On December 22, 2017, President Donald Trump signed into law the Tax Cuts and Jobs Act (TCJA), P.L. 115-97, enacting sweeping changes to the federal tax system for both businesses and individuals. Among its most consequential changes, the law permanently cuts the corporate income tax rate, lowering the top rate from 35 percent to 21 percent. Corresponding rate reductions and tax bracket revisions occur for individual income tax as well. Additional changes affect business credits and deductions, including limiting the deductions for interest expenses, meals and entertainment expenses, and research and development expenditures. Owners of certain pass-through entities, like partnerships and S corporations, may receive up to a 20 percent deduction on qualified business income. In addition, the reform moves the country to a territorial tax system, in which only domestic profits of multinational companies are taxed, with each foreign subsidiary paying the tax rate of the country in which it is legally established. It imposes a one-time “deemed” repatriation tax on foreign earnings at reduced rates.
This significant tax reform has prompted companies to remeasure tax attributes, remodel reporting procedures, reconsider corporate structures and implement tax planning strategies that maximize the benefits of the new provisions. However, in addition to taxpayer uncertainties at the federal level, it also has created ambiguity at the state level as legislators and revenue departments contemplate major policy decisions pertaining to their tax regimes.
Due to the broadening of the tax base under the TCJA’s provisions, most states—unless they decouple from certain federal provisions—will benefit from an overall increase in tax revenues. On the other hand, states such as New York with high individual tax rates are concerned this will cause top performers to exit their jurisdiction in search for more tax-attractive states, which may ultimately decrease state revenues. State legislators have been struggling to analyze and balance the impacts to their tax regimes and potential conformity/decoupling issues as a result of the TCJA.
To some degree, all states that impose income tax conform to the Internal Revenue Code (IRC). However, the more a state decouples from the IRC, the bigger the risk of inconsistency among states, which increases complexities, the potential for double taxation of revenue flows and the ultimate burden on taxpayers. Conformity can be defined in three categories—rolling, static and specific reference.
Rolling conformity references the IRC currently in effect. When the IRC is amended, states’ laws automatically conform to the relevant provisions. Rolling conformity with the IRC is present in the tax laws of 24 states. These states must take legislative action to decouple from specific provisions not already addressed in their statutes.
Twenty-one states have static conformity in regard to the IRC. 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 three states. Rather than conforming to the IRC as of a specific date or in general, these states' tax statutes reference the IRC on a section-by-section basis. As such, these states must adopt IRC provisions as they see fit to conform or not.
With the close of most states’ legislative sessions for 2018, 17 states with static conformity have amended their conformity statutes, while many states with rolling or selective conformity have enacted legislation to specifically decouple from certain TCJA changes. Several states that have yet to enact legislation in response to the TCJA have instead issued preliminary reports or informational publications to begin informing the public of the effect of federal tax reform for state income tax purposes. The trend among states is clear that regardless of whether there is rolling or static conformity, states have amended their conformity statutes to decouple from a variety of IRC sections creating specific exceptions to their conformity; however, responses have not been uniform. In addition, most legislative action to date has centered on individual income tax provisions (specifically the $10,000 limitation on the itemized deduction for state income taxes), as business tax issues are more complex and state responses are taking longer to evolve.
As tax practitioners work with clients on implementing tax planning strategies to take advantage of the federal benefits of the new provisions, it is vital they also consider the tax ramifications on the state and local side of the equation. Changes that may seem advisable on the surface may be less attractive after considering unintended state tax liabilities. For example, conversions from an S corporation to a C corporation as a result of the new lower tax rate, no alternative minimum tax and/or better deductibility of owner fringe benefits may all provide tax savings at the federal level. However, upon further analysis, the taxpayer may have differing results at the state level due to filing footprints, nexus rules, sourcing rules and/or interplay of tax regimes for multistate taxpayers.
Multistate taxation has always been a murky area that many taxpayers do not focus on. However, in today’s tax environment in which many states face large budgetary deficits, the TCJA has aimed an unusually large spotlight on state taxation that taxpayers cannot afford to ignore. Taxpayers should take advantage of available tax resources, monitor states’ legislative activities and work closely with their leaders, advisors and state representatives to help obtain the most favorable structural, federal tax and state tax outcomes available. Contact Melissa or your trusted BKD advisor for information on how BKD can help you keep up with these changes and provide guidance with analysis of how these changes may affect your current and prospective business operations.