Not subject to as much media attention as federal income tax legislation, the state impacts resulting from the enactment of federal legislation always poses budgetary challenges for leadership in those jurisdictions. Oftentimes, federal income tax incentives, such as accelerated and bonus depreciation, can prove unduly costly for states whose income tax regimes are predicated upon taxpayers’ federal taxable income. In other cases, deductions that have historically been allowed for federal income tax purposes that relate to state and local income taxes essentially work to make the state tax more cost effective for inhabitants of those states.
The Tax Cuts and Jobs Act (TCJA), which was enacted in December 2017, included many federal provisions that are, in fact, detrimental to state budgets. Exactly how harmful this legislation has been, however, is difficult to measure. To take a look at the effect of the federal legislation on state finances, a conference hosted by the Urban Institute was held recently to examine state responses one year after passage of the TCJA.
View the video of the January 29, 2019, conference, presented by the Urban-Brookings Tax Policy Center, American Tax Policy Institute, Murphy Institute at Tulane University, and Boyd Center for Business and Economic Research at the University of Tennessee.
A number of issues were discussed at the conference. A few of the panel discussion topics are summarized below.
Federal-State Tax Conformity Challenges
All states’ income tax rules conform to the federal tax rules under the Internal Revenue Code (IRC) in some manner. When the IRC is amended, as occurred with the TCJA, states’ rules must adapt to the changes. One of the biggest challenges for states after the passage of the TCJA was the timing of the legislation. Because the TCJA was enacted near the end of 2017, most state budgets had already been finalized by the Governors. As such, state legislatures had to develop a response in order to conform with the new federal rules. In the end, most states ended up adopting positions to ensure that the effect on revenue was neutral or there was a reduction. Some states are still in the process of issuing guidance. A few states, that have a “rolling conformity” approach have not yet passed legislation and can now do so based on the effects of the TCJA.
Representatives from Grossman Yanak & Ford LLP did not attend this conference, but have monitored state income tax developments on a daily basis since passage of the law. It should be understood that many states have elected to decouple from the federal legislation, either crafting specific state provisions or, alternatively, rejecting the applicability of the incentive provisions in the TCJA, such as bonus depreciation and the Qualified Business Income (QBI) deduction.
Impact of the TCJA’s International Provisions
Several issues were raised in regard to repatriated income. [The federal government is supposed to police the shifting of income, but this is a difficult and cumbersome compliance process, and improper income shifts are extremely slow to resolve from an administrative process.] Repatriated income includes income earned over 30 years. Panelists questioned how states can procedurally deal with income earned over time but realized only now.
Complex matters related to this question include consideration of apportionment, which is based on current conditions and may or may not represent how the income was earned. Further, under the unitary business principle, income arising from a single economic enterprise is apportioned by the state. However, if the income does not arise from the business it must be separately allocated. Generally, for GILTI and repatriated income it would be allocated to the place of commercial domicile.
Another issue discussed was whether repatriation could even be taxed under Kraft v. Iowa Dept. of Revenue, which eliminated the discriminatory taxation of foreign dividends in separate-company filing states. Panelists also noted concerns that states may need to figure out apportionment factors for the past 30 years to apportion the income. With respect to GILTI, in many cases the income is not generated because of intangibles overseas but because the company has operations on the ground.
States’ Responses to the TCJA’s Adverse Impacts
The primary topic of discussion was how states were trying to work around the negative effects to taxpayers as a result of changes to the State and Local Tax (SALT) deduction. Several states have filed lawsuits challenging the cap on the SALT deduction and others are attempting to allow additional deductions through alternative mechanisms, including:
- Reclassifying certain state tax payments as charitable contributions
- Creating employer-based payroll taxes
- Potentially enacting a pass-through entity tax
The Treasury Department has issued proposed regulations designed to clarify the relationship between state and local tax credits and the federal tax rules for charitable contribution deductions. Several previous posts on our website have discussed these issues in greater detail.
There is no question that the TCJA has had a profound effect on state budgets. Rarely is the connection between federal and state finances and budgetary concerns considered in the development of federal legislation. While opinions may vary as to the inherent policy matters, there can be little doubt that changes in the federal tax laws very often leads to serious implications at the state level.
We continue to observe fallout from the imposition of the $10,000 cap on deductibility of state and local income and real estate taxes as an itemized deduction. High-tax states such as California, Connecticut, Maryland and New York are suffering the most. However, the taxpayers most affected by the change are very high income taxpayers, and the Democratic House members find themselves in a difficult position. To introduce legislation that reinstates the previous unlimited deduction will be serving the interest of their most wealthy constituents, a position usually held to be politically unsound. Time will tell.
Grossman Yanak & Ford LLP is extremely attentive to state and local tax developments affecting our clients and friends. You can expect us to continue this effort to monitor and communicate regularly on important state and local tax developments.