The tax law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115 - 97 , which was enacted in December, contained the most sweeping federal tax law changes in more than 30 years. Despite the rhetoric about simplifying the Internal Revenue Code (IRC), the TCJA did just the opposite — it added layers of new complexity for many taxpayers.
The federal complexity is matched by uncertainty regarding how state legislatures and taxing authorities will respond. This column provides an overview of state tax considerations resulting from the TCJA and the status of states' legislative responses.
Summary of federal changes
Below is a summary of some of the TCJA provisions that may affect state tax filings. (For a more comprehensive discussion of the TCJA's provisions, see Nevius, "Congress Enacts Tax Reform," 225 - 2 Journal of Accountancy 52 (February 2018), www.journalofaccountancy.com.) Unless indicated otherwise, these changes became effective Jan. 1, 2018. Most individual tax provisions are effective through 2025, while most corporate tax provisions are permanent.
Individuals
Depreciation
State conformity
The fiscal impacts that will be felt by the states and their residents as a result of the TCJA's provisions depend on multiple factors, including how the state conforms to the IRC and what starting point (federal AGI, taxable income, etc.) is used by the state in calculating taxable income.
Types of conformity
All states that impose an individual and/or corporate income tax conform to the IRC to some degree, and some states follow different methods for individual vs. corporate taxes. "Rolling conformity" is achieved by referencing the IRC currently in effect. When the IRC is amended, states' laws automatically conform to the relevant provisions. Rolling conformity is used in 18 states and the District of Columbia for individual income taxes, and in 22 states for corporate taxes. These states must take legislative action to decouple from specific provisions not already addressed in their statutes. For example, some states with rolling conformity may specifically address in their statutes the standard deduction and personal exemption amounts, how NOLs are calculated, and how bonus depreciation is treated.
Nineteen states currently have "static" conformity for individual income taxes, and 21 states follow this approach for corporate income taxes. These states conform to the IRC as of a specific date and typically decouple from specific provisions. When the IRC is amended, a state using static conformity may update its conformity date or may incorporate specific provisions of the federal changes. Many states routinely update their conformity dates when the IRC is amended.
The IRC is incorporated by specific reference in five states for individual income tax purposes and three states for corporate income tax purposes. In these states, rather than conforming to the IRC as of a specific date, the state's tax statutes incorporate or reference specific IRC sections. For example, New Jersey does not start with federal AGI when calculating its gross income tax. Rather, the tax is based on New Jersey gross income, computed based on specific categories of income.
Income base
Most states base their taxable income — for both individual income and corporate taxes — on federal income, but their starting points vary.
For individual income tax purposes, 31 states and the District of Columbia start with federal AGI, six start with gross income, and four start with federal taxable income (Colorado, Minnesota, North Dakota, and South Carolina). Colorado and North Dakota use rolling conformity, which means that unless they specifically decouple from the new flowthrough - entity deduction discussed above, this deduction presumably will reduce their individual income tax bases. Taxpayers in states that use a starting point other than federal taxable income may not benefit from the new flowthrough - entity deduction, absent state legislation.
With regard to corporate tax, 22 states use line 28 (before NOLs and special deductions) of federal Form 1120, U.S. Corporation Income Tax Return, as the starting point for calculating state taxable income; 16 states use line 30 of Form 1120 (federal taxable income) as the starting point.
Impact and issues
A number of new federal provisions do not lend themselves well to predictable state treatment. Among them:
Due to the broadening of the tax base under the provisions of the TCJA, most states, absent decoupling from some provisions, will benefit from increased cash flowing into their coffers. For example, in the author's home state, a Preliminary Report on the Effects on Maine Taxes of the Federal Tax Cuts and Jobs Act published in January by the Maine Revenue Services' Office of Tax Policy estimates that full conformity with the TCJA's provisions will cost Maine individual and business taxpayers additional taxes of $250 million in fiscal 2019. The repeal of Maine's individual exemptions will account for the majority of this — an estimated $233 million. Multiple other states have published similar reports indicating significant expected increases in tax revenue as a result of the TCJA. This has prompted many state leaders to begin pushing for decoupling provisions or other measures that will reduce the forecast burden of increased taxes.
In addition to potentially increased individual state tax burdens, individual taxpayers in some states are facing potentially large federal tax increases due primarily to one specific TCJA provision. The SALT deduction cap when computing itemized deductions is one of the most contentious changes in the new law. Those in Democratic - leaning states such as California, Connecticut, New Jersey, and New York — which have some of the highest individual income tax rates among states — are certain that this provision was politically motivated, and it will be costly to many higher - earning residents of these states.
The Preliminary Report on the Federal Tax Cuts and Jobs Act issued by the New York State Department of Taxation and Finance on Jan. 23 estimates that the cap on the SALT deduction will cost New York individual taxpayers $14.3 billion per year. Based on 2015 data, the average SALT deduction taken by New York taxpayers was approximately $22,000, and the average for California and New Jersey taxpayers was approximately $18,000.
Enacted state conformity legislation
While many states are considering ways to address conformity, including ways to blunt the impact to their residents of some of the TCJA's changes, as of this writing only six states had passed conformity legislation: Georgia, Idaho, Oregon, Virginia, West Virginia, and Wisconsin.
Georgia: The IRC conformity date was updated to Feb. 9, 2018, for tax years beginning on or after Jan. 1, 2017. Georgia adopted the majority of the TCJA's provisions but decoupled from bonus depreciation and the 30% business interest expense limitations.
Idaho: Gov. Butch Otter signed H.B. 355 on Feb. 9, updating the state's IRC conformity date to Dec. 21, 2017, for the 2017 tax year, except that the conformity date is changed to Dec. 31, 2017, with regard to the dividend repatriation provisions and the decreased AGI threshold for the individual income tax deduction for medical expenses. On March 12, Otter signed H.B. 463, which changed the state's conformity date for tax years beginning after 2017 to the IRC currently in effect as of Jan. 1, 2018. Idaho conforms to the provisions of the TCJA with some exceptions.
Oregon: The state's legislation conforms to most TCJA provisions for 2017 but decouples from the deemed - dividend repatriation and Sec. 199A's 20% deduction for flowthrough entities.
Virginia: Under emergency legislation enacted by the 2018 General Assembly on Feb. 22, 2018, the state's conformity date was changed to Feb. 9, 2018 (Va. Dep't of Tax'n, Tax Bulletin 18 - 1 (2/26/18)). The state does not conform to the increased medical expense deduction or bonus depreciation, and some other provisions.
West Virginia: The state enacted conformity legislation on Feb. 22 that adopts all changes to the IRC in effect after Dec. 31, 2016, and before Jan. 1, 2018. It generally conforms to both the individual and corporate law changes but allows individual exemptions as if they had not been eliminated under the IRC for tax years beginning after 2017.
Wisconsin: Legislation maintained the state's conformity date of Dec. 31, 2016, but incorporated some specific amendments made by the TCJA.
States get creative: Reactions to TCJA other than conformity
Several states are working on measures other than conformity to counter the TCJA's impact and, specifically, the SALT cap. As of this writing, four alternatives had been put forth.
Legal challenge
On Jan. 26, New York Gov. Andrew Cuomo announced that Connecticut, New Jersey, and New York were forming a coalition to sue the federal government and challenge the SALT provision in the TCJA. Cuomo argued that the new provision "preempts the states' ability to govern by reducing the ability to provide for their own citizens and unfairly targets New York and similarly situated states in violation of the Constitution." Cuomo also suggested that the SALT cap provision targeted specific states, a belief echoed by New Jersey Gov. Phil Murphy, who said, "It is a clear and politically motivated punishment of blue states." As of this writing, no suit had yet been filed.
Employer-paid payroll tax
On Feb. 12, Cuomo announced that New York's 30-Day Amendments to the Executive Budget includes legislation that would allow employers to opt in to a new Employer Compensation Expense Tax (ECET) system. Under this system, which is meant to reduce the effect of the new cap on the SALT deduction on the state's individual taxpayers, the participating employer would be subject to a tax based on a percentage of a covered employee's wages above $40,000. This would be a deductible expense for the employer. The employee would receive a state income tax credit computed as follows: Compensation greater than $40,000 × tax rate × [1 — (tax due before credit ÷ taxable income)]. For 2019, the tax rate would be 1.5% and would increase to 3% in 2020 then to 5% for 2021 and thereafter. If the credit exceeds the employee's tax liability for the year, the excess may be carried forward indefinitely. It may not be refunded.
Opting into the system requires the unanimous consent of all owners of a noncorporate employer or all trustees of a trust. For for - profit and not - for - profit corporations, any authorized officer or manager can make the election. The CEO of a governmental entity can also make the election. The election must be made by Oct. 1 to be effective in the subsequent calendar year. An election would need to be made by Oct. 1, 2018, to be effective for calendar year 2019.
Some possible concerns about this new system include:
State tax credit for charitable contributions
Several states, including California, New Jersey, New York, and Rhode Island, are considering establishing public - purpose funds to which taxpayers could make donations that would be eligible for a charitable contribution deduction (based on the states' position) and for which the taxpayer would receive a state income tax or municipal property tax credit for some portion of the contribution.
On Jan. 30, California S.B. 227 passed 27—7. This bill would create the California Excellence Fund, to which California taxpayers could choose to make a charitable donation and receive California income tax credits equal to 85% of their contribution.
In New Jersey, a bill that passed the state Senate on Feb. 26 might allow municipalities to create charitable funds to which property owners could make donations, for which they would receive credits against property taxes due. The intent is that donations to the funds would also be allowable as charitable donations for federal income tax purposes.
State Sen. Ryan Pearson and state Rep. Kenneth Marshall introduced bills in Rhode Island in early February that would create the Ocean State Fund. Similar to the California bill, Rhode Island taxpayers could make charitable contributions to the fund and receive a Rhode Island income tax credit for a portion of the contribution.
Arrangements like this are not new or unique. Many states have used these types of funds in the past to support tuition benefits, conservation, and other public purposes. However, there is concern that some of these arrangements will not qualify as charitable contributions under the IRC. At a White House briefing on Jan. 11, Treasury Secretary Steven Mnuchin stated, "It's one of the more ridiculous comments to think that you can take a real estate tax that you're required to make and dress that up as a charitable contribution." And while testifying before Congress on Feb. 14, acting IRS Commissioner David Kautter stated, "Under the general principles for charitable contribution, the primary purpose of the contribution is donative, which is disinterested and detached interest of generosity." Do the proposed programs meet this standard?
Neither Mnuchin nor Kautter commented on what, if any, actions might be taken if the states pass their proposed legislation.
Entity-level tax approach
Connecticut and New Jersey are considering assessing tax at the entity level for flowthrough entities.
In early February, Connecticut Gov. Daniel Malloy proposed legislation (S.B. 11) that would implement a " revenue - neutral " tax on passthrough entities. The proposal, developed by the state's Department of Revenue Services, would impose a tax of 6.99% on the state taxable income of S corporations, partnerships, and limited liability companies taxed as partnerships for federal income tax purposes. As an entity - level tax, it would be deductible federally, thereby reducing the flowthrough income of the owners. The owners would receive a corresponding credit against their state income tax. If passed, the change would be effective for tax years beginning in 2018.
In addition to legislation related to the property tax credit for donations to charitable funds, New Jersey legislators are now also considering altering their tax treatment of flowthrough entities. As in Connecticut, tax would be imposed and deducted at the entity level. The owners would then receive a corresponding individual income tax credit on their New Jersey individual income tax returns.
If states start taxing flowthrough entities at the entity level as is being considered in Connecticut and New Jersey, multiple issues must be considered. Below are just a few:
Practitioners will be working closely with their clients to implement tax planning strategies that maximize the federal benefits of the new provisions. However, changes that seem advisable on the surface may be less attractive after considering unintended and unfavorable state tax results.
Conversion from S corp. to C corp.
Example 1: The shareholders of an S corporation, SB, a consulting (service) business, determined that it would be advantageous for them to convert the entity to a C corporation to benefit from the new, lower rates. SB is located in Florida, and all of its services are performed in Florida for its business customers throughout the United States. SB has employees, primarily relationship managers, in Georgia, Massachusetts, and Rhode Island and files composite returns in those states. The entity has no filing requirements in any other states.
Some state matters to consider include the following:
Adding payroll
Flowthrough entities may be inclined to begin hiring their own employees instead of independent contractors to receive the benefit of the 20% QBI deduction of new Sec. 199A.
Example 2: LLC, a partnership for federal income tax purposes, is located in Washington state. LLC's members are Washington state residents, and it does not have income tax nexus or filing requirements in any other states. Traditionally, LLC would outsource many of its functions, i.e., pay independent businesses for accounting services and development of marketing programs. To increase its wage base, a decision is made to hire individuals to address these functions internally, and employees are added in several states.
As a result, income tax nexus may be created in these states, which could result in increased state income tax filing requirements and related compliance costs, state tax liabilities at the entity level, and state tax liabilities for the owners that will not be deductible at the entity level. The individual state income tax liabilities will not be creditable in the owners' home state of Washington, as it imposes no income tax. Due to the new SALT cap, owners likely will receive no federal tax benefit from the increased state taxes. Numerous other compliance responsibilities and costs will materialize, including state unemployment taxes, wage withholding, etc. The costs and complexity may outweigh the benefits of the increased flowthrough - entity deduction.
Reducing owner salaries
Shareholders of S corporations may take lower salaries to increase the income eligible for the Sec. 199A deduction. However, for S corporations that file in multiple states, this would increase the income subject to apportionment in those states, potentially increasing state taxes at the entity level.
Example 3: An S corporation, A, is owned by New Hampshire resident shareholders and is based in New Hampshire, which has an entity - level tax on S corporations but no conventional individual income tax (other than a tax on certain investment income). A files income tax returns in New Hampshire and several other states. Historically, A's shareholders have drawn significant salaries, thereby reducing the entity - level income apportionable in New Hampshire and other states. If wages are reduced, A's apportionable income will increase, resulting in higher entity - level taxes in New Hampshire, with no corresponding decrease in (the nonexistent) individual state tax. These costs need to be weighed against the benefit of the increased QBI deduction of Sec. 199A.
Compliance challenges ahead
Corporate income taxes are imposed in 45 states and the District of Columbia, and individual income taxes are imposed in 41 states plus the District of Columbia. The TCJA created myriad new complexities at the federal level that each of these states must address. States will approach their conformity, or lack thereof, in multiple ways, creating new compliance challenges for taxpayers and their advisers. Planning opportunities and potential traps will materialize, and each client's tax situation will need to be independently evaluated. There will be no one - size - fits - all solutions.
Resources are available to help tax practitioners stay current on the state changes. The AICPA's Tax Reform Resource Center (available at aicpa.org/taxreform) and Tax Season Resources for CPAs webpages (available at www.aicpa.org contain state - related resources for members. Other useful resources may be found on the websites of the National Conference of State Legislatures (ncsl.org), the Tax Policy Center (taxpolicycenter.org), and the Tax Foundation (taxfoundation.org).
Tax advisers should take advantage of these resources, monitor states' legislative activities, and work closely with their clients to obtain the most favorable state tax outcomes.