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Comprehensive federal tax reform has been a talking point of the Republican-controlled White House and Congress. In the last few months, both Congress and the White House have released plans that aim to simplify the current tax code by broadening the corporate and individual tax bases and reducing rates. While tax reform seems to have taken a back seat to other initiatives, such as health care reform, corporate finance departments continue to seek guidance on how federal tax reform will impact state income tax compliance.
Experts agree that federal tax reform will have a significant impact on states. The fact that almost every state starts the computation of corporate taxable income with the amount from the federal return is just the tip of the iceberg. Couple a foundational federal-tax law change with the many variances in state conformity and the snowball effect for corporations will be monumental.
To that end, this article will examine the numerous factors that impact how states will likely react to federal tax reform. Anticipating how states will react is crucial to helping companies devise a nimble state income tax reform strategy.
What’s on the table
Considering the sweeping tax reform changes currently being proposed, it is natural for corporate finance executives to want to best prepare for the potential changes. For the first time in over 25 years, tax reform is a real possibility. Some of the major corporate tax reform items being considered include:
- Border adjustment tax or a value added tax levied on imported goods.
- Disallowance of interest deductions on loans to fund business.
- Changes to Net Operating Losses (NOLs), which will allow NOLs to carry forward indefinitely, but not carryback.
- Pass-through entities tax rate cap of 25 percent tax rate vs. the current taxation at the individual’s varying rate.
Conformity factors
Internal Revenue Code (IRC) conformity refers to the degree to which state tax codes conform to the federal tax code. Due to the high administrative costs of administering their own tax code, most states conform in some respects. However, when a federal-level change impacts a state’s ability to meet their budgetary mandates or political agenda, they tend to “decouple” from certain federal provisions by leaving them out of their own tax codes. Here are some of the top factors that will impact how states will react to federal tax law changes.
Economic conditions
The top consideration in whether a state will conform to federal tax reform is the state’s current economic condition. More than half the states faced revenue shortfalls for the 2017 fiscal year. In addition, many states have industry-related economic issues such as oil and gas heavy states like Louisiana, Texas and Alaska, which have been impacted by the global drop in commodity prices. In these states, for example, reduced oil and gas drilling has resulted in job losses, and lower income and less consumer spending, all of which means less tax revenue for those states. Naturally, states with a deficit will be more likely to decouple from any revenue reducing federal tax provisions.
Political environment
The current political climate will steer how states respond to any federal tax reform. Whether a particular party has control of the legislature and/or the governorship in a state will greatly impact decisions related to federal conformity.
Beyond party affiliation, tax policy promises made by government officials will play a role in federal tax reform conformity. Tax reform proposals were brought front and center in State of the State addresses by many governors. In addition, during the 2017 legislative session, significant tax changes have been proposed in several states, including Illinois and Louisiana.
Differences in budget planning windows
Federal budgets are typically planned in a 10-year period. In contrast, states commonly have a two-year budget cycle. When it comes to federal tax reform, differences in budget cycles are a critical consideration for states deciding to conform to IRC codes. For example, states often decouple from IRC changes around depreciation and asset changes that are “front-loaded” in nature. As noted previously, with a typical two-year budget cycle, any significant changes to depreciation laws that accelerate corporate depreciation mean less revenue for states in a given budget cycle. As a result, states routinely adopt their own depreciation rules. Case in point is Section 168(k), which allows for a bonus depreciation deduction of 50 percent of the basis of qualified property is allowed. Most states don’t follow Section 168(k) as it is a short-term revenue reducer, but they do follow regular depreciation rules.
Corporate tax and individual tax reform timing
Most corporations are not generally concerned with individual tax laws, but if corporate and individual tax reform are not passed jointly, companies need to understand the implications. In general, corporate tax reform without individual tax reform could equate to reduced revenue to states. This means that if corporate tax reform were to pass ahead of individual tax reform, states with a surplus may conform, but states with budget deficits would likely decouple from any revenue reducers. While comprehensive tax reform is currently being proposed, legislators may find that passing corporate tax cuts is a less daunting task and still accomplishes some of their major objectives. States may react to this much differently than they would to comprehensive tax reform.
Even when states do conform to Internal Revenue Codes, there is still the issue of rolling vs. static conformity. Static conformity states adopt the IRC as of a specific date, such as January 1, 2017. Rolling conformity states adopt IRC changes as they are enacted on the federal level. As of June 2017:
- 21 states adopted static conformity
- 20 have rolling conformity
- Three have no conformity
- Four states are using gross receipt taxes
- Three states don’t have state income tax.
For a corporation doing business in multiple states, keeping track of these varying dates makes it even more challenging to comply with any changes made to federal tax laws.
What the future holds
Will tax reform come to fruition? Only time will tell. What we do know is that state corporate income tax is already difficult to navigate, and any changes at the federal level, even minor ones, will only compound complexity for corporations. Given the drastic changes being proposed, at a minimum, companies need to anticipate how states will react to proposed tax reform so, if and when such federal tax laws become reality, they can act accordingly.
Chreasea L. Dickerson is a State Tax Law Editor at Bloomberg BNA.