State Tax Treatment of Section 199A Qualified Business Income Deduction

States have been slow to adopt the qualified business income deduction, also known as the pass-through income deduction. Only a handful of states allow individuals, trusts, and estates to take the IRC Sec. 199A deduction. There may be various reasons, including:

  • protecting state revenues;
  • the starting point used in calculating taxable personal income;
  • conformity with federal tax laws; and
  • states having similar business income deductions.

What Is the IRC Sec. 199A Deduction?

The Internal Revenue Code (IRC) Section 199A pass-through income deduction can be taken by individuals, trusts, and estates with income from:

  • partnerships, limited liability partnerships, and limited liability companies;
  • S corporations; and
  • sole proprietorships.

The deduction is often referred to as the qualified business income deduction or QBID and is in effect for tax years 2018 through 2025.

How is the Deduction Computed?

The deduction is generally the lesser of:

  • combined qualified business income (up to 20% of qualified business income, plus 20% of REIT dividends and publicly traded partnership income); or
  • 20% of the excess (if any) of taxable income over net capital gain.

Why Have the States Been Slow to Adopt QBID?

It’s been nearly two years since the federal QBID was enacted. But very few states allow individual taxpayers to take the deduction in computing state income tax. There may be various reasons why states do not follow the federal deduction.

States Want to Keep Revenues

One possible reason for not allowing the federal QBID is that states do not want a decrease in revenues. By not actively adopting the provision, or decoupling if necessary, states do not decrease revenue.

Oregon starts with federal taxable income and generally conforms to the TCJA. Oregon had to decouple from the federal provision or face lowering state revenue. Oregon’s Governor expressed concern over such an impact. Oregon enacted legislation decoupling from the federal deduction.

The legislation was challenged by two state legislators claiming the law was a tax increase enacted in violation of the Oregon Constitution. But the Oregon Tax Court held the legislation requiring an addback of the deduction did not violate the Oregon Constitution.

Starting Point Does Not Include Deduction

To calculate state income tax, most states start with:

  • federal adjusted gross income (AGI); or
  • federal gross income.

The federal QBID deduction is not included in determining federal AGI. The deduction is a “below-the-line” deduction taken after determining federal AGI. Because the 20% QBID is taken after AGI, these states would have to adopt the deduction.

California’s personal income tax is based on federal AGI. Also, its conformity provision specifically excludes the federal IRC Sec. 199A deduction. So California does not allow the deduction, nor does it require an addition or allow a subtraction adjustment.

New York uses federal AGI as its starting point and has not adopted the federal QBID. Since New York does not allow the deduction and this is a below-the-line deduction, no adjustment is required for individual taxpayers. However, an addback is required for estates and trusts filing fiduciary returns.

State Does Not Conform to Deduction

Virginia’s IRC conformity provision specifically excludes the federal QBID deduction and Virginia’s starting point in computing state personal income tax is federal AGI. So Virginia does not require an addition or allow a subtraction adjustment.

Wisconsin also specifically excludes the federal deduction. Because Wisconsin’s starting point is federal AGI, it does not require an addition or allow a subtraction adjustment.

Existing State Business Deductions

Some states have their own existing business income deductions. Ohio has a business income deduction unrelated to the federal QBID. Because Ohio uses federal AGI as its starting point, the federal deduction does not affect Ohio’s income tax calculation. Taxpayers are not required to make any adjustment.

How Are Other States Responding to the IRC Sec. 199A Deduction?

South Carolina utilizes a federal taxable income starting point. In updating its IRC conformity, legislation specifically decouples from the deduction. Accordingly, South Carolina requires an addback in computing state taxable income.

Other states, such as Colorado, Idaho, and North Dakota, do allow the qualified business income deduction. Colorado and North Dakota have a starting point of federal taxable income and so do not require any adjustment for the deduction. Idaho uses federal AGI, in practice, as the true starting point in determining Idaho taxable income. So Idaho allows a subtraction adjustment.

Iowa allows a percentage of the federal deduction beginning in tax year 2019. So an adjustment will be required. The percentage is:

  • 25% for tax years after 2018 but before 2021;
  • 50% for the 2021 tax year; and
  • 75% after 2021.

The federal qualified business income deduction is still relatively new, so it will be interesting to see if more states decided to allow it. However, unless the deduction is extended beyond tax year 2025, many states may not see a need to consider it further.

By Tralawney Trueblood, J.D., M.B.A.

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CCHTaxGroup

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