The states covered in this issue of our monthly tax advisor include:
California
Corporate, personal income taxes: Business interest deduction fix and other cleanup enacted
California has enacted legislation that:
- Decouples for personal income tax purposes from the federal limitations on IRC Section 163(j) business interest deductions enacted under the Tax Cuts and Jobs Act and Coronavirus Aid, Relief, and Economic Security Act, fixing a drafting error from Ch. 231 (S.B. 711), Laws 2025, and making the California personal income tax treatment consistent with the corporate tax treatment.
- Repeals state conformity to IRC Section 1446(f), because a misalignment between the federal definition of effectively connected income and the treatment of California-source income made it difficult for taxpayers to comply with the withholding requirements.
- Clarifies for purposes of the California earned income tax credit that California’s modified disqualified investment income amount will remain at $3,400 regardless of changes made to the federal disqualified investment income amount.
- Conforms to federal law that clarifies that excess business loss for noncorporate taxpayers doesn’t include deductions, gross income, or gains attributable to any trade or business of performing services as an employee.
- Deletes outdated IRC references and makes other technical corrections.
The legislation takes effect immediately and applies retroactively to taxable years beginning on or after Jan. 1, 2025, except that various technical corrections apply in the same manner and for the same periods as specified for federal purposes or, if later, the date of incorporation.
Ch. 236 (S.B. 1435), Laws 2026, effective as noted; Bill Analysis, California Franchise Tax Board, August 2026; Bill Analysis, Committee on Revenue and Taxation, August 2026.
Corporate income tax: Company’s divisions didn’t operate as a unitary business
A taxpayer’s Colorado-based beverage distribution division didn’t operate as a unitary trade or business with its other divisions, according to the California Office of Tax Appeals (OTA). The beverage distribution division conducted its activities solely in Colorado. Thus, when the company sold that division, it reported income from the sale as nonbusiness income sourced entirely to Colorado for tax purposes.
The Franchise Tax Board (FTB) audited the company and determined that the beverage distribution division operated as a unitary business with the company’s other divisions, including an interstate trucking division. Accordingly, the FTB believed that a portion of the income from the sale was apportionable to California.
Unitary business tests not met
However, the OTA concluded that the three unities test for determining the existence of a unitary business was not met, because unity of use was not present. Also, the OTA found that the dependency or contribution test was not met because there was insufficient operational interdependence between the divisions.
Tax benefit rule did not apply
As an alternative argument, the FTB contended that if the company’s beverage distribution division was viewed as a separate business from the other divisions, the company should be forced to recapture certain past deductions under the tax benefit rule because characterizing the sale of the beverage distribution division’s assets as a sale of the assets of a separate trade or business would be inconsistent with the company’s original characterization of the assets as part of a single unitary business. However, the record showed that the company previously apportioned a net loss to California, and the FTB didn’t show that the company actually received a tax benefit from the past deductions. Thus, the tax benefit rule didn’t apply.
Western Distributing Company, California Office of Tax Appeals, 2026-OTA-467P, June 18, 2026 (released September 2026).
Sales and use tax: Tax applies to digital products beginning Jan. 1, 2027
Beginning Jan. 1, 2027, the definition of “tangible personal property” in the sales and use tax law is expanded to include digital products and any copyright or patent interests associated with those digital products. As a result, retail sales of digital products in California or the storage, use, or other consumption in California of digital products purchased from any retailer may be subject to sales and use tax.
Entities affected by legislation
This change is the result of recently enacted legislation and generally affects: sellers of prewritten computer software; prewritten software as a service (SaaS) providers; businesses that license or provide remote access to prewritten software; and purchasers of digital products. A “digital product” is prewritten computer software transferred on tangible storage media, transferred electronically, or accessed remotely. “Prewritten computer software” is computer software that is held or exists for general or repeated sale or lease, even if it was initially developed on a custom basis or for in-house use, including the combination of two or more prewritten programs.
Items not considered digital products
The following items aren’t considered digital products under the new law: digital assets (such as cryptocurrency); digital audio works (such as music, spoken recordings, and ringtones); digital audiovisual works (such as movies and videos with sounds); digital books (also known as eBooks); digital infrastructure (such as cloud platforms that allow customers to create, deploy, or run their own software applications); digital video game products; and digital visual works (such as computer-generated artwork).
Exempt digital products
The following digital products are exempt under the new law: digital products representing a service, not including SaaS; custom computer software; digital products transferred with reproduction and distribution rights; and digital products purchased solely for use outside of California.
Special Notice L-1036, California Department of Tax and Fee Administration, September 2026.
Corporate income tax: Holding company and equipment rental business subsidiary weren’t unitary
An Arizona holding company and its equipment rental business subsidiary, which operated throughout the United States, including California, weren’t engaged in a unitary business when the holding company sold part of its interest in the equipment rental business. Thus, gain from the sale of that interest was nonbusiness income allocable outside of California for tax purposes.
The Franchise Tax Board argued that the holding company and the equipment rental business were engaged in a unitary business, so gain from the sale of the membership interest was apportionable business income. However, the contribution or dependency test for determining the existence of a unitary business wasn’t met, as there was no substantial flow of value or integrated executive force. Also, the three unities test wasn’t met because unity of operation wasn’t established.
Watts, California Office of Tax Appeals, 2026-OTA-423, Feb. 28, 2025, petition for rehearing denied, 2026-OTA-424, July 14, 2026.
Colorado
Sales and use tax: Guidance for utilities updated
Colorado updated its sales and use tax guidance for utilities. The guidance explains that gas and electric service furnished and sold for commercial consumption, steam consumed or used by the purchaser and not resold, and electricity, gas, and firewood that hotels and motels acquire for heating or lighting are taxable. It also covers exemptions for industrial and residential energy use, renewable energy components, and certain purchases by governmental entities, schools, housing authorities, and charitable organizations. In addition, it addresses restaurant credits for gas and electricity used in processing food and state-administered local taxes on residential energy use.
Sales and Use Tax Topics: Utilities, Colorado Department of Revenue, Aug. 2026.
Illinois
Corporate income tax: Alternative apportionment request denied for lack of distortion
Illinois denied a petition to use alternative apportionment by the subsidiary of a global automobile manufacturer because it didn’t show that the statutory single sales factor formula failed to fairly represent the market for its goods, services, or other sources of business income in the state. The taxpayer’s unitary business group engaged in the design, development, manufacturing, financing, distribution, and sales of automobiles and related products throughout the U.S. manufacturing and research activities that took place outside Illinois, but vehicles were sold nationwide, including in Illinois.
The taxpayer argued that the statutory formula unfairly distorted its Illinois income and replacement tax liability because it ignored the significant contributions of property and payroll involved in designing and manufacturing automobiles. It maintained that manufacturing and research activities generated a substantial portion of its profits, and that a formula based only on sales failed to reflect how it actually earned income in Illinois. To support its position, the taxpayer submitted a transfer pricing analysis, showing that profit from manufacturing assets, intellectual property, and research activities far exceeded the returns expected from routine sales distribution functions alone.
As a remedy, the taxpayer requested the use of an equally weighted three-factor formula based on property, payroll, and sales. Illinois rejected the taxpayer’s request because the petition merely showed the statutory and alternative formulas reached different apportionment results. Additionally, the assertion that the statutory method was not the most accurate, or not as accurate as some other method, did not by itself demonstrate that the statutory method did not fairly represent the extent of the taxpayer’s market in Illinois. Finally, the transfer pricing analysis didn’t demonstrate a grossly distorted result to warrant an alternative apportionment method. A slightly higher operating margin in comparison to other firms in a sample didn’t show that the statutory formula operated unreasonably and arbitrarily in attributing a percentage of the taxpayer’s income to Illinois that was out of all proportion to the market for the taxpayer’s goods, services, or other sources of business income in the state. A higher operating margin did not, in itself, amount to evidence of a grossly distortive result or unfair representation of the taxpayer’s market in Illinois.
General Information Letter IT 26-0006-GIL, Illinois Department of Revenue, June 25, 2026, released Sept. 8, 2026.
Sales and use tax: Rental of storage containers not subject to tax
Illinois issued a general information letter discussing the taxation of gross receipts from the rental of storage containers placed permanently on real property. The tax on leases and rentals of tangible personal property doesn’t extend to real property. For example, room rentals, locker rentals, and storage facility rentals are not subject to Illinois sales tax. Property installed as fixtures permanently attached to real property is not tangible personal property and is not subject to the tax on leases and rentals.
General Information Letter ST 26-0029-GIL, Illinois Department of Revenue, July 28, 2026.
Michigan
Sales and use tax: Maintenance of ambient temperature did not qualify for industrial processing exemption
A Michigan industrial processor could not claim a 100% industrial processing (IP) sales tax exemption for utilities purchased to maintain a certain temperature for its machinery. The exemption statute states that the “design, construction, or maintenance of production or other exempt machinery, equipment, and tooling” are exempt IP activities. The associated-words canon of statutory interpretation requires that there be commonality among “design, construction, and maintenance.” As both “design” and “construction” are active processes, the tribunal held that “maintenance” must also require an active process.
The taxpayer’s interpretation of “maintenance,” however would be contrary to the associated-words canon in that it would include the passive process of maintaining an ambient temperature alongside two active processes (design and construction). The tribunal clarified that its interpretation of maintenance does not exclude preventative maintenance from exemption.
Northeastern Fabrication LLC v. Department of Treasury, Michigan Tax Tribunal, No. 25-000335, Sept. 2, 2026.
New York City
Corporate income, miscellaneous taxes: Supplemental 2025 instructions issued on OBBBA decoupling
New York City has issued a finance memorandum providing supplemental 2025 form instructions concerning Part G of the 2026 budget bill, which decoupled the city’s unincorporated business tax, general corporation tax, banking corporation tax, and business corporation tax from the following federal OBBBA provisions:
- Depreciation deductions under IRC Section 168(n).
- Increased limitation for deductions under IRC Section 179.
- Deductions of domestic research or experimental expenditures under IRC Section 174A.
- Addback of depreciation, amortization, and depletion deductions to adjusted taxable income used to calculate the interest expense limitation under IRC Section 163(j).
Because the decoupling modifications apply to taxable years beginning after Dec. 31, 2024, taxpayers who have already filed a return for the affected period must file an amended return to report these changes. The finance memorandum explains each decoupling provision and provides instructions for reporting the new modifications on tax returns covering calendar year 2025, and fiscal years beginning in 2025.
The finance memorandum also discusses interest and penalty abatement.
Finance Memorandum 26-2, New York City Department of Finance, Sept. 9, 2026.
Miscellaneous tax: Insurance agent was independent contractor subject to unincorporated business tax
The New York City Tax Appeals Tribunal affirmed an administrative law judge’s determination, holding that an agent for an insurance company was an independent contractor whose income was subject to the unincorporated business tax. The agent’s claim that he was an employee of the company was rejected. The record did not establish that the company possessed or exercised sufficient control over the means and methods of the agent’s work to create an employer-employee relationship.
Friedman, New York City Tax Appeals Tribunal, TAT(E)03-21(UB), TAT(E)03-22(UB), TAT(E)03-23(UB), Aug. 26, 2026.
North Carolina
Corporate, personal income taxes: FAQs on updated IRC conformity and new adjustments
The North Carolina Department of Revenue provides answers to frequently asked questions (FAQs) about legislation enacted in 2026 (S.L. 2026-31 (S.B. 595), Laws 2026 and S.L. 2026-41 (S.B. 257), Laws 2026 that:
- Updated the state’s reference to the Internal Revenue Code to July 5, 2025 (formerly, Jan. 1, 2023).
- Enacted several new adjustments for individuals and corporations including adjustments required for domestic research and experimental (R&E) expenditures and the timber casualty loss deduction.
- Enacted a new state itemized deduction for gambling losses for individuals.
FAQs Regarding Recent Session Law Changes, North Carolina Department of Revenue, Sept. 11, 2026.
Corporate income tax: Request to use alternate method of apportionment denied
The taxpayer, an LLC taxed as a C corporation for federal tax purposes and wholly owned by a parent corporation, was not allowed to use an alternate method of apportionment for the purpose of determining its North Carolina corporate income and franchise tax for tax years 2025, 2026, and 2027. The taxpayer had requested permission to source its receipts from sales of tangible personal property based on the end customer’s location instead of the location of the intercompany transfer.
Under the method proposed by the taxpayer, the taxpayer’s: (1) receipts from intercompany sales to the parent would be sourced in proportion to the states of the parent’s final customers, and (2) direct third-party sales would continue to be sourced under the normal destination-based rules. The net effect of this method would be that the taxpayer’s North Carolina sales factor would reflect only the portion of its sales received by third-party purchasers in North Carolina. However, the taxpayer wasn’t legally or otherwise restricted from modifying its tax structure to mitigate the harm that it claimed, and as such, the request was denied.
Secretary of Revenue Administrative Decision No. 2026-01, North Carolina Department of Revenue, July 2, 2026.
Ohio
Corporate income tax: FIT not discriminatory
The Ohio Supreme Court affirmed a financial-institutions tax (FIT) decision denying a bank’s refund request because Ohio’s FIT is internally consistent and does not unfairly discriminate against interstate commerce.
The bank argued that the tax’s rate structure, which taxes the first $200 million of Ohio equity capital at 0.8%, equity capital between $200 million and $1.3 billion at 0.4%, and equity capital above $1.3 billion at 0.25%, caused it to pay more in taxes than a similarly sized bank that operates exclusively in Ohio and therefore violated the dormant Commerce Clause. The court determined the disparity exists because Ohio chooses to impose a regressive tax that incentivizes banks to increase their Ohio equity capital, not because of any discrimination against interstate commerce. Ohio’s tax scheme simply favors banks that do more business in Ohio. The court reasoned that the tax reaches only the portion of a bank’s equity capital attributable to its business in Ohio by applying the apportionment factor to total equity capital, so, if every state adopted the same tax, no part of a bank’s equity capital would be taxed by more than one state. Thus, the tax operates evenhandedly because an in-state or out-of-state bank with the same amount of total Ohio equity capital pays the same Ohio tax rates.
Lastly, the court declined to rewrite the apportionment method and rejected its Due Process Clause argument as a repackaged Commerce Clause challenge.
Dollar Bank, FSB v. Tax Commissioner, Supreme Court of Ohio, No. 2025-0412, Aug. 13, 2026.
Sales and use tax: Disbursement service taxability needs clarification
The Ohio Supreme Court vacated in part and remanded a sales tax refund case because the Ohio Board of Tax Appeals’ lack of clarity concerning the taxability of the taxpayer’s disbursement authorization service frustrated judicial review. The taxpayer collected sales tax from customers while providing financial services products consisting of debit authorization and disbursement authorization, accompanied by ancillary services. The taxpayer requested a refund arguing that the services weren’t specifically enumerated as subject to Ohio sales tax.
The court didn’t disturb the board’s determination that the debit authorization service was nontaxable. But the court held that the board had to clarify how the state sales tax applies to the disbursement authorization service, including whether the service constitutes automatic data processing. Further, the taxability of each separately invoiced ancillary service supporting the debit authorization and disbursement authorization services must be independently evaluated under the true object test and that the board, not the tax commissioner or the court, must perform that analysis in the first instance.
CheckFree Services Corporation v. Harris, Supreme Court of Ohio, No. 2024-1569, Sept. 16, 2026.
Pennsylvania
Corporate, personal income taxes: Interest expense calculation guidance issued
Pennsylvania issued guidance on how IRC Section 163(j) interest expense limitations apply for corporate net income tax purposes for tax years beginning on or after Jan. 1, 2025. Pennsylvania fixed its conformity to IRC Section 163(j) to the version in effect on Dec. 31, 2024, so later federal changes don’t apply when calculating the applicable interest expense deduction for Pennsylvania corporate net income tax purposes. Taxpayers with a Pennsylvania corporate net income tax filing obligation must calculate the federal interest expense deduction on a separate-entity basis, include intercompany and third-party interest, and allocate federal limitations on a pro rata basis for Pennsylvania interest expense addbacks and nonbusiness income.
Pennsylvania follows the federal result under which partnerships calculate the interest expense limitation at the partnership level and apply it at the partner level. Once a partnership calculates its own federal interest limitation amount pursuant to IRC Section 163(j) as in effect as of Dec. 31, 2024, those interest and excess business interest expense amounts will flow to its corporate partner(s) in the same manner and percentage as other amounts flow up from the partnership to its corporate partner(s).
Corporation Tax Bulletin 2026-01, Pennsylvania Department of Revenue, Sept. 10, 2026.
