While the recently enacted Tax Cuts and Jobs Act (TCJA) has tax practitioners and taxpayers alike eager to see the federal implications carried out, federal tax reform will also have far-reaching effects on state taxation. Generally, business or individual state income tax computation begins with federal taxable income or adjusted gross income. Therefore, any and all TCJA provisions that alter the federal tax base will affect state tax liabilities.
State Legislatures Have Decisions to Make
With nearly all state legislatures currently, or soon to be, in budget sessions, the impact of the TCJA figures to be a focal point of the deliberations, especially as certain provisions affect 2017 taxes due shortly. States are now tasked with the balancing act of deciding whether and how to conform to the federal changes, while keeping in mind much-needed tax revenue as well as their constituents’ best interests in light of the TCJA’s limitation on the state and local tax deduction.
Historically, states have conformed to the Internal Revenue Code (IRC) in one of three ways:
Depending on the type of conformity, states must consider whether to adopt or decouple from the IRC changes entirely or only with respect to specific provisions. All modes of conformity will require swift and careful state action in response to the TCJA, as some of the federal provisions are already in effect and the rest will come into effect in 2018.
State Actions and Proposals to Date
The District of Columbia, a Rolling Conformity jurisdiction, was the first to act by introducing a bill on December 19, 2017 requiring its Chief Financial Officer to submit a report by April 30, 2018 outlining the steps and amendments necessary to decouple from the federal changes. While the outline is still pending, it is worth noting that some amendments may need to be retroactively applied as the 2017 returns, absent extensions, are due prior to the CFO’s report.
Pennsylvania, a Selective Conformity state, promptly issued Corporate Tax Bulletin 2017-02 on December 22, 2017, decoupling from the newly enacted 100% bonus depreciation on qualified property under IRC §168(k). The Pennsylvania Department of Revenue advised that any federal immediate expensing deduction would be required to be added back to taxable income for Pennsylvania income tax purposes and further, that its law provides no alternative means of cost recovery until the qualified property is sold or otherwise disposed. However, on February 6, 2018, the Pennsylvania House Finance Committee unanimously approved a bill intended to reverse the harsh effects of the Bulletin by allowing a depreciation deduction for the immediately expensed qualified property under IRC §§ 167 and 168, but stipulating that IRC §168(k) shall not apply.
Other states are crafting ways to counteract the TCJA’s $10K state tax deduction limitation. California introduced legislation in early January to establish the “California Excellence Fund Tax Credit,” permitting a personal or corporate income tax credit equal to the amount of the contributions to the “California Excellence Fund” and, thereby, eliminating state tax liability. The contribution to the Fund would presumably be deemed a charitable contribution, allowing taxpayers to claim a federal charitable deduction in lieu of the state tax deduction. While seemingly simple and effective in theory, questions remain as to whether the contribution is truly voluntary in order to constitute a deductible charitable gift, and whether the Treasury and the IRS would override this work-around with additional regulations of their own.
New York Governor Cuomo released the first details of his plan to mitigate the impact of the federal limit on state and local tax deductions on February 12, 2018, proposing a 5% payroll tax and the creation of two charitable funds. The proposed Statewide Employer Compensation Expense Tax would be used to replace or supplement the state personal income tax. Some of the New York proposals would require employers to bear some or the entire tax burden through a payroll tax, while employees would see reduced or no state income tax liabilities.
Anticipated State Modifications
Arguably, the most anticipated provision of the federal tax reform affecting pass-through entity owners is the newly enacted 20% Qualified Business Income Deduction. However, expectations should be tempered from a state tax perspective. Under the TCJA, the Qualified Business Income Deduction is taken “below the line” as a reduction to taxable income, not as an itemized deduction; in effect, a new category. As such, the majority of states will not automatically follow this provision because most states use federal adjusted gross income, determined prior to this deduction, as the starting point for determining their state personal income tax base. Thus, only the implementation of state modifications will enable taxpayers to realize the benefit of the 20% pass-through entity deduction for state tax purposes. For the few states that start with federal taxable income, taxpayers should receive the benefit of the federal deduction, unless the states expressly choose to decouple and require an addition to their state tax bases. For more on the Qualified Business Income Deduction, see [Section 199A Pass-Through Deduction for Qualified Business Income].
International Implications – All That GILTIs
Another TCJA provision affecting corporate income taxpayers that states will be required to act upon is the Global Intangible Low-Taxed Income (GILTI) provisions under new IRC § 951A. The GILTI provisions tax currently – through a subpart F-like income inclusion – certain income derived from business conducted outside the U.S. through certain foreign corporations. As a new category of income in the federal tax base, the GILTI inclusion will also expand the state tax base subject to the full state rate without subsequent state adjustments.
Further, in order to achieve the desired reduced federal tax rate, the TCJA’s GILTI provisions also contain a new deduction under IRC § 250 (contained in the “special deductions for corporations” section of the IRC).1 Assuming the GILTI/Foreign Derived Intangible Income (FDII) deduction is treated as a special deduction, the effect on state corporate income tax will vary depending on each jurisdiction’s starting point. In states that begin with federal taxable income before special deductions, corporate taxpayers will be required to include the additional GILTI income, but will not be entitled to the corresponding deduction, absent a specific adjusting state modification. For more on the GILTI income inclusion and related deduction, see [Once Again Congress is GILTI of Compounding Tax Complexity].
Similar to GILTI, the TCJA, in Section 965, also provided for a transition tax (TT)2 through a one-time income inclusion under Subpart F, and a corresponding deduction, in order to arrive at a preferred effective federal tax rate. Effective for the 2017 tax year, the TT deems otherwise deferred foreign earnings and profits of controlled foreign corporations (CFCs) be included in the federal tax base. Like the GILTI, this inclusion will automatically expand the state tax base absent a state-specific exclusion for income received from CFCs or a dividend-received deduction for states that treat this type of income as such. While the TT is generally expected to increase state taxes, for those states that choose to exclude this income, taxpayers may benefit from the TT because the state tax base will otherwise still include the IRC § 965 deduction. Thus, some states will need to enact a new add-back in order to avoid this unexpected loss. Also, for federal income tax purposes, taxpayers may elect to defer the TT liability by paying the tax in eight installments. However, the election will likely not apply to the states because it is merely deferring the payment rather than deferring the income recognition. Thus, absent a state-specific election, any state tax liability resulting from the TT will be due and entirely payable in the 2017 tax year.
Some States May Benefit
Additionally, though most states are focused on devising plans to thwart the potential negative impact on their resident taxpayers, states themselves may stand to profit from the reform. For Rolling Conformity states, the broadened federal tax base will provide states with increased tax revenue without the states themselves having to raise rates. A minority of states uniquely allow taxpayers to claim a deduction for federal income taxes paid. As such, any reduction in federal income taxes for residents of these states will cause an increased state tax liability. During a time when states are searching for ways to generate additional tax revenue, it will be interesting to see whether these states take action to neutralize this unanticipated impact on their residents.
With many unanswered questions surrounding how the federal tax reform will be carried out for state tax purposes, only time will tell how states will react. One thing we do know is that some state action and clarification is necessary. Until then, we can only advise that you keep a close eye on impending state legislative sessions and encourage you to contact Terence Avella at 212.331.7690 | firstname.lastname@example.org or your Berdon tax advisor with any questions.
Berdon LLP New York Accountants
1 The new section 250 deduction incorporates amounts relating to certain foreign derived intangible income (FDII).
2 The TT relates to the adoption of a partial territorial system for certain U.S. outbound taxpayers.