Pennsylvania's Loss Carryover Deduction Cap Ruled Unconstitutional

The Bloomberg BNA Tax Management Weekly State Tax Report filters through current state developments and analyzes those critical to multistate tax planning.

By Robert Willens

Robert Willens is president of the tax and consulting firm Robert Willens LLC in New York and an adjunct professor of finance at Columbia University Graduate School of Business.

Nextel Communications of the Mid-Atlantic Inc., for Pennsylvania tax purposes, carried over net losses of $150 million in 2007. Nextel earned $45 million of taxable income in 2007.

Consistent with the “net loss carryover” (NLC) deduction provision of the Pennsylvania Tax Reform Code, Nextel took only a $5.6 million NLC deduction (the greater of 12.5 percent of its taxable income or $3 million). As a result, the company reduced its taxable income for 2007 to $39.4 million and paid corporate net income (CNI) tax of $4 million on that amount.

In the recent Pennsylvania Commonwealth Court case Nextel Commc'ns of Mid-Atlantic, Inc. v. Commonwealth, Nextel argued that the NLC deduction “cap” is unconstitutional. It contended that the cap violates the uniformity clause of the Pennsylvania Constitution (Nextel Commc'ns of Mid-Atlantic, Inc. v. Commonwealth, 2015 BL 384508, Pa. Commw. Ct., No. 98 F.R. 2012, 11/23/15). 

The uniformity clause provides: “… All taxes shall be uniform, upon the same class of subjects ….”

Nextel contended that the limitations on the NLC deduction favor businesses with taxable income of $3 million or less. Assuming these taxpayers have a “positive net loss carryover position” (i.e., a loss carryover in excess of taxable income in a particular year), these taxpayers can reduce their taxable income to zero. Any taxpayer with taxable income of more than $3 million that is also in a positive net loss carryover position is precluded from reducing its taxable income to zero.

Disparate Treatment Based on Size

Nextel maintained that this disparate treatment of taxpayers based solely on the size of the business in terms of taxable income violates the uniformity clause.

Pennsylvania contended that there is no violation because the single statutory rate (of 9.99 percent) is applied to the same base in every case (taxable income less the NLC deduction).

The court agreed with Nextel.

It is axiomatic that a taxpayer challenging the constitutionality of tax legislation “bears a heavy burden.” The taxpayer must demonstrate that the provision being challenged results in some form of classification, and that the classification the provision engenders is unreasonable “and not rationally related to any legitimate state purpose.”

Tax legislation, the court noted, is presumed to be constitutionally valid and won't be declared unconstitutional unless it “clearly, palpably and plainly violates the constitution.”

The Pennsylvania Legislature, the court pointed out, can't treat similarly situated taxpayers differently. Even where a tax law provides for a fixed statutory tax rate applied to all taxpayers, the tax scheme may still yield unconstitutionally divergent tax burdens. It did here.

Classification Found
To Be Unreasonable

Nextel, the court found, has demonstrated that the NLC deduction provision creates classes of taxpayers according to their taxable income. Both classes of taxpayers entered 2007 in a positive net operating loss carryover position. The only factor that distinguishes the classes is the amount of taxable income. Taxpayers with $3 million or less in taxable income in 2007 could offset 100 percent of their taxable income through the NLC deduction provision. By contrast, taxpayers with more than $3 million in taxable income in 2007 couldn't offset 100 percent of their taxable income.

Having concluded that the NLC deduction provision treated taxpayers with taxable income in excess of $3 million differently than taxpayers with $3 million or less in taxable income, the court had to determine whether this classification is unreasonable and not rationally related to any legitimate state purpose. The court was up to the challenge.

A classification based solely on income amount can't withstand scrutiny. “A classification that is based solely on a difference in quantity of precisely the same kind of property is necessarily unjust, arbitrary, and illegal.”1

The Pennsylvania Legislature, the court observed, has elected to tax property—corporate net income. It has also allowed taxpayers to deduct from their taxable income carryover of net losses from prior years. By capping that deduction, it said, the Legislature has favored taxpayers whose property is valued at $3 million or less.

To the extent these taxpayers are in a positive net loss carryover position, they pay no corporate income tax. A similarly situated taxpayer (i.e., a taxpayer in a positive net loss carryover position) with more than $3 million in taxable income can't avoid paying tax under the NLC deduction provision.

The distinction is based solely on asset value, which is, under In re Cope's Estate, 43 A. 79 (Pa. 1899)—which has stood the test of time—unjust, arbitrary and in the final analysis, illegal. That Nextel and other high-income taxpayers may, in future years, be able to apply unused net losses to reduce taxable income (in Pennsylvania there is a 20-year carryover of net losses) doesn't change the fact that some taxpayers paid no income tax in 2007 because of the NLC deduction provisions and other (similarly situated) taxpayers did.

This unequal treatment must be remedied, but how? The court found that it can only be remedied in one of two ways: The favored taxpayers pay more tax, or Nextel pays less tax. The latter, the court determined, is the only practical solution.

Thus, like similarly situated taxpayers with $3 million or less of taxable income in 2007, Nextel should be permitted to reduce its taxable income to zero by virtue of its positive net operating loss position that tax year. (This problem, it should be noted, hasn't gone away. For tax years beginning after Dec. 31, 2014, the NLC deduction is also capped, at the greater of 30 percent of taxable income or $5 million. Presumably, the deduction cap, although more generous than the 2007 version, is also unconstitutional).

1 See In re Cope's Estate, 43 A. 79 (Pa. 1899).
2 For federal tax purposes, a corporation with net operating losses that has undergone an “ownership change” can only offset a specified amount of its taxable income, in any taxable year ending after the change date, with its pre-change net operating losses. This amount is known as the tax code Section 382 limitation and it is equal to the product of the value of the loss corporation's stock immediately before the ownership change and the long-term tax-exempt rate in effect for the month in which the change date falls. If the loss corporation has a “net unrealized built-in gain” that exceeds certain thresholds, it can increase the Section 382 limitation by any such gains that are recognized during the five-year recognition period that commences on the change date.

Thus, taxpayers that have experienced ownership changes, and are in a positive net loss position, can't reduce their taxable income to zero in cases where such taxable income exceeds the Section 382 limitation. By contrast, those loss corporations that haven't undergone ownership changes, whose net operating loss carryovers are in excess of taxable income in the carryforward year, can reduce their taxable incomes to zero. One wonders whether this distinction between seemingly similarly situated taxpayers would withstand scrutiny. To our knowledge, no taxpayer has ever mounted a constitutional challenge directed at the provisions of Section 382.

The disparate treatment of taxpayers with net operating losses may well be justified by the fact that Congress sought, through the provisions of Section 382, to inhibit, or at least discourage, what it termed “trafficking in net operating losses.” Accordingly, it may be that the “classification” created by the disparate treatment of taxpayers with net operating losses is rationally related to a legitimate state purpose, i.e., to provide unfettered use of net operating losses only in cases where the corporation, at the time the losses are sought to be utilized to reduce taxable income, remains majority-owned by the same shareholders who owned the stock when the losses were sustained.