From the enactment of the Tax Cuts and Jobs Act of 2017 (TCJA), California was one of the handful of states that did not conform to a number of provisions in the law. Most notably, the state continued to allow taxpayers to take full advantage of the net operating loss (NOL) deduction and ignore 80% of taxable income limitation. In the latest round of budget proposals, taxpayers may see changes to the NOL deduction for the upcoming tax year.
Details on Governor Gavin Newsom's proposed budget were released earlier this year, which included a number of changes that would affect companies doing business within the state. The most notable change includes a plan to increase business tax revenue by restricting the use of net operating loss deductions. Following the provisions of TCJA, California is now seeking to conform to the NOL treatment under federal law, by also limiting the state NOL to 80% of taxable income.
Why is California Seeking to Limit NOLs?
The administration cites one of the reasons behind the proposed change is to conform the state’s NOL provisions with that of TCJA. However, taxpayers should be aware that a true conformity will not exist under the current proposals by the Governor. Any taxpayer that is carrying forward an NOL from a previous tax year may still have an adjustment when calculating California taxable income.
Department of Finance representative Colby White stated:
“It is effective for taxable years beginning on or after January 1, 2024. So, when a corporation files their tax return for 2024 or later, NOLs they had earned or any NOLs they earned in the past, they can use all their NOLs but only up to 80 percent of their taxable income, so they can’t fully offset.”
If this interpretation of the NOL limitation were to pass in the final budget, California would have even stricter NOL limitations in place than under federal law.
What are the Impacts if California Limits NOL Deductions?
Department representatives are claiming that all accrued NOL carryovers, even those originating from 2017 and earlier, would be subject to this new 80% taxable income limitation. However, under the Internal Revenue Code (IRC), NOLs incurred before 2018 were grandfathered and are fully deductible until depleted. The administration has also not clarified whether the proposed adjustment would also include adopting the IRC’s indefinite life of unused NOL carryovers.
Without clarification, California businesses may expect to be restricted to an 80% limitation and face a 20 year carryover period, or risk losing the benefits.
If the proposed changes to the NOL deduction are passed, this would not be the first time in recent years that the state has made changes to the deduction. During the pandemic, the state fully suspended the NOL deduction for both corporate and individual taxpayers with incomes of $1 million or greater, only to reinstate them again starting with the 2022 tax year.
This proposal, which if passed, would take effect starting with the 2024 tax year and estimates that an additional $300 million in revenue would be raised in the first year alone. After the initial year, the administration claims the provision would raise an additional $200 million annually.
As of now, it appears that the changes will only impact corporate taxpayers, meaning individual taxpayers with an NOL will not see an 80% limitation imposed. However, these measures are still proposed and we may see changes if adopted into the final budget.
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