The CARES Act provides for special federal tax treatment for “coronavirus-related distributions” from most types of tax-qualified retirement plans and IRAs1. The distribution must be made between January 1, 2020 and December 31, 2020 to an individual diagnosed with the virus, caring for a spouse or dependent diagnosed with the virus, or experiencing adverse financial consequences stemming from certain pandemic-related situations (such as quarantine). Income related to those distributions is subject to federal income tax ratably over three years, rather than all at once, unless the individual elects not to have the ratable inclusion apply. However, this favorable tax treatment may not apply for state and local tax purposes.
For background, the threshold issue when analyzing the state and local tax impact of federal legislation is whether and how a state conforms to the Internal Revenue Code (IRC). Generally, most states conform to the IRC through “rolling” conformity (adopting the IRC as-amended, e.g., Maryland, Massachusetts, and D.C.) or “fixed” or “static” conformity (adopting the IRC as of a specified date, e.g., Florida, Georgia, and Virginia). A handful of states adopt so-called selective conformity, where they conform to specific provisions of the IRC – Arkansas, California, Mississippi, New Jersey, and Pennsylvania. Further, all states selectively decouple, to varying degrees, from certain IRC provisions. As just a few of the many examples, most states do not adopt bonus depreciation under Section 168(k) and many states have separately enacted net operating loss rules and dividends received deductions that are different from the IRC provisions.
While historically a rolling conformity state, New York’s FY 2021 Budget Act temporarily adopts fixed conformity as of March 1, 2020 through January 1, 2022 for purposes of the both the state and New York City personal income taxes. The FY 2021 Budget Act also decouples New York State franchise (Article 9-A) and New York City corporation tax law from certain of the CARES Act’s changes to the IRC, e.g., Section 163(j)(10)(A) – the election to increase the Section 163(j) limitation from 30% of adjusted taxable income (ATI) to 50% of ATI.
As a result of this fixed conformity, New York became the first state to take action to decouple from the CARES Act, including the three-year ratable income inclusion for coronavirus-related distributions from retirement plans.2 Therefore, if a plan participant subject to New York income tax takes a coronavirus-related distribution, he or she may be surprised to learn that for New York state and local income tax purposes, the distribution is taxed 100% in 2020, rather than the federal ratable treatment.
Other states may not automatically conform to the three-year ratable income inclusion of the federal CARES Act because they adopt either selective or fixed conformity to the IRC. It is possible that these states’ legislatures may ultimately elect to follow the CARES Act amendments, including the three-year ratable income inclusion, but at this point, we cannot be certain how the states will respond until the legislatures reconvene. However, because the three-year ratable income inclusion provides individual taxpayers material tax benefits and much-needed liquidity, it is anticipated that most states will follow the federal rules.
In addition to the three-year ratable tax provision, the CARES Act provides that if the coronavirus-related distributions are repaid to the plan within three years, the original distribution is not treated as taxable. Individual taxpayers who have made a repayment will likely need to file amended returns and make a tax adjustment. The tax adjustment in the case of a recontribution has not been spelled out by the IRS for the current coronavirus situation, but in previous guidance for natural disasters the IRS allowed individuals to file Form 8915 to make an adjustment. With respect to state taxes, we expect that states generally will conform to the federal provisions for extended recontribution periods and tax adjustments for affected individuals, as with prior federal disaster relief legislation. However, this is another area that will need to be monitored for potential differences. We also anticipate that some states will adopt additional, unique tax relief provisions, largely dependent on a specific state’s tax structure and local economy.
Given these potential unexpected differences between federal and state taxes, it is advisable that any participant communications regarding the CARES Act specify that the ratable income tax change applies for federal income tax purposes, and state tax results may vary. Plan sponsors may also want to track the state tax treatment in the jurisdictions in which they have the most employees in order to better tailor their communications to participants. Employers should also consider whether any other benefits under recent federal legislation may have different state tax treatment as well, such as the CARES Act’s provision that allows certain employer payments to be made towards employee student loans on a tax-free basis.
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1 These plans include section 401(k), 403(b), and governmental 457(b) plans, as well as IRAs. For more information about the CARES Act benefits provisions, see https://us.eversheds-sutherland.com/NewsCommentary/Legal-Alerts/230380/Legal-Alert-Congress-delivers-a-CARES-package-to-employers-and-other-recent-developments.
2 For more information about the New York budget bill, see https://us.eversheds-sutherland.com/NewsCommentary/Legal-Alerts/230842/New-York-budget-bill-passes-legislature.
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