As many as 43 states and the District of Columbia could lose up to $5.5 billion in tax revenue through 2011 if they do not take steps to "decouple" their tax laws from the federal tax code because of a little-noticed provision in the American Recovery and Reinvestment Act, a new report warns.

The revenue losses would come at a time when most states already are facing significant budget shortfalls, notes the report, which was released yesterday by the Center on Budget and Policy Priorities.

Cautioning that its estimates are not precise, the center found that California could lose $1.3 billion in tax revenue and New York could lose $400 million from a provision intended to provide tax relief to businesses.

At issue is a "cancellation of debt income," or CODI, provision in the stimulus law. When a business or individual borrows money, the amount borrowed is not considered taxable income because it must be repaid. However, if the lender forgives all or part of a loan, then the borrower must count the amount forgiven as taxable cancellation of debt income.

The provision in the stimulus law allows businesses to defer until 2014 the reporting of taxable income from debt that was canceled in 2009 and 2010. In addition, the businesses can spread the CODI over five tax years through 2018. And since most states' income tax codes are updated to reflect changes in federal tax law, the provision could defer collections at the state level as well as the federal level.

The amount of CODI is expected to spike in the next few years due to the large volume of devalued debt in the marketplace, according to the report.

States could be affected differently depending on how their tax codes are updated to conform with federal tax law. Twenty-four states plus the District of Columbia have a "rolling conformity" policy, meaning any changes to the federal tax code are automatically and immediately reflected in the state laws. Those states could begin experiencing revenue losses as early as the end of the current quarter unless they take deliberate steps to block conforming with that particular provision, the report stated.

Another 19 states have a "fixed-date conformity" policy, meaning that the state's tax laws conform to the federal code on a certain date, usually Dec. 31 or Jan. 1. The state legislatures typically pass bills annually to roll forward the dates of conformity so their codes are updated with changes that occurred at the federal level. If a state passes legislation updating its code to a day between Feb. 17, 2009 - the date the stimulus was enacted into law - and Dec. 31, 2010 - the date the provision sunsets - it will lose revenue if it does not take steps to prevent the losses.

But states can easily protect themselves from the unexpected revenue loss by changing the definition of gross income contained in their tax codes to exclude the new CODI provision. Florida, Maryland, and Minnesota already have taken such action.

The center warns states that are considering keeping the CODI provision in place to relieve flagging businesses at the state level that they could be providing relief to out-of-state businesses.

"If states choose to conform to the federal CODI provision, they will needlessly compound the already-serious revenue declines caused by the recession," the report said. "In many cases, the primary beneficiaries would be out-of-state corporations that have few, if any, facilities within the state and only a small number of employees."

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