The Pennsylvania Supreme Court held that the state’s flat $3 million cap on net operating loss (NOL) carryforwards violates the state constitution’s Uniformity Clause.1 Unlike the lower court, however, the Supreme Court left intact the percentage cap that limits NOL carryforwards to 12.5% of the taxpayer’s net income.


Unlike most states, Pennsylvania limits the amount of net operating losses a taxpayer can use to offset income in a carryover year. The limitation—referred to as a “cap”—is determined based on the higher of a fixed dollar amount or a percentage of the taxpayer’s income in the year in which the loss is used. For the only year at issue, 2007, the NOL carryforward was capped at the greater of $3 million or 12.5% of taxable income.2 In subsequent years, the legislature increased both the flat-dollar amount and the percentage cap. For 2016, the NOL carryforward was capped at the greater of $5 million or 30% of taxable income.

Flat-Dollar Cap Unconstitutional

The Pennsylvania Supreme Court held that the flat $3 million cap violates the state’s Uniformity Clause, which requires that “[a]ll taxes shall be uniform, upon the same class of subjects.”3 The flat-dollar cap created two classes of taxpayers—those with taxable income of $3 million or less and those with taxable income greater than $3 million—and treated them differently. The taxpayers in the first class could use NOLs to reduce their taxable income to zero and pay no tax—a “de facto” exemption. Taxpayers in the second class could not exempt their entire income from tax, even if they had enough NOLs to do so, because of the $3 million cap.

Eversheds Sutherland Observation

A key component of the court’s analysis was the fact that the $3 million cap operated to create an exempt class of taxpayers. The court recognized that its decisions have “consistently viewed as unconstitutional tax laws which, although applicable to an entire class of taxpayers, wholly exempt some of those taxpayers from paying the tax.”

According to the Pennsylvania Department of Revenue (Department), 98.8% of all taxpayers could use the full $3 million cap and reduce their income to zero. Thus, the cap resulted in substantial uniformity, the Department argued. The court implicitly rejected this argument when it noted that the remaining 1.2% of taxpayers would be required to shoulder the entire corporate tax burden for that year “due only to the fact that each of those class members had income in excess of $3 million.”

Retaining the Percentage Cap

Although the court agreed with the Commonwealth Court that the flat-dollar component of the cap violates the Uniformity Clause, it did not strike down the cap entirely. Rather, the court severed the flat-dollar cap while retaining the percentage cap, noting that the legislature’s inclusion of an NOL cap indicates that the state budget cannot support an unlimited NOL carryforward. The court concluded that striking the cap in full and allowing unlimited NOL carryforwards would “be clearly contrary to the wishes of the General Assembly,” which enacted the cap precisely because the previously unlimited cap caused “excessive drain of the public fisc.” Leaving the percentage cap intact cures the Uniformity Clause violation by treating all taxpayers equally, and ensures that large taxpayers with taxable incomes over $3 million do not bear a disproportionately large tax burden.

Eversheds Sutherland Observation

By upholding the constitutionality of the percentage cap, the court limited the availability of the NOL carryforward for companies with taxable income over $3 million. Under the lower court’s decision, which struck the NOL cap entirely, these companies could have reduced their income to the full extent of their available NOLs. For example, following the Commonwealth Court’s decision, a taxpayer with $20 million in taxable income may have filed its 2016 return and applied $20 million in NOL to reduce its income to zero. But under the Supreme Court’s holding, the taxpayer would be required to limit its NOL deduction to $2.5 million, thus reporting $17.5 million in income.

This decision will also impact taxpayers with income under the flat-dollar cap, many of which may now be subject to assessment. For example, consider a taxpayer that filed its 2016 return reporting $5 million in taxable income and applying $5 million of NOL to reduce its taxable income to zero, thus paying no tax. Under this decision, that taxpayer would now be limited to an NOL deduction of 30% of taxable income, or $1.5 million, leaving the taxpayer with taxable income of $3.5 million and a tax liability of approximately $350,000.

While the court’s reasoning is based upon the application of a particular Pennsylvania constitutional provision, it may be applicable to other states that have NOL caps, such as Connecticut, Delaware, Louisiana, Utah and West Virginia. Special consideration should also be given to those states that have constitutional provisions protecting taxpayers from unequal taxation, such as state uniformity, equal protection or special tax legislation provisions.