The Extended Federal NOL Carryback Period—State Tax Considerations

On November 6, 2009, President Obama signed H.R. 3548, The Worker, Homeownership, and Business Assistance Act of 2009. Under the legislation, certain businesses may elect to carry back federal net operating losses (NOLs) for up to five years for losses incurred in tax years beginning or ending in either 2008 or 2009 (at the election of the taxpayer), but not for both years. In this blog series, we address common questions regarding state tax consequences of carrying back a 2008 or 2009 loss.

Could state taxable income increase as a result of carrying back an NOL for federal purposes?

As odd as it sounds, a taxpayer might actually find that its state taxable income increases as a result of availing itself of the federal NOL carryback provisions. For example, if the taxpayer is permitted to take an IRC Section 199 deduction for “qualified production activities,” the taxpayer’s state taxable income could increase. The Section 199 deduction is limited to the lesser of (1) “qualified production activities income” and (2) a certain percentage of Line 30 (i.e., federal taxable income after application of NOLs and special deductions). Accordingly, if Line 30 income decreases (as a result of an NOL carryback), the Section 199 deduction may decrease.

The Section 199 deduction is generally allowed by a state simply by starting the computation of state taxable income with federal taxable income (either Line 28 or Line 30 of Form 1120) and not requiring the taxpayer to add back the deduction. When a Section 199 deduction decreases (due to application of the federal NOL carryback), federal taxable income increases. If a state does not require the Section 199 deduction to be added back, a taxpayer’s state taxable income (and ultimate state tax liability) could increase as a result of the decrease in the Section 199 deduction.