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02/21/2018

State Tax Implications of Federal Tax Reform (article)


The recently enacted tax reform legislation represents the most significant change to federal tax law since 1986. But while much of the focus has been on the direct effect of the new federal provisions, there are major indirect implications for state income taxes as well.

CBIZ keeps you up-to-date about tax reform and the new tax law changes.

On Dec. 22, 2017, President Trump signed into law the bill introduced as the Tax Cuts and Jobs Act, formally called H.R. 1, “An Act to Provide for Reconciliation Pursuant to Titles II and IV of the Concurrent Resolution on the Budget for Fiscal Year 2018” (the Act). The Act’s sweeping changes will affect corporations, individuals, and pass-through entities (PTEs). The general effect of the Act on individuals is to pair noteworthy tax reductions with a significant broadening of the “base” to which such tax rates are applied.

While the Act is a federal law, it will also have a dramatic impact on state and local taxation. Most states follow the provisions of the Internal Revenue Code (IRC) in some form or fashion. Whether a state adopts the changes in the federal tax law depends on the extent to which it conforms to the IRC.  

A critical part of this conformity is the starting point, in which a state begins its calculation of taxable income. Most state income tax systems generally use federal taxable income (FTI) or adjusted gross income (AGI) as a starting point for state taxable income (STI) computations. However, this does not mean states will automatically conform to federal tax rate changes. As a result, it appears that states with high levels of conformity to federal taxable income stand to receive a windfall benefit from the expansion of the tax base.

States that adopt the IRC automatically when the federal changes become effective are considered “rolling” conformity states. States that adopt the IRC as of a specific date are considered “static” or “fixed” conformity states. The Act will not apply to the latter unless those states specifically enact legislation to conform to the federal provisions. The remaining states either do not impose an income tax or they have an independent calculation that may incorporate selective provisions of the IRC. 

In other words, each state will face a policy decision based on multiple choices:

  • Adopt all changes resulting from the Act,
  • Retain its fixed conformity date, thus adopting no new federal changes, or
  • Choose to adopt or decouple from specific provisions of the Act.

This article discusses some of the general state implications of the Act, which we expect to be the salient provisions for most taxpayers. In addition, the table provided at the end of this article focuses on three states (California, Massachusetts and New York) and how the Act will potentially affect individuals and corporations as it relates to the discussed federal changes.

Individuals

Standard Deduction & Personal Exemptions

The Act dramatically expands the standard deduction amount. As a result, it is expected that fewer taxpayers will be able to itemize their deductions. 

States which use FTI as a starting point for the determination of STI (e.g., Colorado, Minnesota, North Dakota, South Carolina, and Vermont) will necessarily conform to the new federal standard deduction amount. However, states that use AGI as a starting point, and those states which only permit taxpayers to itemize deductions if they do so for federal purposes, will need to consider adoption of the new federal provisions for conformity with the new standard deduction or itemized deductions.  

For federal purposes, personal exemption amounts have been reduced to zero.  This means that a state which bases its personal exemptions on the number of federal exemptions claimed (now zero) will automatically adopt this provision of the Act without new legislation. Additionally, the states that reference federal taxable income as a starting point for STI will automatically conform to this provision. In contrast, a state which has its own definition of a “personal exemption” may continue to allow its exemption irrespective of its general conformity to the IRC.

20 Percent Reduction of Pass-Through Entity Income

With the introduction of new IRC Section 199A, non-corporate taxpayers will be entitled to a 20 percent deduction against certain “qualified business income” from PTEs. This provision is intended to benefit businesses that will not enjoy the effect of the federal corporate income tax rate reduction. 

Interestingly, the Act in its final version provides that the 20 percent PTE deduction is not permitted in computing AGI; rather, the deduction is allowed in calculating FTI. Accordingly, only the handful of states that begin the computation of STI with FTI will automatically conform to the federal Section 199A deduction. The others will have to actively choose to follow this provision.

Corporations

Bonus Depreciation and Section 179 Expenses

One of the most favorable changes resulting from the Act is the increase of bonus depreciation from 50 percent to 100 percent for qualified capital investments. Traditionally, most states decoupled from federal bonus depreciation provisions. This decoupling will likely continue.

With the introduction of new bonus depreciation provisions, IRC Section 179 is rendered largely irrelevant for tax years prior to 2023, at which time the increased bonus deprecation amounts will be phased out for federal purposes. However, to the extent a state decouples from federal bonus depreciation and continues to follow federal rules for Section 179, issues may arise.

Interest Expense Deduction Limitation

In general, the Act limits deductions for net interest expense to 30 percent of qualifying income (generally, EBITDA through 2021 and EBIT thereafter).

Since business interest expense is a deduction used to determine federal taxable income, “rolling” conformity states would automatically apply the limitations, “fixed” conformity states would not incorporate the changes until IRC conformity is updated, and the remaining states must actively adopt the new provisions for them to apply. 

Subpart F Income

One of the more complex provisions of the Act is a one-time transition tax applied to foreign accumulated earnings held by foreign businesses that are owned by U.S. taxpayers. Under the Act, such earnings would be deemed repatriated to the extent they had not been previously taxed, and included in taxable income as part of Subpart F income. While the income is included one time, for federal purposes, taxpayers can elect to pay the resulting tax over eight years. 

The states currently treat existing categories of Subpart F income (as well as foreign dividends) in a variety of ways (e.g., state modifications to federal income, state dividend received deduction, etc.). While some states currently allow a deduction/exclusion for Subpart F income, complexities arise by the application of state-specific rules that disallow deductions of expenses related to non-taxable income.

At this point, the answers with respect to Subpart F Income will be specific to each state: 

  • Does the state tax the Subpart F income?
  • If taxed, will Subpart F income resulting from the deemed repatriation be taxed at a lower rate, as is the case for federal purposes?
  • Will taxpayers be able to elect to pay the deemed repatriation tax over an extended period?
  • How will taxpayers’ own state filing methods affect the treatment of foreign-source income?

In short, to the extent a state conforms to a prior version of the IRC and does not tax Subpart F income, this one-time inclusion may never become part of state taxable income absent legislative action. But once a state conforms (even in part) to the federal provisions, the impact on state taxable income could be significant.

Net Operating Losses

The Act made a few changes to net operating loss (NOL) deductions. Losses which arise in tax years beginning after 2017 will no longer be permitted to be carried back for most taxpayers. However, such post-2017 NOLs can be carried forward indefinitely. The usage of the carryforward will be limited to 80 percent of the taxpayer’s taxable income (versus 100 percent under prior law).

Most states will be unaffected by changes to federal NOL provisions, as states compute NOLs separately.

Stay Tuned for More Changes

We are indeed in a new world of income taxation, not just for federal purposes but for state purposes as well. The implications on state income taxation are now beginning to receive attention, and the states face many issues as to the degree to which they will follow the new federal provisions. There may be pressure on states that benefit from the tax base expansion to lower state tax rates, consistent with the federal policy objective.  Such initiatives will take some time before their propriety can be ascertained. However, the state consequences of the Act may prove to be more far-reaching than the federal law contemplated. We will keep you informed as the states deal with the various issues posed by federal tax reform. 

State Implications of Tax Reform

 

California

Massachusetts

New York

GENERAL

Federal conformity

As of 1/1/2015
[Cal. Rev. & Tax Code §17024.5(a)(1)]

Rolling For Corporations
[Mass. Gen. Laws Ch. 63 §1]
As of January 1, 2005 for individuals
[Mass. Gen. Laws Ch. 62 §1]

Rolling
[N.Y. Tax Law §208(9)(b); N.Y. Tax Law § 612(a)]

Proposed Legislation by State

N/A

N/A

N/A

INDIVIDUAL

Starting Point

Federal AGI
[Cal. Rev. & Tax Code § 17073]

Federal gross income
[Mass. Gen. Laws Ch. 62 §1]

Federal AGI
[N.Y. Tax Law §612(a)]

Standard Deduction

Yes
[Cal. Rev. & Tax Code § 17073.5]

No
MA does not have a standard deduction.  It does allow certain deductions found on Sch A of Federal 1040.

Yes
Taxpayers may take NY standard deduction even if itemized deductions for federal purposes.
[N.Y. Tax Law § 614; NYCRR 20 § 113.1, §114.1]

Personal Exemption Available

CA permits tax credits for personal exemptions (versus deductions).  These credits are state defined and are not based on federal exemptions. 
[Cal. Rev. & Tax Code §17054]

Yes
[Mass. Gen. L Chapter 62 §3(B)(b)]

Yes
NY permits exemptions to the extent they are allowed under IRC § 151(c).
[N.Y. Tax Law § 616].
The Act did not eliminate the concept of personal/dependent exemptions.  Rather, the temporary exemption amount is zero.  [IRC § 151(c)]

Permits 20% Reduction of Pass-through income (a)

N/A

N/A

N/A

CORPORATE

Starting Point

FTI before NOL & special deductions
[Form 100 Instructions]

FTI before NOL & special deductions
[Form 355 Instructions]

FTI before NOL & special deductions
[N.Y. Tax Law §208(9)(i); Form CT-3 Instructions]

Permits § 179

Yes but limits the amount to $25,000
[Cal. Rev. & Tax Code §24356(b)]

Yes
MA is a rolling conformity state and there are no provisions that require an addback for §179.
[Mass. Gen. Laws Ch. 63 § 1]

Yes
Except for disallowing the expensing of sports utility vehicles, NY follows federal. [N.Y. Tax Law § 612(b)(36)]

Permits Bonus Depreciation

No
[Cal. Rev. & Tax Code § 24349]

No
[Mass. Gen. Laws Ch. 63 § (30)(4)]

No
[N.Y. Tax Law § 208(9)(b)(17)]

Limits Interest Expense Deduction

Currently, interest expense will not be limited as CA conformity date is prior to the Act.

Yes because the limitation is factored into FTI

Yes because the limitation is factored into FTI

    (a)  Since these states begin with AGI, none will be affected by 20% Reduction of PTE income.     

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Copyright © 2018, CBIZ, Inc. All rights reserved. Contents of this publication may not be reproduced without the express written consent of CBIZ. This publication is distributed with the understanding that CBIZ is not rendering legal, accounting or other professional advice. The reader is advised to contact a tax professional prior to taking any action based upon this information. CBIZ assumes no liability whatsoever in connection with the use of this information and assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect the information contained herein.

CBIZ MHM is the brand name for CBIZ MHM, LLC, a national professional services company providing tax, financial advisory and consulting services to individuals, tax-exempt organizations and a wide range of publicly-traded and privately-held companies. CBIZ MHM, LLC is a fully owned subsidiary of CBIZ, Inc. (NYSE: CBZ).

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