B Sarah Horn, J.D.
On December 22, 2017, President Donald Trump signed into law P.L. 115-97, also known as the “Tax Cuts and Jobs Act.” While this is a significant event for federal taxation, it will also have far-reaching effects on state taxation. This article provides a brief overview of its impact, both on individuals and businesses, and considers key areas that may affect state taxation.
Tax Cuts and Jobs Act. Tax reform has been the subject of contentious debate in Congress. There have been changing plans, outlines, frameworks, and legislative texts, making it difficult for even the most seasoned practitioners to follow along. The Tax Cuts and Jobs Act, which is estimated to add $1.46 trillion to the national deficit over the next 10 years, features significant modifications to the tax code for both businesses and individuals.
Businesses: Corporations will be subject to a single rate of 21% for tax years beginning after December 31, 2017. Currently, corporations are subject to a bracket structure with a top marginal rate of 35%. Businesses will also no longer be subject to the alternative minimum tax (AMT). Unlike many provisions in the Act, neither the corporate rate change nor the AMT repeal is set to expire.
In terms of deductions, the Tax Cuts and Jobs Act caps net interest deductions at 30% of EBITDA for a period of four years. Under our current tax system, businesses are allowed a full deduction for business interest, subject to some limitations. The Act also eliminates the current two-year carryback of net operating losses (NOLs), but allows indefinite carryforwards (limited to 20 years under current law), subject to a limitation of 80% of taxable income. However, a two-year carryback applies in the case of certain farming losses and NOLs of property and casualty insurance companies can be carried back two years and carried forward 20 years to offset 100% of taxable income. Certain manufacturers and producers will also be unable to take the IRC §199 domestic production activities deduction going forward.
Cost recovery provisions will be drastically different in the new year. Instead of requiring capitalization and depreciation of eligible purchases (with some property qualifying for special bonus depreciation), capital investments placed in service after September 27, 2017, can be fully “expensed” under IRC §168(k). The deduction is not permanent and will begin to phase out after five years. Unlike under current law, certain used property will be eligible for full “expensing.” Small businesses may also benefit from increased caps on IRC §172 expensing, which will be raised to a $1 million cap with a $2.5 million phase-out.
Perhaps one of the most drastic changes to our tax code will be the shift from a worldwide system of taxation to a territorial system with base erosion provisions. Designed to prevent businesses from parking income overseas and allow them to compete on a “level playing field” with foreign competitors, the territorial system will only tax U.S. companies on U.S. income with most foreign income exempt. A transitional tax to switch between the two systems will require deemed repatriation of deferred offshore earnings at 15.5% for liquid assets and 8% for illiquid assets.
Individuals: The Tax Cuts and Jobs Act maintains the current seven income brackets for individual taxpayers, but reduces the rates, with a top marginal rate of 37%. The standard deduction is roughly doubled for single and joint filers, and personal exemptions are eliminated. While the Act repeals the corporate AMT, the personal AMT is sticking around. However, the exemption is increased to $109,400 and the phase-out threshold for joint filers is raised to $1 million. The Act also makes significant changes to both above-the-line and itemized deductions. Notably, it does not repeal deductions for educator expenses and student loan interest. The deduction for charitable contributions is also still in place, as is the deduction for mortgage interest. However, itemized deductions for mortgage interest will be capped to acquisition indebtedness of $750,000 on new purchases.
Perhaps one of the most controversial aspects of tax reform, the itemized deduction for state and local taxes is capped at $10,000 in property taxes and either income or sales taxes. The Act also zeroes out the Affordable Care Act’s individual mandate penalty beginning in 2019.
Recipients of income from pass-through entities were not left out of tax reform. The Tax Cuts and Jobs Act features a 20% deduction for pass-through income limited to the greater of 50% of wage income or 25% of wage income plus 2.5% of the cost of tangible depreciable property for qualifying businesses. Importantly, qualifying businesses do not include service providers, such as doctors, lawyers, and accountants, where the “principal asset” of the trade or business is the reputation or skill of the employees.
The majority of the individual provisions, including the rate structure and the standard deduction increase, are not permanent and expire at the end of 2025.
For both businesses and individuals, tax reform fundamentally changes (at least until 2026) the rates, the tax base, and even the structure of the tax system.
Estates: The Act doubles the basic exclusion for the estate tax to $10 million, subject to adjustments for inflation. The provision is temporary and is set to expire at the end of 2025.
Alcohol excise taxes: The Act makes a few temporary changes to federal excise taxes on alcoholic beverages. The excise tax rate on beer is lowered until the end of 2019. Restrictions on exemptions for certain transfers between breweries are relaxed. Credits against the wine excise tax will be available to more taxpayers. A tiered-rate tax structure applies to distilled spirits.
State and Local Tax Concerns. The Tax Cuts and Jobs Act will have impacts beyond just federal taxation. While state corporate and individual income taxes are likely to be the most affected by tax reform, estate and sales and use taxes may also be directly or indirectly impacted.
Income taxes: Almost all state income taxes piggyback on the federal system by using a federal starting point for calculating state taxable income. As a result of this federal conformity, states incorporate a lot of federal provisions into their own state tax bases. States generally conform to varying versions of the Internal Revenue Code, with a few exceptions. Roughly half of the states imposing an income tax conform to the Internal Revenue Code as of a specific date (e.g., as of December 31, 2016) that the state legislature updates annually or periodically, while the other half conform to the current code on a rolling basis without need for legislative action. If federal income is changed due to tax reform, state taxable income may be as well, depending on the provision and the state.
States will not be directly impacted by the new federal tax rates because states use their own rates. States that impose a gross receipts tax in lieu of a net-income based tax may not be as significantly impacted by the Act.
Timing will be the overriding consideration for state conformity to federal tax reform. State legislatures will not be back in session until next year to even begin to respond to the sweeping federal changes. States that have static conformity dates will still conform to previous versions of the Code (absent legislative action), resulting in increased compliance burdens for taxpayers who have to compute a hypothetical federal starting point based on the old Code.
Changes to federal corporate deductions will impact states that conform to those provisions. Most states conform to IRC §163, so the new federal limitations on interest deductions may result in a broader state tax base in those states. Similarly, changes to federal NOL provisions may impact states that conform to the federal provisions. However, many states already decouple from the IRC §172 federal NOL deduction and instead use a state-specific NOL. Elimination of the federal IRC §199 deduction will also create a broadened tax base in states that conformed to the deduction.
Many state decisions to conform to or decouple from federal tax reform will be budget-driven. Unlike the federal government, nearly all states have to maintain balanced budgets. Therefore, they may not be able to afford to conform to federal provisions that would result in a revenue reduction for the state. For example, states may choose to decouple from or limit the new provisions allowing immediate “expensing” of capital investments. Many states have historically decoupled from special federal depreciation provisions, like bonus depreciation, because of revenue concerns. It will be interesting to see whether states consider the net impact of conformity to interest expense caps in conjunction with potentially disallowing the new “expensing” regime.
State conformity to the international provisions in the Tax Cuts and Jobs Act may be more complicated. Conformity to the foreign-source dividend exemption and repatriation of offshore earnings will depend on a state’s treatment of foreign income. The impact may be ameliorated in combined reporting states where certain foreign dividends are already eliminated as intercompany transactions. Further, unlike the federal government, states are constitutionally limited in their ability to treat foreign dividends in a different manner than domestic dividends.
Both state and federal practitioners should carefully consider unintended state consequences of new federal planning opportunities that may arise from tax reform. For example, service providers may acquire new revenue streams or property to qualify for or increase the amount of the pass-through deduction.1 However, adding new business operations or property to a pass-through entity may trigger nexus for the entity or its owners in a new state or affect the apportionment factors used to calculate state tax liability.
The Tax Cuts and Jobs Act may also impact individual taxation at the state level. In states that use federal taxable income as the starting point for computing state taxable income, the state would conform to the federal increased standard deduction and the federal elimination of personal exemptions. States may or may not conform to other changes to federal personal income tax provisions. In later years, states will need to decide whether to conform to the expiration of these changes as well.
Limitations on the federal SALT deduction may impact individuals indirectly at the state level. Inability to deduct more than $10,000 of state and local taxes for federal purposes might increase the cost of those taxes for individuals, especially in high-tax states. Notably, the Tax Cuts and Jobs Act does not allow taxpayers to pre-pay state or local income taxes to take advantage of higher deduction amounts in 2017 and avoid the 2018 cap. Under IR 2017-210, in order to claim a deduction for real property tax prepayments made in 2017, the taxes must have been assessed prior to 2018. According to the IRS release, prepayments of anticipated real property taxes that have not been assessed prior to 2018 are not deductible in 2017. State or local law determines whether and when a property tax is assessed. Some governors have issued executive orders intended to facilitate property tax prepayments (see e.g., New Jersey Executive Order 237, 12/27/2017 and New York State Executive Order #172, 12/22/2017) and some jurisdictions have issued guidance relating to prepayments of property taxes (see e.g., Statement on Prepayment of Real Property Taxes, DC Office of Tax and Revenue, 12/20/2017 and Notice, Wisconsin Dept. of Rev., 12/22/2017).
Estate taxes: While few states impose an estate tax, some states may see reduced revenues to the extent those states conform to the new federal exemption amount.
Alcohol excise taxes: Temporary modifications to federal alcohol excise taxes will not significantly impact the states. States typically impose their own alcohol excise taxes with very little conformity to federal provisions.2
Sales and use taxes: While the Act may not have a direct impact on state sales and use taxation, states may need to rely more on those taxes to offset any revenue losses that result from federal tax reform. States are already aggressively pursuing economic nexus, which we can expect to continue and potentially increase if state revenues drop.3
Conclusion. Taxpayers will be faced with a lot of uncertainty in the coming weeks and months as they begin to navigate the intricacies of the new federal provisions. This will be especially true in the area of state taxation where varying tax structures, balanced-budget restrictions, and legislative schedules may result in drastically different levels of conformity and increased compliance burdens on taxpayers. Ultimately, taxpayers and practitioners alike should be cautious not only in the area of state compliance, but also of unintended state consequences that may arise from new federal planning opportunities.
1Avi-Yonah, Batchelder, et al., The Games They Will Play: An Update on the Conference Committee Tax Bill (12/18/2017).
2Checkpoint Catalyst Topic #1062, Alcohol Taxes: Wholesalers and Distributors (forthcoming 2018), will provide an in-depth discussion of the state taxation of wholesalers and distributors of alcoholic beverages.
3See Rebecca Newton-Clarke, Navigating the “Kill Quill” Revolt: Considerations for Remote Sellers, Thomson Reuters (12/18/2017).