State Income Tax and Federal Net Operating Losses

States differ in how they treat the federal net operating loss deduction on state corporate income tax returns. The variety of state approaches can make compliance complex for multistate corporations. However, knowing these differences can provide tax planning opportunities for corporate income taxpayers, especially multistate corporations.

How Are NOLs Treated Under Federal Law?

A federal NOL deduction is available to corporate taxpayer under IRC Sec. 172. Generally, an NOL arises when a taxpayer’s deductions are more than their income for the year.

A NOL is not deducted in the tax year it occurs. Instead, the NOL is carried back or carried forward to other tax years, then deducted. The lengths of time for carrying NOLs back or forward are called carryback and carryover periods.

Before the Tax Cuts and Jobs Act (TCJA) was enacted, a NOL could be carried back two tax years and carried forward up to 20 years. Now, the Code allows NOLs to be carried forward indefinitely.

Do States Follow the Federal NOL Rules?

In general, many states don’t.   Common practices in states include:

  • computing state income tax starting with federal taxable income before NOLs;
  • requiring taxpayers to add back the amount of the federal NOL deduction to income; or
  • modifying the federal NOL deduction.

No Federal NOL Deduction in State Computation

Approximately half of the states do not allow the federal NOL deduction. Most of these states base a corporation’s taxable income on federal taxable income before the federal NOL deduction (federal Form 1120, Line 28). States that follow this approach include:

Adding Back the NOL Deduction

In a number of states, corporations must add back the amount of the federal NOL deduction to their state income. The state may then allow a net operating loss to be calculated using its own rules. States that follow this approach include:

Modifications to Federal NOL Deduction

Some states modify the federal NOL. For example, Maryland conforms to the federal NOL deduction, unless:

  • an extended carryback is claimed;
  • federal taxable income subtraction modifications exceed addition modifications in the year of loss; or
  • subtraction modifications include foreign source dividends.

Other states like Missouri and Virginia require an addition or add back for the federal NOL deduction only under certain circumstances.

Conformity to Federal NOL Carryforward and Carryback Rules

State carryforward and carryback periods vary significantly. Many states did not permit carrybacks prior to the enactment of TCJA. Additionally, states that did permit carrybacks often decoupled from extended federal carryback periods. Different approaches that are taken across the states include:

  • prohibiting NOL carrybacks (e.g., North Carolina);
  • conforming to federal carryback periods (e.g., Mississippi);
  • conforming to federal carryforward periods (e.g., Wisconsin);
  • allowing carryback periods of two or three years (e.g., Utah and California); and
  • allowing carryforward periods that range from five to twenty years (e.g. Rhode Island and Illinois).

In a later post, we will explore how states have responded to changes in the NOL deduction made by the TCJA.

By Catherine S. Agdeppa, J.D.

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All stories by: CCHTaxGroup