What are the State Implications of Federal Tax Reform? It Depends.
The Tax Cuts and Jobs Act (TCJA) contains the most sweeping and significant changes to the Internal Revenue Code (IRC) in 30 years. At the federal level, the TCJA includes a myriad of tax provisions that, overall, broaden the federal tax base while reducing federal tax. There has been a flurry of analysis and discussion regarding the TCJA’s impact on the federal taxation of business entities and individuals, and some of that impact remains uncertain due to some ambiguity in applying the TCJA’s rules. However, what should not be overlooked as well is the arguably greater uncertainty of the impact that the TCJA will have at the state level, i.e., the implications to a state’s tax base, and how each state’s legislature and taxing authority will respond.
This state impact will greatly depend on how each state decides to conform or not conform to the new federal tax laws. This in turn may depend to some extent on a state’s starting point for its taxable income, be it an individual’s taxable income or a corporation’s taxable income, i.e., whether that starting point is federal AGI, federal gross receipts, federal taxable income, or something else. For instance, an individual filing in a state that uses as a starting point something other than federal taxable income may be precluded from reducing their state taxable income by the amount of the new IRC Section 199A pass-through entity deduction, unless the state issues guidance or passes legislation that would allow such deduction.
Below is a summary of state responses to the TCJA (through July 31, 2018) and of some items of considerations in light of those responses.
State Approaches to Adopting Federal Tax Laws
All states that impose an individual income tax and/or a corporate income tax conform to the IRC in some manner. There are three general state approaches to IRC conformity: rolling, static, and specific reference.
States with rolling conformity automatically adopt federal tax law changes as those occur. However, some of these states have routinely enacted laws that decouple from certain federal tax provisions. Currently, rolling conformity is used in 18 states plus the District of Columbia for individual income taxes and in 22 states for corporate income taxes.
States with static or fixed-date conformity do not automatically adopt federal tax law changes. Instead, these states conform to the IRC as of a specific date. As such, for these states to conform to federal tax law changes, their conformity dates must be updated. Nineteen states currently have “static” conformity for individual income taxes, and 21 states follow this approach for corporate income taxes.
States that conform to the IRC by specific reference incorporate a specific federal provision either by addressing the provision in a specific state tax statute or by specific reference to the IRC section at issue. Five states use “specific reference” conformity for individual income taxes, and three do so for corporate income tax purposes.
Federal Tax Reform Provisions
With respect to some major TCJA provisions, some potential state-tax implications are as follows.
Business Entity Tax Provisions
|Corporate Tax Rate Reduction
||States that impose a corporate tax generally do not conform to federal tax rate changes.
|Pass-Through Entity Deduction
||It is expected that most states will likely not adopt the new IRC Section 199A 20% deduction for pass-through entity income. This is because the federal deduction reduces an individual’s taxable income, but is not considered in computing adjusted gross income, the starting point for most states. Only six states use federal taxable income as the starting point in computing state taxable income (Colorado, Idaho, North Dakota, Oregon, South Carolina, and Vermont), and these states will need to take legislative action if they choose not to allow this new federal deduction.
|Domestic Production Activities Deduction (DPAD) Repeal
||The repeal of the DPAD will impact states that conform to IRC §199. In these states, a state-only DPAD may still be available. An estimated two-thirds of the manufacturing sector takes the DPAD, which makes conformity more significant for state corporate tax bases in industrial states.
|Modification of NOL Provisions
||Most states impose their own NOL rules and specifically decouple from the federal NOL carryback provisions. Overall, no major state impact is anticipated, although there may be minor impacts from the TCJA NOL provisions.
|Reduction in Domestic and Foreign Dividends Deduction (DRD)
Most states have their own dividend received deduction (DRD) rules, and it is expected that states will continue to follow their DRD rules in the post-TCJA era.
Most states provide for a deduction or exclusion for foreign dividends. Seven states currently impose a 30% tax of a taxpayer’s foreign source dividends.
|100% Bonus Depreciation and Small Business Expensing
The TCJA expanded the IRC §179 small business expensing provision, which allows investments in machinery and equipment to be fully expensed in the year of purchase.
Thirty-seven states conform to this immediate expensing under IRC §179. Furthermore, fifteen states conform to the federal bonus depreciation provision provided in IRC §168(k).
Individual Tax Provisions
|Individual Tax Rate Reduction
||States that impose an individual income tax generally do not conform to federal tax rate changes.
|Repeal of Personal Exemptions and Increase to Standard Deduction
||Most states either conform completely to both the federal standard deduction and personal exemptions, or conform, in whole or in part, solely to the federal personal exemption. In either case, the repeal of personal exemptions will result in a broader tax base for many states.
|Itemized Deduction Modifications and Eliminations
||States that begin their tax calculations with federal taxable income incorporate itemized deductions by definition. States that begin their tax calculations with federal adjusted gross income generally provide for itemized deductions. If a state ties its itemized deductions to the IRC, the new tax law changes to itemized deductions will have an impact, i.e., for states that conform to the federal itemized deduction provisions, the new tax law changes will generally result in a broadened state tax base and hence increased tax revenue.
|Enhanced Child Tax Credits and Education Saving Incentives
Federal tax reform doubled the amount of the child tax credit, from $1,000 to $2,000, while increasing the refundable portion to $1,400. Furthermore, the credit is now available to a wider range of taxpayers, as a result of increased income phase-out thresholds. However, most states do not offer a child tax credit and are expected to continue to decouple from this provision.
Three states (Colorado, New York, and Oklahoma) provide for child tax credits equal to a percentage of the federal credit. The expanded federal credit therefore would represent a cost to these states if they choose neither to decouple from the federal provision nor to reduce the percentage at which they match the federal provision.
Thirty-three states permit deductions for contributions to IRC §529 education savings accounts. Utilization of IRC §529 saving accounts may increase, because pursuant to the TCJA, they may now be used for primary and secondary education, in addition to higher education. Certain states specify that contributions to IRC §529 accounts may be deducted only if the accounts are used for higher education. It is possible that some or all of these states may consider expanding their enabling legislation to include primary and secondary education as well.
||The TCJA doubled the federal estate tax exemption amount. As such, this change affects states that conform to the federal exemption level (Hawaii, Maine and the District of Columbia).
State Responses to Federal Tax Reform
- Currently, only six states have passed legislation to conform to aspects of the TCJA. These states are Georgia, Idaho, Oregon, Virginia, West Virginia, and Wisconsin.
- Connecticut, Maryland, New Jersey, and New York have filed suit against the federal government to directly challenge the $10,000 SALT deduction cap.
- Several states have announced a workaround for the SALT deduction cap. Namely, California, New Jersey, New York, and Rhode Island are all considering establishing public-purpose funds in which taxpayers could make donations that they state would be eligible for a federal charitable contribution deduction. The taxpayer would also receive a state income or municipal property tax credit for some portion of the contribution. However, the IRS has recently released Notice 2018-54, announcing the Treasury Department’s intention to issue proposed regulations on SALT workarounds involving charitable contributions. This could mean that the Treasury view is that these workarounds will not work in providing a federal charitable deduction for taxpayers.
- Additional SALT cap countermeasures: Connecticut has passed an entity-level tax on flow-through entities. The tax is deductible on the entity’s federal tax return, and owners of a flow-through entity receive a corresponding tax credit against their state individual income tax. New Jersey is considering imposing similarly an entity-level tax on flow-through entities, with the owners of a New Jersey flow-through entity to receive a corresponding tax credit against their New Jersey individual income tax.
Winners and Losers
States that conform to the now repealed federal personal exemption, such as Maine, should realize the largest revenue increases under the TCJA. It is expected that most states will benefit from modifications to deductions for mortgage interest and moving expenses. The SALT deduction cap of $10,000 would increase revenue for 24 states and the District of Columbia.
Absent legislative action, six states that use federal taxable income as their income starting point may experience revenue losses, because of the new IRC Section 199A pass-through entity income deduction.
As of the end of 2017, it is estimated that U.S. corporations had accumulated about $2.5 trillion in overseas earnings. Prior to the TCJA, United States corporations paid taxes on income earned overseas, but the tax liability was deferred until the income was repatriated. Pursuant to the TCJA, these deferred overseas earnings were deemed to have been repatriated as of the end of calendar year 2017, making them immediately subject to federal taxation. This deemed repatriated income is characterized as Subpart F income. States that conform to Subpart F may therefore experience a windfall from this deemed repatriation. It is expected that states that had not been taxing Subpart F income will likely be unable to retroactively conform to take advantage of this tax reform provision.
What Does CohnReznick Think?
State responses to the TCJA is very much a work in progress, and the final form of these responses will be impacted by many items, including political considerations, and lobbying efforts of interested parties. Companies and individuals need to consistently monitor each respective state’s changes to understand their impacts, and assess any resulting risks accordingly. Each state’s rules will need to be reviewed independently to determine their implications for resident businesses and individuals.
Any advice contained in this communication, including attachments and enclosures, is not intended as a thorough, in-depth analysis of specific issues. Nor is it sufficient to avoid tax-related penalties. This has been prepared for information purposes and general guidance only and does not constitute professional advice. You should not act upon the information contained in this publication without obtaining specific professional advice. No representation or warranty (express or implied) is made as to the accuracy or completeness of the information contained in this publication, and CohnReznick LLP, its members, employees and agents accept no liability, and disclaim all responsibility, for the consequences of you or anyone else acting, or refraining to act, in reliance on the information contained in this publication or for any decision based on it.