Federal action to stimulate the economy with tax breaks for business has sparked trouble for state tax departments and difficulty for businesses trying to comply with the changes.

The Job Creation and Worker Assistance Act of 2002 (JCWA), signed into law by President Bush on March 9 of this year, created several changes to the tax laws that were retroactive to the 2001 tax year, affecting 2001 tax returns that had already been filed or were about to be filed. Since most states use the Internal Revenue Code as the base for their state income taxes, the federal tax cuts threatened to reduce state revenues, as well, but state legislatures have, for the most part, forestalled that possibility.

Businesses--from large corporations to self-employed individuals--received the lion's share of the tax breaks under the JCWA. The two main tax-saving provisions were a temporary 30 percent depreciation "bonus" and a five-year carryback period for net operating losses (NOLs). Both applied retroactively to affect 2001 tax returns.

To qualify for bonus depreciation, property must be new and acquired after September 10, 2001 and before September 11, 2004 and it must be placed in service generally before January 1, 2005. The NOL provision applies to 2002, as well.

More Dollars for the States, More Complexity for Taxpayers

The federal stimulus package as passed was much smaller than the one originally proposed by the Bush administration, but its implications for state budgets were still too large for many state legislators to go along with, according to John Logan, JD, CCH senior state tax analyst.

"With many states already facing budget shortfalls because of the slowdown in the economy, the prospect of losing additional tax dollars was very unattractive to their legislatures," Logan said.

Through legislative action or inaction, a majority of states have declined to fully adopt both the depreciation "bonus" and the NOL provisions. As a result, more tax dollars will flow into straitened state treasuries, but businesses will face increased complexity as they account for their income and assets differently for state and federal purposes.

Depreciation "Bonus" Leads to Extra Bookkeeping

The depreciation "bonus" in the JCWA allows taxpayers an additional first-year depreciation deduction equal to 30 percent of the adjusted basis of qualified property. On federal returns, the 30 percent "bonus" depreciation is allowable for regular and alternative minimum tax (AMT) purposes for the tax year in which the property is placed in service.

The basis of the property and the depreciation allowances in the year of purchase and in later years must be adjusted to reflect the additional first-year depreciation deduction.

Only thirteen states have laws that conform to the new federal provisions on "bonus" depreciation. Twenty-four states plus the District of Columbia have not conformed. Of the remaining nine states with personal income taxes, corporate income taxes or other business taxes that are substantially similar to corporate income taxes, most require taxpayers to add back a portion of the federal depreciation "bonus" when figuring their state tax, but then allow for the remainder of the "bonus" to be taken in future years. South Dakota, which does not have a corporate income tax but which does impose a financial institutions franchise tax, allows an additional depreciation subtraction for the excess of the state undepreciated tax basis over the federal depreciable basis.

"Businesses in states that chose not to conform fully with the depreciation 'bonus' will find themselves having to keep multiple sets of books on the current cost basis for each asset that qualifies for the federal provision," Logan noted.

Few States Adopt NOL Provisions

Ordinarily, federal taxpayers can carry back NOLs two years. The new law temporarily extends that general carryback period from two to five years. In addition, certain NOLs that are ordinarily carried back for three years, such as casualty losses, can also be carried back five years under the JCWA.

This enhanced federal carryback applies only to losses that arise in tax years ending in 2001 and 2002. Taxpayers are given one opportunity to elect out of this treatment and their election is final. The new law also allows a taxpayer's NOL deduction to reduce its alternative minimum taxable income (AMTI) up to 100 percent.

Only seven states have adopted the NOL provisions and only four of those--Alaska, North Dakota, Oklahoma and Vermont--have adopted the provisions as written in the federal law. Delaware, New York and Wisconsin adopted the basic NOL provision but limited the amounts that can be carried back.

Of the remaining jurisdictions, 40 states and the District of Columbia have not adopted the NOL provisions thus far, while Nevada, Washington and Wyoming don't impose corporate or personal income taxes.

Not Too Late

The fact that a state is out of conformity with the JCWA now doesn't mean that it will necessarily remain so.

"A number of states ordinarily synchronize their laws to the federal provisions as of January 1 of each year. Since the JCWA was passed in March of this year, in those states that are out of conformity simply because they synchronize with the IRC as of January 1, the JCWA could become a part of state law in January 2003. But, with state legislatures scrambling for dollars, it may not be business as usual," Logan observed.

A summary of states' conformity to the new provisions is listed below.

States with Special Situations

• Nevada, Washington and Wyoming do not impose a corporate income tax.
• Maine will allow the bonus depreciation for 2001. However, for tax years beginning in 2002, the bonus depreciation may be reduced based on the amount of funding in the Tax Conformity Reserve account.
• Michigan allows the bonus depreciation deduction in computing the federal taxable income amount that is the tax base for the Single Business Tax. However, the federal depreciation deduction must be added to federal taxable income for purposes of determining the Michigan tax base. Minnesota will allow the bonus depreciation subject to an 80 percent addback provision, and the addback amount is allowed as a subtraction for the five tax years following the addback, effective for tax years ending after September 10, 2001.
• Montana specifically adopts IRC section 167 without specifically referencing section 168. However, it has been the state's longstanding practice to follow section 168 treatment if that is the method chosen by the taxpayer.
• Nebraska requires that 85 percent of any bonus depreciation be added back. The amount may later be deducted over five years beginning with tax year 2005.
• North Carolina does not currently allow the bonus depreciation. However, the Department of Revenue will process original returns claiming the bonus depreciation until it is clear if the legislature will conform to the federal treatment. If the legislature does not conform, taxpayers will have to file amended returns and pay any additional tax and interest.
• Ohio requires taxpayers to add back 5/6 of the amount of bonus depreciation taken for federal purposes. Taxpayers may deduct the add-back amount in equal installments over the following five tax years.
• Oklahoma requires taxpayers to add back 80 percent of the federal bonus depreciation, which can then be claimed in equal amounts over the next four years.
• South Dakota does not have a corporate income tax but does impose a financial institutions franchise tax. The state conforms to the IRC as of a date prior to the JCWA, but allows an additional depreciation subtraction for the excess of the state undepreciated tax basis over the federal depreciable basis.
• Texas generally does not allow bonus depreciation because it adopts the IRC in effect for the federal tax year beginning on or after January 1, 1996, and before January 1, 1997. However, for corporations that qualify and elect to use the FIT (federal income tax) method of reporting taxable capital (including S corporations, close corporations with not more than 35 shareholders, and corporations with taxable capital of less than $1 million), the bonus depreciation will be allowed as long as the same method was used in the corporation's most recent federal income tax return.

*Although Delaware, New York and West Virginia incorporate the extended NOL carrybacks, they limit the amount that may be carried back. Delaware limits NOL carrybacks to $30,000 and New York limits NOL carrybacks to $10,000 per year. West Virginia limits NOL carrybacks to $300,000.

States with Special Situations

Nevada, Washington and Wyoming do not impose a corporate income tax.

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