The Massachusetts Legislature recently incorporated into Massachusetts law the Internal Revenue Code (the "Code") as amended on January 1, 1988, and in effect for the taxable year.

Massachusetts previously used the Code as amended on January 1, 1985. The change applies to all taxable years beginning on or after January 1, 1988.

By this legislation, Massachusetts adopts many of the federal tax law changes enacted by Congress in the Tax Reform Act of 1986 (TRA 86). Those changes generally took effect for federal purposes for taxable years beginning on or after January 1, 1987. TRA 86 changed federal law governing certain exclusions from federal gross income and placed significant restrictions on many federal deductions. Because Massachusetts uses federal gross income as the starting point in computing Massachusetts gross income and because certain deductions from Massachusetts gross income are based on federal deductions, the changes in the federal law affect the computation of Massachusetts personal income tax for taxable years beginning on or after January 1, 1988.

Under the new Massachusetts income tax provisions Massachusetts taxpayers will be required to include in Massachusetts gross income all items which are required to be included in federal gross income under the Code as amended on January 1, 1988, unless a specific Massachusetts modification excludes such items from Massachusetts gross income. G.L. c. 62, § 2(a). Deductions from Massachusetts gross income that are based on federal deductions will generally be allowed to the same extent as the corresponding deductions are allowed for federal purposes under the Code as amended on January 1, 1988. G.L. c. 62, § 2(d)(1).

The purpose of this Technical Information Release (TIR) is to provide rules for the transition to the Code as amended on January 1, 1988. This TIR applies only to the personal income tax, imposed under General Laws Chapter 62.

Transition Rules

A. Carry Forward of Losses and Expenses.

TRA 86 permits the following items of loss and expense to be carried forward to succeeding taxable years to the extent that such items are disallowed as federal deductions because of the restrictions imposed by the new federal law:

1) Trade or business losses disallowed because of the passive loss rules imposed by Code section 469;

2) Trade or business losses from real property holdings disallowed because of the at-risk limitation imposed by Code section 465(a);

3) Code section 179 expenses disallowed because of insufficient trade or business income under Code section 179(b)(3); and

4) Home office expenses disallowed because-of insufficient trade or business income under Code section 280A(c)(5).

For taxable years beginning on or after January 1, 1988, these items of disallowed loss and disallowed expense may be carried forward to succeeding taxable years for Massachusetts purposes in the same manner as they may be carried forward for federal purposes under the Code as amended on January 1, 1988. However, items of loss and expense which were disallowed for federal purposes in taxable years beginning on or before December 31, 1987, may not be carried forward for Massachusetts purposes. Items of loss and expense allowed as Massachusetts deductions with respect to business and income producing property in taxable years beginning during calendar 1987 must be applied to reduce Massachusetts adjusted basis upon the sale of such property. G.L. c. 62, §6F(3).

B. Recovery of Pension Contributions.

TRA 86 repealed the three-year rule for the recovery of employee contributions to certain retirement plans. The repeal applies to retirement plans under which pension payments began after July 1, 1986. I.R.C. § 72(b).

Generally, for taxable years beginning on or after January 1, 1988, pension income will be excluded from Massachusetts gross income to the same extent that it is excluded from federal gross income under the Code as amended on January 1, 1988, unless a specific provision of Massachusetts law requires the pension income to be included in Massachusetts gross income. G.L. c. 62, § 2(a). This rule applies to all pension income, including that of retirees whose pension payments started before January 1, 1988, and after July 1, 1986, and who previously excluded pension income from Massachusetts gross income under the three-year rule. Retirees who have already excluded from Massachusetts gross income an aggregate amount of pension income equal to the amount of their entire pension contribution, must include in Massachusetts gross income all pension income in excess of their contribution.

C. Depreciation.

TRA 86 changed the federal law governing deductions for depreciation of business and income producing property placed in service during taxable years beginning after December 31, 1986. I.R.C. § 168(b)(c).

For taxable years beginning on or after January 1, 1988, the Massachusetts deduction for annual depreciation of business and income producing property placed in service after December 31, 1986, will generally be the same as the annual federal depreciation deduction for such property under the Code as amended on January 1, 1988. G.L. c. 62, § 2(d). However, the Massachusetts deduction for depreciation of business and income producing property placed in service during taxable years beginning during calendar year 1987 will not be allowed after an aggregate amount of depreciation has been deducted for Massachusetts purposes equal to the Massachusetts initial depreciable basis of such property. The Massachusetts deduction for depreciation of business and income producing property placed in service during taxable years beginning during calendar year 1987 will be allowed to the full extent of Massachusetts and federal purposes.

If business or income producing property placed in service during taxable years beginning during calendar year 1987 is sold before it is fully depreciated for Massachusetts purposes, then depreciation allowed as a federal deduction for taxable years beginning during calendar year 1987 will be disregarded in determining Massachusetts adjusted basis. G.L. c. 62, § 6F(2). Rather, the Massachusetts basis for such property will be adjusted to reflect the Massachusetts depreciation deduction allowed for taxable years beginning during calendar year 1987. G.L. c. 62, § 6F(3).

D. Uniform Capitalization Rules.

TRA 86 added Code section 263A, which provides a uniform set of accounting rules under which inventory costs must be capitalized. Where the new federal law requires a taxpayer to change accounting methods, Code section 481 requires adjustments to the taxpayer's taxable income to prevent items of deduction from being duplicated. P.L. 99-514, § 803(a).

Taxpayers who adopted the federal uniform capitalization rules and who made the adjustments to income required by Code section 481 for Massachusetts purposes when they were required to do so for federal purposes, must continue to use the new rules for taxable years beginning on or after January 1, 1988. These taxpayers need take no further steps to implement the uniform capitalization rules for Massachusetts purposes.

For taxable years beginning on or after January 1, 1988, Massachusetts taxpayers who did not adopt the federal uniform capitalization rules for Massachusetts purposes when they were required to do so for federal purposes, must capitalize costs for property they produce or acquire for resale in the same manner as they are required to capitalize such costs for federal purposes under the Code as amended on January 1, 1988. Amounts required to be included in federal gross income because of adjustments required by Code section 481 must also be included in Massachusetts gross income. G.L. c. 62, § 2(a).

For taxable years beginning on or after January 1, 1988, the cost of property produced by a taxpayer or acquired by a taxpayer for resale will be allowed as a Massachusetts deduction only to the extent that the deductions of such cost does not result in the duplication of deductions previously allowed as Massachusetts current business expenses. Amounts required to be included in Massachusetts gross income because of adjustments required by Code 481 will not be subject to Massachusetts taxation to the extent that such adjustments result in the duplication of items of income for Massachusetts purposes.

E. Long-Term Contracts.

TRA 86 added Code section 460, which changed the federal accounting rules for long-term contracts entered into after February 28, 1986. The new federal accounting rules for long-term contracts were later amended for contracts entered into after October 13, 1987. P.L. 100-203, § 10203(a)(1)-(2).

Taxpayers who adopted the new federal accounting rules for long-term contracts for Massachusetts purposes when they were required to do so for federal purposes, must continue to use the new rules for taxable years beginning on or after January 1, 1988. These taxpayers need take no further steps to implement the new long-term contract rules for Massachusetts purposes.

For taxable years beginning on or after January 1, 1988, taxpayers who have not adopted the new federal accounting rules for long-term contracts must now account for long-term contracts for Massachusetts purposes in the same manner as they are required to account for such contracts for federal purposes under the Code as amended on January 1,1988. These taxpayers must include in Massachusetts gross income for taxable years beginning during calendar year 1988, the amount by which income from long-term contracts reported for federal purposes in taxable years beginning during calendar year 1987 exceeds income from long-term contracts reported for Massachusetts purposes in taxable years beginning during calendar year 1987. Costs relating to long-term contracts may be included in items of deduction under the new accounting rules only to the extent that the deduction of such costs does not result in the duplication deductions previously allowed for Massachusetts purposes.

F. Bad Debt Reserves.

TRA 86 repealed Code section 166(c), which allowed taxpayers a deduction for funds allocated to bad debt reserves. Now bad debts must be deducted in the taxable year in which the debt becomes worthless. I.R.C. § 166(b). Where the new federal law requires a taxpayer to change accounting methods, Code section 481 requires adjustments to the taxpayer's gross income to prevent bad debt deductions from being duplicated. P.L. 99-514, § 805(d).

Taxpayers who adopted the direct write-off method of accounting for bad debts and who made the adjustments to income required by Code section 481 for Massachusetts purposes when they were required to do so for federal purposes, must continue to use the direct write-off method for taxable years beginning on or after January 1, 1988. These taxpayers need take no further steps to implement the new accounting rules for Massachusetts purposes.

For taxable years beginning on or after January 1, 1988, Massachusetts taxpayers who have not adopted the direct write-off method of accounting for bad debts must now account for bad debts for Massachusetts purposes in the same manner as they are required to account for bad debts for federal purposes. G.L. c. 62, § 2(d). Amounts required to be included in federal gross income because of adjustments required by Code section 481 must also be included in Massachusetts gross income. G.L. .c 62, § 2(a).

Bad debts which become worthless in taxable years beginning on or after January 1, 1988, will be allowed as a Massachusetts deduction only to the extent that the deduction does not result in the duplication of items previously allowed as Massachusetts deductions for contributions to bad debt reserves. Amounts required to be included in Massachusetts gross income because of Code section 481 will not be subject to Massachusetts taxation to the extent that such amounts exceed the amount in the taxpayer's Massachusetts bad debt reserve at the close of the taxable year preceding the change in accounting methods.

Stephen W. Kidder
Commissioner of Revenue

January 23, 1989

TIR 88-12