Pending Tax Reform Necessitates Strategic State NOL Modeling
As tax reform looms, the old adage, “a dollar today is worth more than a dollar tomorrow” has never been truer. With over $200 billion in Net Operating Loss (NOL) assets sitting on the books of Fortune 1000 companies, now is the time for these companies to model out potential tax reform impacts and monetize NOLs into cash tax savings.
Although there is a myriad of federal corporate tax reform proposals, the one that seems certain is a tax rate reduction. The current 35% tax rate on corporate income is among the highest in the world, and critics say it creates a competitive disadvantage for American companies doing business in an increasingly global economy. While lowering the rate will certainly benefit American companies, any changes to current tax law will be felt beyond the Corporate 1120. Financial statements will be significantly impacted as well.
One area in particular that may be impacted is the deferred tax asset (DTA) which is generated when a company incurs an NOL. When incurred, the matching principle says we should account for that future deduction against taxable income on today’s income statement. This means that the NOL is tax-effected (using 35%), the total income tax expense is reduced, and a deferred tax asset is created to account for the timing difference between GAAP and tax. Note that the NOL is tax-effected at the expected future tax rate, so that the right amount of future deduction is booked to today’s financial statements. If the tax rate is lowered, the tax-expense booked for GAAP purposes will have accounted for more future deductions than it should have. Therefore, the deferred tax asset needs to be reduced by the difference, with that difference running through the income statement. Here’s an example of one company:
The effect tax reform could have on NOL DTAs doesn’t stop at the federal level. Reducing the DTA for a federal NOL will make any state NOL more material, simply by default. Continuing with our previous example, assume that the same company has a state NOL DTA as well.
The reduction of the DTA at the federal level, due to a lower tax rate, has increased the proportion of the state DTA by 75%. Extrapolate that to a large company with filings in all 50 states, and suddenly state DTAs add up to a significant number on the balance sheet.
With tax reform there is likely to be an even greater wave of state modifications than already exists today, adding to the difficulty of properly tracking a state NOL. Unfortunately, in many tax departments tracking NOLs at the state level has become somewhat of a guessing game. Multiple and different filing groups, changing apportionment formulas, state modifications, NOL rules, and tax rates make tracking NOLs very manual, time consuming, and error prone. This is especially true when using spreadsheets, when last minute changes collide with the tight deadlines that come with calculating provision. Tax departments need to act quickly in order to streamline their management and tracking capabilities; otherwise a material weakness may be inevitable.
State Tax Analyzer™ from Bloomberg Tax delivers the ability to accurately predict NOL impacts. Its NOL Manager gives you and your staff 20/20 vision when it comes to your state NOL positions. With the latest built-in tax law, NOL Manager automatically performs calculations and applies generation and utilization (carryback/forward) rules for all states that have corporate income tax, plus the District of Columbia, across multiple years and scenarios. It enables tax professionals to:
- Manage cash tax as NOL assets are used
- Compute and document valuation allowances to withstand scrutiny
- Forecast taxes for financial statements and quarterly estimates
- Calculate and track NOL generation and utilization across years
- Manage NOLs for various state filing groups, on both a group and entity-by-entity basis
- Show impacts of IRS and state tax audits on NOLs
Only by implementing best practices that automate the tracking, computation, and forecasting of state NOLs, can companies know with certainty that they are leveraging their valuable state NOLs to the fullest extent.
For advanced corporate tax planning in the federal arena, Corporate Tax Analyzer™, from Bloomberg Tax is also available. This is the same software that the IRS uses to conduct corporate audits, as well as the same software many companies use to eliminate surprises, by mitigating audit risks, and analyzing tax planning scenarios over multiple years and multiple scenarios.