Many uncertainties surround the state tax impacts of the IRC Section 163(j) interest expense limitation as amended by the 2017 tax reform legislation (the Act). One significant open issue involves whether the limitation is calculated on a separate-company or group basis in states that allow or require consolidated or combined reporting. Although future issuance of federal regulations may clarify the federal treatment, it is unclear at this point how the states will follow such regulatory guidance. Therefore, taxpayers should evaluate the potential options when determining their state interest expense limitation until further guidance is issued.
State taxpayers need to determine how the new Section 163(j) imitation applies on separate-entity, combined, and consolidated bases. Taxpayers should consider the interaction with existing state intercompany interest addback provisions and potential Section 385 recharacterization.
The creation of a new carryover attribute for disallowed interest causes complexity for state income tax purposes since states may (1) decouple from the unlimited carryover period, (2) apportion the carryover, or (3) impose Section 381 and Section 382 limitations.
Finally, the application of these new limitations to partnerships and S corporations raises various state tax considerations, such as state conformity to flow-through treatment and different state rules for corporate-owned versus individual-owned partnerships.
At the same time, analyzing the state tax implications associated with the new Section 163(j) limitation may suggest opportunities for taxpayers to revisit accomplishing other structural goals and benefits. For example, consideration could be given to legal entity simplification initiatives that may facilitate improved interest deductibility taking into account the new Section 163(j) limitation and may facilitate the ‘elimination’ of intercompany indebtedness to address potential state tax issues arising pursuant to the Section 385 regulations.