The states' conformity to follow the federal lead and extend the filing and tax payment deadlines to July 15, 2020, has affected states’ abilities to meet fiscal budgets. The true financial impact continues to unfold. According to the Center on Budget and Policy Priorities, the state budget shortfalls are estimated to be approximately 15% for fiscal 2020 and more than 25% for fiscal 2021. State legislative sessions either were suspended, ended or will end soon. Only a handful of states have sessions extending into fall. While states are learning to conduct business remotely, their ability to do so has been hindered due to unpreparedness and, in some instances, laws requiring in-person meetings. Therefore, at this time, states may have limited capability to operate, let alone legislate change. Times are certainly uncertain. What does this mean for state taxpayers?
Tax increases
The New York State Assembly and Senate introduced nearly identical bills to increase income tax rates imposed on individuals, with new tax brackets created for taxable income over $90,000. The bills target the wealthy to raise their rates above the current 3.4% for taxable income exceeding $500,000. The highest graduated rate increases to 10.32% on taxable income greater than $100 million. Both bills were referred to their respective committees for further consideration.
Illinois voters will have a question on their Nov. 3, 2020, ballot regarding a constitutional amendment to adopt graduated tax rates as opposed to the current flat tax rate of 4.95%. If voters approve the amendment, taxpayers with incomes above $250,000 can expect their tax rate to increase to 7.75%. Individual rates would cap at 7.95% for those with income greater than $1 million. C corporations could see their rate go up to 10.45% from 9.5%.
States’ responses to the CARES Act
Approximately 22 states including the District of Columbia have not yet adjourned their 2020 legislative sessions. Several legislative sessions were suspended and, as of May 31, 2020, two states will hold special sessions in June. As the states attempt to balance their budgets by cutting expenditures, it is possible more states will join New York and Illinois and attempt to raise tax rates or pass other legislative measures to combat their fiscal crises.
States with rolling conformity to the Internal Revenue Code (IRC) will automatically conform to the Coronavirus Aid, Relief, and Economic Security (CARES) Act unless the state decouples as New York did. Other jurisdictions with rolling conformity that have not decoupled from the CARES Act include Alabama, Colorado, District of Columbia, Illinois, Maryland, New Jersey, Pennsylvania and Tennessee (not an all-inclusive list). Any state with a conformity date prior to March 27, 2020, will need to either 1) adopt in full or in part, or 2) decouple in full or in part from the IRC. Wisconsin adopted only specific sections of the CARES Act and New York as noted above decoupled in full.
The CARES Act authorized loans through the Small Business Administration (SBA) for the Paycheck Protection Program (PPP). The funds received under these loans may be forgiven for federal income tax purposes if qualifications of the program are met. The states in the preceding paragraph including the District of Columbia also follow the federal treatment and forgive the income. These states should also follow federal treatment for expenses paid related to the program, which at the time of this writing, are not deductible. Additionally, Wisconsin adopted the PPP section of the CARES Act and, therefore, follows federal treatment of the loan proceeds and expenses. If states fail to pass legislation to conform to the CARES Act, those businesses receiving PPP funds potentially have taxable income unless another state law precludes taxation. However, the expenses paid with said funds should be deductible if used to pay business expenses, again, assuming the income is taxed in these states not otherwise conforming.
When it comes to net operating losses (NOLs), most states have their own laws, which means conformity to the CARES Act would likely have no bearing on the ability to carry back losses. Only a few states allow NOL carrybacks. While that is some good news, unfortunately, the carryback amounts can be limited and it will likely take the states some time to process the amended returns. Therefore, do not rely on these refunds for cash flow.
The federal technical amendment to claim bonus depreciation on qualified improvement property (QIP) and/or use of 15-year life on QIP is another aspect of the CARES Act to determine state treatment. If states adopted bonus under the Tax Cuts and Jobs Act of 2017 (TCJA), then the state would automatically conform to this amendment including use of 15-year life. States with rolling conformity that have adopted bonus include Alabama, Colorado, Illinois (100% bonus only), Missouri and Nebraska (not an all-inclusive list). States that do not allow bonus, including Ohio and Wisconsin, did adopt the technical amendment and will treat QIP as 15-year property using an allowable depreciation method other than bonus.
The majority of states adopted the business interest limitation provisions under the TCJA. However, as noted above, unless the state has rolling conformity, the new provisions under the CARES Act will not apply. Consequently, those states conforming to section 163(j) will need to follow TCJA provisions to determine allowed interest deduction.
Aggressive enforcement of nexus laws
Short of just raising tax rates, there is no better method of raising revenue than to pursue the payment of tax by nonresident, nonvoting taxpayers. Nexus matters continue to be important state issues for businesses and ignoring it is not an advisable strategy. Of the 46 jurisdictions imposing sales and use taxes, 44 have enacted economic nexus laws pertaining to sales and use tax as a result of the Wayfair decision. The remaining two have proposed laws. State coffers were relatively full pre-COVID-19, primarily due to a bustling U.S. economy, which translates into consumer spending and payment of sales taxes. Now, the coffers are empty.
Economic nexus laws affect companies beyond remote sellers. Physical presence nexus must still be analyzed. Companies need to know where they are both economically and physically present. Every state has a nexus or discovery unit, which actively seeks unregistered taxpayers. If discovered by a state, a company may face potential liability for tax, interest and penalty for all tax years in which nexus is deemed to exist — all without statute-of-limitation protection.
An additional nexus matter to consider is employees who are teleworking. Only a handful of states have indicated these employees will not create nexus in their state if only working there due to a state of emergency or stay-at-home orders. Without explicit guidance from states, teleworking employees could cause additional nexus for state taxes even during a pandemic.
Therefore, it is possible states reallocate resources to revenue-raising departments like a nexus or discovery unit. It costs very little for a state to issue a nexus inquiry letter. Knowing your nexus footprint and proactively managing this risk is an advisable strategy.
Increase in state audit activity
State auditors are revenue raisers as well. Within the last several weeks, states learned how to work remotely and that includes the auditors. In fact, they probably know it best since most are in the field. Numerous states have auditors working from home when not auditing taxpayers.
While it is a bit more expensive and time-intensive to have a state audit a taxpayer, the end generally justifies the means. While audits in general are hard for the taxpayer, complying with data requests may be daunting if the company’s records are not available electronically.
Several states are known for their aggressive positions not only when it comes to determining nexus but in their audit practices as well. Taxpayers have the burden of proof to support positions taken on a return whether it be exempt sales filed on a sales/use tax return, calculation of apportionment factor or other expense taken on an income tax return. It is common to have an auditor challenge transaction(s) without seeking additional information and simply enter issue(s) as audit adjustment(s).
While states may not have the ability to hire new auditors, reallocation of current employees to this function may provide states with additional resources to audit more taxpayers. States may also increase auditors’ caseload requirements. If you find yourself in the unfortunate position of having received an audit letter, it is advisable to engage services of your Baker Tilly tax professional.
View more insights from our guide to tax planning during and after COVID-19
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The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely. The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.
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