State Income Taxes Decoupled From IRC on Cancellation of Debt Income

The recently enacted American Recovery and Reinvestment Act of 2009 amended IRC § 108 by adding a provision cancelling debt income. This provision allows taxpayers to elect to defer the recognition of income realized from the discharge of indebtedness until 2014, when they may then spread the deferred income ratably over five years or until 2018. Since most states conform their income tax laws to the federal tax code, states risk seeing significant revenue declines over the years 2009 through 2011 unless they decouple the relevant portion of their income tax law from the cancellation of debt income (CODI) provision. Maryland has recently done this, enacting legislation that decouples its income tax code from the Internal Revenue Code.

Author Andrew Swain writes: In April of this year, Maryland became one of several states to enact legislation effectively decoupling its state income from the federal income tax law. Section 210.1 of Title 10 in Maryland's Code, as amended by the Budget Reconciliation and Financing Act of 2009 (BRFA), provides in pertinent part that gross income includes income from the discharge of indebtedness and the allowance of any deduction with respect to original issue discount without regard to IRC § 108(i). . . .  Through this provision, Maryland ensures that taxpayers who realize income from the discharge of indebtedness recognize the state's portion of the income in the same year in which it was earned, preventing a projected decline in state income tax revenues of up to $116 million in fiscal year 2010 and $69.6 million in fiscal year 2011, a total of approximately $186 million over two years.

Maryland, with respect to its state income tax code, is what is known as a rolling conformity state. As the IRC changes, Maryland's tax code does too. Unless Maryland decoupled its state income tax code from the CODI provision as have other rolling conformity states, the state could have experienced revenue loss as early as the current quarter.  Maryland's move, like that of other states, to decouple its relevant provision from the CODI provision is not deemed radical or even unprecedented. Maryland has decoupled select provisions of its state income tax from the federal tax code before. The state's Budget Reconciliation and Financing Act of 2002, for instance, provided for a permanent decoupling of its state income tax law from two components of the Job Creation and Worker Assistance Act of 2002.

The available literature suggests few if any disadvantages that will outweigh the projected benefits of Maryland's decoupling legislation. In fact, evidence seems to suggest more cost than benefit to a state that complies with the CODI provision. Both the Center on Budget and Policy Priorities and the Urban-Brookings Tax Policy Center have concluded that the stimulative effect of both the CODI provision and state compliance with it are highly questionable.

Indiana's state income tax law, like that of Maryland and most other states, is closely tied to the IRC. Like most other states, Indiana risks suffering revenue loss as a result of the CODI provision unless it decouples its state income tax law from IRC § 108(i). The Center on Budget and Policy Priorities estimates that the state could see declines in its income tax revenue of approximately $117 million over fiscal years 2009 through 2011 should it fail to decouple its state income tax law from the CODI provision.  Decoupling a state tax law provision from the federal tax code is neither radical nor unprecedented. Though the process of decoupling varies depending on whether a state is a rolling-conformity state or fixed-date-conformity state, it ordinarily involves a state's amending a provision or provisions in its income tax law so as to decouple them from their federal analogs.

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