Since the release of the House Republican tax reform “Blueprint” in June 2016, which was shortly followed by the release of the Trump proposal later that summer, there has been endless discussion of the proposed tax reform and what the ramifications will be at the federal level. Significantly less discussion, however, has been devoted to the impact this reform will have on state taxing regimes.
The fact that states will be affected is a foregone conclusion; state tax codes rely heavily on federal tax concepts and the framework provided by the Internal Revenue Code. In fact, you can’t get past the first line of many state tax returns without contemplating federal tax law, as most states adopt the federal definition of taxable income as a starting point for calculating state taxable income.
Before diving into a discussion of specific elements of the proposed federal tax reform and how states might react, it is necessary to address how states conform to the Internal Revenue Code. As mentioned, most states conform, at least in part, to the Internal Revenue Code. The way in which states conform, however, is the threshold consideration when evaluating the impact federal tax reform will have on state tax codes.
There are two broad categories of state conformity statutes: rolling conformity statutes and static conformity statutes. States that have adopted rolling conformity adhere to the Internal Revenue Code as currently in effect. Any changes to the Internal Revenue Code will automatically be effective at the state level, absent specific state legislation decoupling from all or part of the federal reform. States that have adopted static conformity, on the other hand, adhere to the Internal Revenue Code as of a specific date. In these states, federal reform will have no impact on the state tax law unless and until state legislation is passed to adopt all or part of the reformed Internal Revenue Code.
How states conform to the Internal Revenue Code is relatively straightforward. The unknown element, however, is timing. When federal reform is enacted may significantly affect when and how the reform is adopted at the state level. If reform is enacted while state legislatures are not in session, states will be unable to react expediently. Short of calling a special legislative session, states will be confined, at least temporarily, to the outcome imposed by their conformity statutes. The result will be significant differences not only between federal and state tax law but also between the states themselves. From the taxpayers’ perspective, this will, inevitably, increase the burden necessary to comply with the various taxing regimes. Multi-state taxpayers will be especially hard-hit by the resulting disjointed tax codes.
Among the myriad of uncertainties that surround the proposed federal tax reform, a few lucid themes have emerged. First, both the Blueprint and the Trump proposal call for reduced federal corporate income tax rates. At first glance, it seems the rate reduction, and corresponding decreased tax liability, will not impact taxpayers at the state level. The calculation of state corporate income tax liability is based on federal taxable income, before the tax rate is applied, not the resulting liability. Moreover, states tend to set their own corporate tax rates, based on state-level tax policy, as opposed to merely conforming to the federal rates. What is important to note, however, is that if federal corporate tax rates drop while state rates remain at their current levels, state taxes will account for a larger component of taxpayers’ overall effective tax rates. With this, taxpayers will find it increasingly necessary to pay more attention to state tax planning considerations.
A second theme that has emerged at the federal level is the shift away from a gradual cost recovery system to one that allows the immediate expensing of business investments. The Blueprint proposes immediate expensing for business investment costs for tangible and intangible property. The Trump proposal, released over the summer, gives manufacturers the option to forgo the deduction for interest paid in lieu of full expensing of capital investments. If history is any indication, most states will take measures to decouple from federal reform that accelerates deductions for capital expenditures (either through depreciation or direct expensing). This would be consistent with how the majority of states reacted to the enactment of federal bonus depreciation under Internal Revenue Code Section 168(k) in 2003, as well as its subsequent modifications and iterations. Currently, fewer than 15 states conform, even in part, to federal bonus depreciation treatment. That number shrinks to only about 10 states when strict conformity with the federal bonus depreciation rules is considered.
The difference between federal and state budgeting is one factor that has caused so many states to decouple from federal provisions that provide for accelerated cost recovery, like bonus depreciation and the proposed immediate expensing of capital expenditures. While the federal government has an annual budget, a 10-year budget projection window is often used to guide the appropriations process. What this translates into is flexibility; the federal government can enact legislation that will spur short-term costs, like immediate expensing, because the effects of these short-term costs are ameliorated by the long-term perspective provided by the 10-year budget projection window.
State lawmakers, on the other hand, must appropriate within stricter parameters. According to the National Conference of State Legislatures, the overwhelming majority of states have strict constitutional or statutory balanced budget requirements. (See NCSL Fiscal Brief: State Balanced Budget Provision.) Although the specifics of these requirements vary from state to state, the bottom line is that state legislatures do not have the flexibility afforded by the 10-year federal perspective. States cannot incur costs that will result in an immediate deficit even if it means reducing costs down the road. As a result, the balanced budget requirements will preclude most states from adopting federal reform that replaces the current depreciation system with laws that allow first-year expensing of capital investments.
The result: most states will decouple from this piece of federal reform and continue using their current depreciation rules. Some states may develop and implement an entirely new incremental cost recovery system. Either way, without the structure provided by the federal depreciation rules, state laws will likely become even more varied, leaving taxpayers responsible for the administrative burden of not only continuing to maintain depreciation records at the state level even if no longer necessary at the federal level, but potentially doing so on a state-by-state basis.
A final theme signaled by both the House Blueprint and the Trump proposal is a likely shift away from a worldwide income tax regime to a territorial system that taxes only U.S. sourced income. According to the Blueprint, U.S. entities will receive a 100 percent deduction for dividends received from foreign subsidiaries. Moreover, the Blueprint proposes the repeal of “Subpart F,” which currently taxes the income of certain controlled foreign corporations. To implement the transition to a territorial system, both the Blueprint and the Trump proposal call for a one-time repatriation tax on foreign earnings and profits. The Blueprint proposes an 8.75 percent tax on foreign earnings held in cash or cash equivalents and 3.5 percent on all other foreign earnings, while the Trump proposal calls for a flat 10 percent tax on all foreign earnings.
As explained above, any provision of any new tax reform that contains a tax rate reduction will generally not be applicable in the states. Consequently, a one-time federal repatriation tax would be a short-term windfall for states, as it will increase the federal tax base that flows through to the states. Therefore, not only will certain incentive deductions likely not be adopted by the states, reduced rates on certain income inclusion provisions also will not apply; the result of both is to increase the state taxable income base.
Alvarez & Marsal Taxand Says:
With so many uncertainties left to be resolved when it comes to federal tax reform, it is difficult to get a clear picture of exactly how these changes will affect state taxing regimes. What we do know, however, is that states rely heavily on the structure provided by the Internal Revenue Code, and as a result, at least some change is inevitable. We also know that states simply do not have the same level of flexibility as the federal government. Balanced budget requirements and other restrictions are non-negotiable parameters within which states must legislate. Although exactly how states will react to federal tax reform is left to be seen, we can predict that as states pick and choose which elements of the federal reform they will adopt, and add their own twists to the federal provisions, taxpayers will feel the increased bite of state tax and the burden of complying with even more varied state tax codes.
The information contained herein is of a general nature and based on authorities that are subject to change. Readers are reminded that they should not consider this publication to be a recommendation to undertake any tax position, nor consider the information contained herein to be complete. Before any item or treatment is reported or excluded from reporting on tax returns, financial statements or any other document, for any reason, readers should thoroughly evaluate their specific facts and circumstances, and obtain the advice and assistance of qualified tax advisers. The information reported in this publication may not continue to apply to a reader's situation as a result of changing laws and associated authoritative literature, and readers are reminded to consult with their tax or other professional advisers before determining if any information contained herein remains applicable to their facts and circumstances.
About Alvarez & Marsal Taxand
Alvarez & Marsal Taxand, an affiliate of Alvarez & Marsal (A&M), a leading global professional services firm, is an independent tax group made up of experienced tax professionals dedicated to providing customized tax advice to clients and investors across a broad range of industries. Its professionals extend A&M's commitment to offering clients a choice in advisers who are free from audit-based conflicts of interest and bring an unyielding commitment to delivering responsive client service. A&M Taxand has offices in major metropolitan markets throughout the United States and serves the United Kingdom from its base in London.
Alvarez & Marsal Taxand is a founder of Taxand, the world's largest independent tax organization, which provides high quality, integrated tax advice worldwide. Taxand professionals, including almost 400 partners and more than 2,000 advisers in 50 countries, grasp both the fine points of tax and the broader strategic implications, helping you mitigate risk, manage your tax burden and drive the performance of your business.