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State and Local Tax Considerations Related to the 2010 Obama Budget Proposals
In February 2009, President Obama issued an outline of his fiscal 2010 budget (see
TaxNewsFlash 2009-103). In May 2009, the Treasury Department released explanations of the administration’s budget proposal (the “green book”) (see
TaxNewsFlash 2009-208). The proposals include tax provisions that may have divergent or ancillary state and local tax effects.
The following discussion summarizes specific provisions of President Obama’s budget proposals and the potential divergent / ancillary effects of these measures on state and local taxes. Areas discussed include the budget proposals concerning:
- Net operating losses
- Codification of the economic substance rule
- Statute of limitations for assessments
- Oil and gas industry—percentage depletion and capitalization of costs
- Income characterization
If enacted, these provisions generally would be effective for tax years beginning after December 31, 2010.
Computation of State Income Tax Base
Federal taxable income—either before or after net operating losses—generally is the starting point for computing states’ net income tax liability. In determining “federal taxable income,” states generally conform to the Internal Revenue Code in one of two ways:
- Static conformity (adoption of the Internal Revenue Code (IRC) as of a specific date) or
- Moving conformity (adoption of the IRC as currently in effect)
As a result, many federal tax proposals, if enacted, would have a similar effect on a taxpayer’s state taxable income in those moving conformity states, as the measures would concerning the taxpayer’s federal taxable income. Likewise, to the extent static conformity states update their IRC adoption date, the federal income tax proposals would similarly affect the computation of state taxable income.
However, the trend over the last several years—even for states that substantially conform to the IRC—has been for the states to “decouple” from the IRC with respect to certain tax provisions. States can decouple from the federal treatment in a number of different ways including:
- Adopting the IRC as of a date prior to certain federal changes
- Passing legislation that specifies certain IRC sections that are not adopted, or
- Requiring various modifications to federal taxable income that result in differing federal and state treatment
- For example, a number of states have decoupled from the IRS with regards to bonus depreciation, expensing of certain depreciable business assets (IRC section 179) and the deduction for domestic production activity (IRC section 199).
Given the various ways in which the states have chosen to decouple, taxpayers need to know not only whether the state has decoupled, but also how and for which tax years the state has decoupled. The ways in which states choose to decouple ultimately will dictate the extent of the differences between the federal and state treatment.
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Accounting Methods
Net Operating Losses: In general, taxpayers—other than certain eligible small businesses—are limited to a two-year net operating loss (NOL) carryback period for federal tax purposes. Under the Obama budget proposal, the federal NOL carryback period would be extended to cover more years, and the category of eligible taxpayers would be expanded. The specifics of the expanded carryback years have been left for Congress to determine.
Potential State and Local Tax Effects: Most states do not allow a NOL carryback. Therefore, an extended NOL carryback period would not be available in most states. Moreover, taxpayers may not receive a state income tax benefit for certain NOL deductions because, in some states, a state NOL deduction only is allowed for the tax year if a federal NOL deduction is taken in the same year. Accordingly, if NOLs are carried back and used for federal income tax purposes, and, therefore are not available for federal carry forward and use in future years, taxpayers may never get the benefit of NOLs in those states.
For example, in computing Rhode Island taxable income, a corporation is allowed a NOL deduction not to exceed the federal NOL taken in the same year. R.I. Code § 44-11-11(b). However, Rhode Island does not allow NOL carry backs. Therefore, all NOLs carried back and used for federal tax purposes are not available for use in future years for Rhode Island corporation tax purposes.
Procedural Issues
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Economic Substance: Under the Obama proposals, the common-law “economic substance” doctrine would be codified. As a result, federal tax benefits related to a transaction likely would be denied unless the taxpayer could demonstrate that the transaction: (1) change in a meaningful way the taxpayer’s economic position; and (2) the taxpayer had a substantial purpose, other than federal taxes, for entering into the transaction. Additionally, a transaction would not be deemed to have economic substance solely by reason of a potential profit motive unless the present value of the reasonably expected pre-tax profit is substantial in relation to the present value of the net federal tax benefits from the transaction.
Potential State and Local Tax Effects: If and when the economic substance doctrine is codified within the IRC could be of significant importance from a state and local tax perspective. For example, if the doctrine is codified in the administrative provisions of the IRC (generally IRC section 6000, et. seq.), rather than the taxable income computation provisions, state adoption of the IRC generally would not capture the codification. Whether a state adopts a codified economic substance doctrine could affect a determination as to whether certain state-level transactions would be deemed to have economic substance.
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Statute of Limitations: Generally, federal income tax assessments must be made within three years after a return is filed. The Obama budget proposal would extend the statute of limitation in instances when there is a state and local adjustment that may increase federal taxable income. The statute of limitations would be extended to the greater of (1) one year from when the taxpayer files an amended federal return or (2) two years from when the state or local government notifies the IRS of the change. The extended statute of limitations would be applicable only to the increase in federal income tax attributable to the state and local adjustment. Further, the extension could only be used once to extend the tax year at issue.
Potential State and Local Tax Effects: While many states refrain from adjusting federal taxable income for purposes of computing state taxable income, it can and does happen. If the budget proposal is enacted, taxpayers may find themselves on statute of limitations “merry-go-round.” For example, if a state modifies federal taxable income for purposes of the state audit and notifies the federal government of the change, the federal statute of limitations is extended. Consequently, the federal government could then audit the taxpayer. Once notified of further changes in the taxpayer’s federal taxable income (if any), states then could require the taxpayer to report the federal change. A federal change could, in effect, “re-open” the state statute of limitations.
Therefore, the effect of extending the federal statute of limitations could result in extending the state statute of limitations as well. Additionally, although some states limit their administrator’s ability to make any additional changes only to the issue raised by the federal adjustment, other states do not have such a limitation. The bright light, if any, in all of this is that the federal extension can only be used once for a particular tax year.
Oil and Gas Industry
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Percentage Depletion: Certain oil and gas independent producers and royalty owners can use the percentage depletion method to recover their investment in mineral properties. Under the Obama budget proposal, the percentage depletion option for independent producers and royalty owners would be repealed. As a result, these businesses would only be allowed to use the cost depletion recovery method. The major difference between the cost and percentage depletion methods is that under the cost depletion method, recovery is limited to the taxpayer’s basis in the property; there is no basis limitation with the percentage depletion method.
Potential State and Local Tax Effects: In certain states—such as Louisiana and Oklahoma—oil and gas producers may have even more divergent depletion deductions than under current law.
- For Louisiana, oil and gas producers are allowed a depletion deduction equal to the greater of the federal depletion deduction or state percentage depletion deduction. La. Rev. Sta. Ann. § 47:287.745.
- Oklahoma oil and gas producers have the option of taking the state percentage depletion deduction or the federal deduction. Okla. Stat. tit. 68, § 2353(10).
The state percentage depletion deduction for Louisiana and Oklahoma is based on 22% of the gross income derived from the property. For these divergent states, separate state depletion deduction computations could be advantageous.
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Expensing vs. Capitalization: Oil and gas companies have the option to expense intangible drilling costs incurred in the U.S. in the year incurred, rather than capitalizing these costs. Intangible drilling costs include tanks, pipelines and other physical structures, among other expenditures. The Obama budget proposal would repeal the expensing option and instead require oil and gas companies to capitalize their intangible drilling costs.
Potential State and Local Tax Effects: Most states use a three-factor formula comprised of property, payroll, and sales to apportion the business income of a multistate business. The property factor typically includes real and personal property used by the taxpayer in its trade or business, including all capitalized costs. Typically, expensed costs are not included in the property factor. Requiring previously expensed intangible drilling costs to be capitalized could have an effect of shifting taxable income among the taxpayer’s taxing jurisdictions as a result of the change to the property factor.
Income Characterization
Carried Interest: The classification of income attributable to a partner in a “services partnership interest” as either ordinary or capital gain is determined by the classification of that income at the partnership level. Additionally, gain recognized from the sale of a services partnership interest currently is treated as capital gain. A services partnership interest is a profits interest held by a partner who provides services to the partnership. As proposed, income attributable to a services partnership interest and the gain from the disposition of such interest would be classified as ordinary income.
Potential State and Local Tax Effects: Capital gains are generally sourced to the individual’s state of residence, and ordinary income is sourced based on the location where the partnership earns its income. The change in characterization of the services partnership interest income from capital to ordinary could have the effect of changing the state where the partner’s income is sourced and potentially could shift taxable income between taxing jurisdictions as well as overall tax liability.
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For more information, contact a KPMG State and Local Tax professional with Washington National Tax:
Michelle Andre, (202) 533-5199, mandre@kpmg.com
Scott Salmon, (202) 533-4202, ssalmon@kpmg.com
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