State conformity to Section 163(j) breaks into three camps: about 17 states and the District of Columbia adopt the federal business interest deduction limit automatically through rolling conformity, roughly 15 states tie their code to a fixed date in the Internal Revenue Code, and about a dozen states have decoupled from the limitation entirely. Five states impose no corporate income tax, so the question does not arise. For 2026, the permanent restoration of EBITDA-based adjusted taxable income under the One Big Beautiful Bill Act widens the gap between these groups, because static-conformity states frozen to an older IRC date may now sit further from current federal law than they did a year ago.
The Three Conformity Postures
Most states start their tax calculation from federal taxable income or federal adjusted gross income, so federal deductions and limitations flow through automatically unless the state acts to change them.1Tax Policy Center. How Do State Individual Income Taxes Conform to Federal Income Taxes How a state adopts the IRC decides whether 163(j) applies at the state level and, if so, which version.
Rolling Conformity
Rolling-conformity states pick up federal IRC changes as Congress enacts them. When Section 163(j) changes, the state calculation changes with it, without any state legislative action. About 17 states plus the District of Columbia work this way. A taxpayer filing in one of these states runs the same 163(j) computation on the state return as on the federal return, including the restored EBITDA-based ATI for 2026. A state legislature can still decouple from a specific provision, but absent that step, the federal rule controls.
Static Conformity
Static-conformity states adopt the IRC as it existed on a specific date. About 15 states use this method, and the fixed date is what matters.
If the conformity date precedes the Tax Cuts and Jobs Act’s December 2017 enactment, the state has never incorporated the modern 163(j) limitation, and business interest is fully deductible at the state level. If the conformity date falls between 2018 and 2021, the state may apply a version of 163(j) that still uses EBITDA-based ATI or that reflects the CARES Act’s temporary 50 percent ATI rate. If the conformity date has not been updated to reflect P.L. 119-21’s permanent EBITDA restoration, the state may still apply the less favorable EBIT calculation even though the federal government has moved past it.
This framework forces businesses to build a pro forma federal taxable income based on the IRC as it stood on the state’s fixed date, which can differ substantially from the actual federal return. Static states update their conformity dates periodically through legislation, and a retroactive update can require amended returns for years already filed.
Full Decoupling
About a dozen states have explicitly rejected the federal 163(j) limitation. These states generally allow a full deduction for business interest at the state level. Starting from federal taxable income, which already reflects the federal disallowance, the state return adds the federally disallowed interest back and then subtracts the full amount, zeroing out the federal restriction.
Why 2026 Widens the Gap
The federal rule caps the annual business interest deduction at the sum of business interest income, 30 percent of ATI, and any floor plan financing interest. Anything over the cap carries forward indefinitely at the federal level.
The consequential piece is ATI. Under the TCJA, ATI was originally computed on an EBITDA basis, meaning depreciation and amortization were added back before applying the 30 percent multiplier. That add-back expired for tax years beginning in 2022, and the calculation switched to an EBIT basis, which shrank the allowable deduction for capital-intensive businesses. The One Big Beautiful Bill Act (P.L. 119-21) permanently restored the EBITDA calculation for tax years beginning after 2024, so the 2026 computation once again adds back depreciation, amortization, and depletion.2Office of the Law Revision Counsel. 26 USC 163 – Interest
For rolling-conformity states, that change flows through automatically. For static-conformity states with a fixed date somewhere between 2022 and 2024, the state calculation may still apply the EBIT basis, producing a state limitation more restrictive than the federal one. Decoupled states are unaffected because they impose no state limit either way.
The small business exemption removes the limitation for taxpayers whose average annual gross receipts over the prior three tax years do not exceed an inflation-adjusted threshold, set at $32 million for 2026.3Internal Revenue Service. Revenue Procedure 2025-32 The exemption does not apply to any entity classified as a tax shelter under Section 448(d)(3).4Internal Revenue Service. FAQs Regarding the Aggregation Rules Under Section 448(c)(2) That Apply to the Section 163(j) Small Business Exemption Taxpayers subject to the limitation report the calculation on Form 8990.5Internal Revenue Service. Instructions for Form 8990
Industry Elections That Depend on Conformity
Section 163(j) lets three categories of trade or business elect out of the limitation entirely: electing real property trades or businesses, electing farming businesses, and certain regulated utilities.6eCFR. 26 CFR 1.163(j)-9 – Elections for Excepted Trades or Businesses Whether the state honors that election depends on its posture. A rolling-conformity state that fully adopts 163(j) will typically accept it. A static-conformity state frozen to a pre-2018 date may not recognize it at all, because modern 163(j) did not yet exist at that date. A decoupled state makes the election irrelevant, because there is no state-level cap to elect out of.
Modifications That Break Conformity Even Where It Nominally Exists
Nominal conformity does not guarantee an identical calculation. Many states have adopted modifications that make the state result differ from the federal one.
Gross Receipts Threshold
Some states apply a gross receipts threshold for the small business exemption that differs from the federal $32 million. A lower state threshold pulls more businesses into the state limitation; a higher one exempts more. A business can qualify for the federal exemption and still face a state cap, or the reverse. Each state’s threshold has to be checked on its own.
ATI Calculation
The most common modification concerns ATI. A number of states legislatively retained the EBITDA calculation while the federal rule ran on EBIT from 2022 through 2024, so the add-back of depreciation and amortization continued at the state level and produced a larger allowable deduction there than federally. With the federal EBITDA restoration for tax years beginning after 2024, that particular divergence largely disappears for rolling-conformity states going forward. Static-conformity states whose fixed date falls inside the 2022–2024 window may still apply the EBIT basis, making the state calculation more restrictive than the federal one.
Pass-Through Entities
Federally, the 163(j) limitation applies at the partnership or S corporation level, and disallowed interest passes through to owners as a carryforward item. States decide whether to follow that entity-level approach or impose the limitation at the owner level. In states with entity-level pass-through entity taxes, the limitation often applies to the entity’s income before the PTE tax, producing a different disallowed amount than the federal computation.
Some states require each entity within a group to run a stand-alone 163(j) calculation, even when the federal return consolidates the group as one taxpayer. Partners in decoupled states face a further problem: because the state allowed a full interest deduction in the year the interest was paid, the partner cannot take a second deduction when the federal carryforward eventually releases. That timing difference has to be tracked through state-specific partner basis records kept separate from the federal basis schedule.
Consolidated and Combined Reporting
Federal consolidated return rules treat all members of a consolidated group as one taxpayer for 163(j) purposes, and intercompany interest between group members is disregarded. Most states do not follow federal consolidation. They require separate-company filings or use combined reporting with group membership rules that differ from the federal 80 percent ownership threshold.
Where a state requires separate-company filing, each entity computes its own 163(j) limitation as if it had never been part of a federal consolidated return. Intercompany interest ignored federally suddenly counts, which can change the result substantially. Some states have issued guidance that no state-level limitation applies to a separate filer if the federal consolidated group as a whole had no limitation, but the approach is not universal.
Combined reporting states create their own problem. Even when a state applies a group framework, the membership of the state combined group rarely mirrors the federal consolidated group. Ownership thresholds, water’s-edge versus worldwide elections, and entity inclusion rules all force a recalculation using the state group’s actual composition. Whether one entity’s excess limitation can offset another entity’s excess interest within the combined group depends on the state; some allow it, others do not.
Related-Party Interest in Decoupled States
Decoupling from 163(j) does not mean a state places no limits on interest deductions. Most decoupled states keep long-standing rules disallowing interest paid to related entities, particularly affiliates in low-tax or no-tax jurisdictions. These add-back statutes predate the TCJA and operate independently of 163(j).
Ordering matters in states that conform to 163(j) and also maintain related-party rules. The prevailing approach among states that have published guidance is to apply the 163(j) cap first, then apply the related-party add-back to whatever interest survived, using a pro rata allocation between related-party and third-party interest. A smaller number of states reverse the order, applying the related-party add-back first and subjecting only the remainder to 163(j). The sequence can produce materially different results depending on the mix of related-party and third-party debt in the capital structure.
In a fully decoupled state, a taxpayer can deduct all third-party interest without limitation but may still lose the deduction for related-party interest under the state’s add-back statute. The interaction of these two regimes is where state-specific guidance matters most and where the compliance burden is heaviest.
Tracking Carryforwards Across States
Whenever a state’s 163(j) result differs from the federal result, whether because of decoupling, a different ATI formula, a different gross receipts threshold, or a different filing methodology, the disallowed interest carryforward will also differ. A multistate business can easily maintain a separate carryforward schedule for every state in which it files, on top of the federal carryforward reported on Form 8990.5Internal Revenue Service. Instructions for Form 8990
The federal carryforward is indefinite, but some states impose a fixed expiration period. State windows can be as short as three years or run indefinitely, depending on the jurisdiction. Missing a state expiration date forfeits the deduction permanently.
Mergers and acquisitions add another layer. When a target with accumulated state carryforwards is acquired, the surviving entity has to determine whether those carryforwards survive under each state’s rules, which may differ from federal treatment under Sections 381 and 382. Some states follow the federal limitation on post-acquisition use; others apply their own restrictions or none at all.
The most common failure in this area is double-counting. When federally disallowed interest becomes deductible in a later year, confirm that the same interest was not already deducted on the state return in the year it was paid. If the state decoupled and allowed the full deduction up front, claiming it again when the federal carryforward releases creates an improper double benefit. Maintaining a detailed bridge between the federal and state carryforward pools, entity by entity and year by year, is the reliable way to prevent that outcome.7Internal Revenue Service. Questions and Answers About the Limitation on the Deduction for Business Interest Expense
Businesses generating large disallowed interest carryforwards during the EBIT years from 2022 through 2024 face this issue directly if a state applied EBITDA during that period while the federal return did not. The pools built during those years still have to be tracked through their release, regardless of what the current-year conformity picture looks like.7Internal Revenue Service. Questions and Answers About the Limitation on the Deduction for Business Interest Expense