When asked what she thinks of the federal Tax Cuts and Jobs Act (TCJA), Marilyn Wethekam jokingly responded that it’s turning out to be the “State Tax Lawyers Relief Act.” Wethekam is a state tax lawyer and partner at Horwood Marcus & Berk in Chicago. She and other state tax practitioners from around the country recently gathered in Washington, D.C., at Georgetown University’s 41st annual SALT conference.
Not surprisingly, the TCJA’s complicated impact on state taxation was the main topic at the conference. While much is still up in the air, the conference presenters provided insight into how the TCJA will affect state business income taxes.
Pass-Through Income Deduction
The TCJA created a new 20% deduction for certain income “passed-through” from a partnership, S corporation, or sole proprietorship (see IRC Sec. 199A). The deduction is a “below-the-line” deduction. Therefore, only those states that use federal taxable income as the starting point for calculating personal income tax will be affected.
The deduction is not expected to have a significant impact on entity-level taxes either, according to Messiha Shafik of Deloitte. This is because the deduction is computed at the partner or shareholder level.
However, the deduction may affect choice-of-entity decisions. According to Shafik, the goal in enacting the deduction was to create more parity between corporations and pass-through entities at the federal level. The deduction can counter-balance the tax rate cut corporations received under the TCJA.
The bonus depreciation rate is increased to 100% by the TCJA (see IRC Sec. 168(k)). However, since most states have already decoupled from federal bonus depreciation, the direct impact on state taxation is relatively small.
Nevertheless, Shafik pointed out that nonconformity creates “a big basis differential between state and federal.” As a result, he warns that tracking basis differential now becomes harder and more important. When deciding whether to sell affected property, taxpayers used to simply do whatever was best from a federal tax standpoint. However, Shafik believes that might change.
Interest Deduction Limitation
The limitation of business interest deductions exceeding 30% of adjusted taxable income (IRC Sec. 163(j)) creates a state “compliance nightmare,” according to Valerie Dickerson of Deloitte.
KPMG’s Harley Duncan blames much of the complexity on different federal-state filing methods. For instance, if a consolidated federal return is filed, problems arise when separate or combined state returns are filed.
Duncan worries that this “mismatch” can result in “trapped interest expense” that cannot be used at the state level. Coordinating the deduction with state related-party expense addback requirements can also create headaches for taxpayers.
Another problem is that disallowed deductions generally cannot be carried forward under state law as they can under federal law. From a planning perspective, Shafik urges taxpayers to “evaluate where to place debt” for state tax purposes.
Steve Wlodychak of Ernst & Young thinks that states will not want to “hire an army of auditors” to figure out compliance for this deduction. So, he said, many states might opt-out, even though there could be a revenue boost by adopting the federal limitations. Ultimately, though, he believes states will still benefit in the long run if they don’t conform.
Net Operating Losses
Generally, the TCJA affected net operating loss deductions in two ways:
- NOLs generally may not be carried back, but they may be carried forward indefinitely.
- NOLs may only reduce 80% of taxable income (IRC Sec. 172).
Most states have their own NOL provisions and/or already eliminated carrybacks. As a result, the state tax impact of these NOL changes will not be great. However, Duncan reminded taxpayers that they are “going to have two buckets of NOLs” to compute. Consequently, he warned that there is “just going to be a whole lot more tracking and computation” required.
Contributions to Capital
Contributions to capital by a state or local government are no longer deductible (see IRC Sec. 118). According to Duncan, these types of contributions often come up with state incentive programs. The contributions might be in the form of cash grants, land, or equipment.
With the new restrictions on the deduction, states may change their incentive programs. For example, the value of cash grants may be reduced.
Government contributions made after December 22, 2017, pursuant to a “master development plan” are still deductible. However, no definition of “master development plan” is provided. Duncan also noted that it is unclear how this exception will apply to incentive agreements established before December 22, 2017.
Repatriation (Transition) Tax
The TCJA imposes a one-time transition tax on repatriated foreign earnings that are “deemed” to be distributed (see IRC Sec. 965).
There are a number of state tax questions stemming from this new federal tax. For example, Alysse McLoughlin of McDermott Will & Emery noted that the earnings may be treated differently from one state to another depending on whether they are:
- treated as Subpart F income for state tax purposes; or
- covered by the state’s dividends received deduction.
She also warned about double taxation when the earnings “deemed” to be distributed are actually distributed.
Apportionment could also be a problem. For example, if foreign income generated years ago is included in a state return, which apportionment percentage should be used – the current year percentages or those from the year the income was generated? In addition, how should changes in state tax laws over the years (e.g., new apportionment formula or sourcing rules) be handled? These questions are unanswered at this point.
Guidance Needed for TCJA Changes
Throughout the conference, several speakers emphasized the importance of receiving TCJA guidance from the IRS and state tax departments. Without proper guidance, taxpayers cannot have “certainty” in their tax positions. As Dickerson noted, “one can’t overstate the necessity of certainty” when dealing with TCJA changes.
Georgetown Advanced State and Local Tax Institute, Washington, D.C., May 31 and June 1, 2018
by Rocky Mengle, JD