June 12, 2018
Tax reform legislation generally referred to as the Tax Cuts and Jobs Act, passed by Congress and signed by the President late last December, has been touted as a major simplification of the federal tax code. However, as taxpayers and their advisers digest the new law, the complexities brought about by implementing the Tax Cuts and Jobs Act changes are suggesting a different result.
Equally complex and uncertain are the implications of the federal changes on the income taxes imposed by many states. Congress focused on reducing federal income tax rates—particularly for businesses—in an effort to reduce tax burdens; however, a number of “base broadening” provisions designed to increase tax revenues, including a limitation on state income or sales and property taxes claimed as itemized deductions, were designed to meet revenue targets established by Congress in the legislative process.
As a result, state income taxes will likely increase as a percentage of total tax expense for many taxpayers because of the Tax Cuts and Jobs Act. With federal income taxes expected to decline and state income taxes to increase, the ratio of state income tax to total income tax will increase. For example, a corporation paying state income taxes at the rate of 5 percent plus federal income taxes at the top rate of 35 percent in 2017 faced a state income tax burden that was approximately 13 percent of its total income taxes. The same corporation, still paying state income taxes at the rate of 5 percent but federal income taxes at the new flat 21 percent rate in 2018, would anticipate that approximately 20 percent of its total income tax expense will be for its state income tax liabilities.
The state-to-state impact will vary depending on several factors, including comparative income tax rates, how a particular state conforms (think of this as “follows”) to the Federal Internal Revenue Code (IRC) and what starting point (Adjusted Gross Income, or AGI; taxable income; corporate taxable income before or after special deductions; etc.) is used in calculating state taxable income. In addition, some states have adopted, or are in the process of adopting, revised approaches to state taxation in light of the Tax Cuts and Jobs Act.
Conformity – States that impose a state income tax use differing approaches when conforming to the IRC. Many use “rolling conformity,” where the IRC provides the basis for a state’s income tax system. These states automatically follow the federal changes unless specific legislative action is taken for selected provisions. Other states conform to the IRC as of a specific date so that legislative action must be taken to adopt federal changes (either in total or selectively).
Starting Point – The starting point for calculating state taxable income varies among states. For individuals, some states start with federal gross income, or use AGI as the starting point, while others begin with federal taxable income. For corporations, things can get a little more complicated, but still start with some reference point on IRS Form 1120.
Where a state’s calculation of taxable income begins can have a dramatic effect on relative state income tax burdens. For example, the new 20 percent federal deduction for qualified business income of non-corporate taxpayers is taken for federal purposes after arriving at AGI. Taxpayers in states that start their taxable income calculations with either gross income or AGI may not receive a state benefit from the 20 percent deduction unless the state takes legislative action.
Responses to the ‘SALT’ Deduction Limitation
One of the more contentious provisions in the Tax Cuts and Jobs Act generally limits the state and local tax (SALT) deduction for individuals to no more than $10,000 ($5,000 if married filing separately) for tax years 2018 through 2025. States with relatively high property, income and/or sales taxes feel their high-income citizens have been targeted unfairly and are taking steps to mitigate the perceived detrimental effects of the federal change. States’ responses, so far, include proposals establishing state charitable foundations allowing citizens to make charitable contributions in lieu of paying state taxes, creating a special payroll tax deduction for employees and suing the federal government.
In a recent notice (Notice 2018-54), the IRS announced it intends to propose regulations asserting that federal tax law, including the “substance-over-form” principle, governs the proper treatment of alternative arrangements being considered by the states. This serves as a warning that the IRS intends to challenge efforts by the states to circumvent the federal limitation on the SALT deduction. Ultimately, courts will likely decide the fate of the state proposals.
Planning: Monitor State Implications
As taxpayers work closely with their tax advisers to develop tax projections and planning strategies, state income taxes take on greater importance than in the past. In addition, some states’ legislatures will not be taking up the issue of federal conformity until later in this year, or early next year, which compresses the time available to react to their decisions. Therefore, monitoring state legislative activities, as well as anticipated guidance from the U.S. Treasury Department and the IRS, will be essential. In some cases, taxpayers may be surprised to find that additional state income taxes partially off-set anticipated federal benefits.
If you have questions concerning the Tax Cuts and Jobs Act’s impact on your combined federal and state income taxes and planning alternatives, contact your Eide Bailly professional.