment will mirror that of the Internal Revenue Service. This is far from the truth in many states. In our experience, the state tax consequences are often thought of at the last minute or ignored entirely. In fact, it is not unusual for these issues to be addressed during the preparation of the state income tax returns and are rarely analyzed in depth. We’d rather see our clients be proactive!
Cancellation of Debt
Income from the cancellation of debt (COD) can be excluded from federal income. This is dependent on the level of insolvency. If a corporation has excluded COD income, they are required to reduce tax attributes (net operating losses, credits, capital loss carryovers, basis of property, passive activity loss and credits carryovers and foreign tax credits). Federal rules dictate an ordering of the attribute reduction unless certain elections are made. To the degree you are able to consider the state consequences prior to the execution of any debt restructuring, a corporation may be able to preserve state income tax attributes. Further, in some instances, a state income tax gain could be inadvertently generated, causing a tax liability for state purposes even when none was generated for federal tax purposes.
Those of us “old timers” have seen multiple downturns of varying degrees and impacting various industries. What remain consistent is the state issues to be concerned about.
State Tax Consequences of COD Income
Here are some of the issues that should be considered when looking at potential state consequences of COD income.
- Once you have an understanding of the federal tax treatment, even if numbers are moving a bit look at the top 5 – 10 states as measured by apportionment. (This is just a practical first step. We don’t suggest to ignore the other states, but typically 5 – 10 states will cover approximately 80% of your apportionment. Of course, there are often exceptions.)
- Review how each state conforms to the Internal Revenue Code (“IRC”) and the date of conformity. During this exercise, it is also important to look at the overlay of the federal consolidated return regulations. Depending on the state, even if they are a unitary state, they may not conform to some or all the consolidated return regulations. This may mean that, barring any state guidance, you could be forced to use the federal treatment as if a separate company return were filed.
- Tax attributes for state purposes are not the same as the federal tax attributes. You will need to identify each states’ tax attributes and evaluate whether they are required to be reduced. For example, state NOLs are generally apportioned, consequently, the amount of NOL available for reduction may be substantially lower. Additionally, some credits may not exist for state purposes (e.g. research credits, foreign tax credits). Further, federal and state basis is often different, resulting in differing levels of reduction.
- The existence of intercompany debt can cause some unexpected state consequences. Federal rules may result in no income or loss being recognized from intercompany COD income for federal consolidated returns purposes. However, in those states that may not recognize consolidated return rules, income and loss could be generated on a separate company basis.
- The computation of apportioned state NOLs should be reviewed. It is not unusual for a corporation that has had a recent history of losses to invest little time into evaluating its state apportionment. Given the losses generated, it often results in merely moving NOLs from one state to another. However, this could result in having fewer NOLs available for attribute reduction. The opposite can be true as well, and a corporation may have more NOLs available than originally thought.
- State conformity, or lack of conformity, with IRC Section 382 should be reviewed. While states may technically conform with Section 382, few have offered any guidance as to how to apply Section 382 for state purposes. For example, if there are separate company NOLs, is the limitation computed for each entity? How does this work if the federal limitation is computed on a consolidated basis? Apportionment is not considered under Section 382, but state NOLs are generally apportioned. When considering the computation of net unrealized built-in gains and losses (NUBIGs and NUBILs), the lack of clarity for state purposes results in more complexity. For example, a NUBIL could exist for federal consolidated return purposes, but it is possible that on a separate company perspective a NUBIG could exist, or vice versa.
The discussion above is not intended to be a technical discussion of all the issues and consequences of COD income from a state income tax perspective. However, we hope to raise awareness that it will not just be a rubber stamp of the federal treatment. Given the lack any guidance in most states, it will be up to many corporations and their advisors to evaluate each circumstance separately, considering federal rules, state conformity and the risk profile of the company. Many times, there is not one clear answer. Historically, we have worked with clients to evaluate the implications under various scenarios depending on differing interpretations. These differing scenarios should be considered when preparing the returns and evaluating the state income tax provision, including reserves and valuation allowances.
Bankruptcy and debt restructuring are subjects likely to be encountered more often as the economy continues to react to the ongoing pandemic. As such, we want to remind our readers that we offer consulting services in the areas mentioned above. For comments or questions on this article and others, please contact us at info@milesconsultinggroup.com.
Be sure to check in next week for Part 2 – Sales Tax Issues for Troubled Companies.
