The Federal Tax Cuts and Jobs Act (TCJA), enacted in December 2017, created new complexities for many taxpayers. At the federal level, the TCJA will mostly result in a reduction of income tax; however, at the state level, federal tax reform will generally result in increased tax and government revenue. The reason is that most states will not conform to tax rate cuts but will conform to many of the federal provisions that increase the tax base. This is good news for the state budgets, but bad news for taxpayers. Based on a study reported by COST (Council on State Taxation), the federal tax reform act may result in an estimated state corporate tax base increase of as high as 12% on average over the first ten years.
How Are State Taxes Affected by TCJA?
The way that federal tax reform affects each state varies depending on each state’s method of conformity, tax rate, starting point, apportionment rules, exemptions, deductions, and so forth. States follow different methods of conforming to the Internal Revenue Code, both for individual and corporate tax. Most start with taxable income from the federal tax return, but then apply certain adjustments which vary by state. Some states take a different approach and utilize gross receipts tax in lieu of a net-income based tax.
States are just beginning to issue guidance and legislation to address the tax reform, and this will continue throughout the remainder of the year. Some of the more notable aspects of the TCJA that may differ from federal to state treatment include the Qualified Business Income Deduction, a 20% deduction under Section 199A. Under this provision of the federal code, owners of flow-through entities including S-corporations, partnerships and sole proprietors that are engaged in an approved trade or business may exclude up to 20% of their qualified business income from taxation. The beginning point of a state’s individual income tax will determine whether pass-through owners may receive the benefit at the state level as well as the federal level. Most states have not incorporated this provision; therefore, there is not a corresponding deduction for state tax purposes.
Other individual tax provisions that may differ include the personal exemption repeal and higher standard deduction which will now be available under TCJA at the federal level, but generally not followed by most states. For states beginning with federal taxable income, the elimination of the federal personal exemptions will broaden the state tax base. Most states also do not offer the child tax credit, which has been increased for federal purposes without a corresponding state benefit.
Businesses will be impacted by the different treatment of net operating losses because few states conform fully to federal NOL (Net Operating Loss) provisions. The majority of states are also decoupling from the full expensing of capital investment, sometimes referred to as 100% bonus, complicating depreciation calculations. And while the Federal section 179 available deduction has increased to $1 million, most states have not increased their lower section 179 expense limits (only $25,000 in PA). Companies should consider whether the increased Section 179 Depreciation deduction amounts will apply at their state level. TCJA is expected to reduce the deductible net interest expense significantly and is another area that may differ in state approach. Treatment of foreign-sourced dividend exemption and repatriation of foreign earnings will also vary by state and is an extremely complicated area to consider.
Many complexities exist when calculating the estimated impact on multistate tax figures. State tax impact should be analyzed for businesses evaluating S to C conversion, nexus considerations, and other business decisions. Each state handles federal tax reform differently, and Stambaugh Ness has the resources available to stay on top of recent state tax developments. For more details regarding the state impact of Federal tax reform, tune in to the complimentary State and Local Tax webinar offered by Stambaugh Ness on November 14.