State Tax Considerations of Federal Tax Reform

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When the Tax Cuts and Jobs Act1 (Tax Act) was signed into law on Dec. 22, 2017, the primary focus naturally fell on federal and international taxes, which were directly affected. However, there will be related impacts on the 50 states and many localities that will be diverse, compelling, and ongoing for years to come.

The states’ varied approaches to conformity with the Internal Revenue Code (IRC) in their own tax structures will be put to the test as multistate taxpayers and practitioners apply the new federal law. The states are just starting to address the federal changes through legislation and administrative guidance, and this information will continue to develop over time. But there are some important short-term state tax implications that need to be addressed for financial statement reporting, tax compliance, and tax and transaction planning.

IRC Conformity

How the states incorporate the IRC into their own system of taxation varies widely. With the Tax Act’s addition of new code sections and the significant revision of others, a state’s conformity with the IRC must be the starting point for analysis. Approaches to conformity can be divided into rolling, fixed date, and selective.

Under rolling conformity, federal tax changes are automatically reflected, unless the state specifically decouples from a provision.

Fixed-date conformity requires the state to affirmatively update its IRC reference to incorporate some or all of the federal tax changes.

Under selective conformity, only specific IRC sections are adopted. These sections may refer to the current IRC as of a specific date, and the new IRC sections must be adopted.

Regarding corporate income taxes, 22 states (including Pennsylvania) and the District of Columbia have rolling conformity with the IRC, and 21 states have fixed-date conformity.2 The remaining states that impose a corporate income tax follow selective conformity.

For individual taxes, 18 states and the District of Columbia have rolling conformity, and 19 states have fixed-date conformity.3 Pennsylvania is among the remaining states lacking conformity to federal individual income tax. Each federal tax law change must be examined to determine if the changes are immediately applicable or only upon further action.

Corporate Taxes

A signature piece of the Tax Act is a reduction in the federal corporate tax rate from 35 percent to 21 percent beginning in tax year 2018. The rate reduction drives many other federal provisions, and is likely to influence a significant amount of planning by taxpayers. For state purposes, this only has a direct corporate tax impact in the four states (Alabama, Iowa, Louisiana, and Missouri) that allow a full or partial federal income tax deduction. However, the rate reduction has wide-ranging effects for pass-through entities, more fully discussed below.

Net operating loss – The Tax Act limits the deductibility of net operating losses (NOLs) generated in tax years beginning after Dec. 31, 2017, to 80 percent of taxable income, with no carryback and an unlimited carryforward period. Federal NOLs generated prior to 2018 remain subject to the current two-year carryback and 20-year carryforward.4 For federal income tax purposes, taxpayers may seek to defer income to 2018 or accelerate deductions to 2017 to maximize NOLs prior to the 80 percent limitation, all of which should be examined for state tax implications.

Most states do not follow the federal NOL rules under IRC Section 172, and instead compute state-specific NOLs. States such as Maryland, Missouri, and Virginia that do follow IRC Section 172, or limit their state NOLs to the amount claimed federally, may be subject to the new limitations. Pennsylvania does not conform to federal NOL rules, and state taxpayers should not be affected by these changes.5 Act 43 of 2017 continues to limit Pennsylvania’s NOL use to 30 percent of taxable income in tax year 2017, 35 percent in tax year 2018, and 40 percent in tax years 2019 and thereafter.6

Net interest expense – Beginning in tax year 2018, the Tax Act generally limits the deduction for net business interest expense to 30 percent of adjusted taxable income, with disallowed amounts carried forward indefinitely.7 Adjusted taxable income changes from EBITDA (earnings before interest, taxes, depreciation, and amortization) to EBIT (earnings before interest and taxes) in 2022. This change is expected to significantly reduce the deductible net interest expense.

The former version of IRC Section 163(j) explicitly required a consolidated calculation of net interest expense, whereas the current version does not, and may lead to calculating the limitation without such netting between entities. (See IRS Notice 2018-28, April 2, 2018, for guidance on interest deduction limits.) This may result in significantly different interest expenses on a separate company basis. Further complicating matters, some states, including Pennsylvania, already have some form of intercompany interest expense disallowance. Companies in these states that are subject to federal interest expense limitations and have both third-party and intercompany debt need to determine how much of the federal limitation is attributable to intercompany debt, and which portion remains subject to state expense disallowance rules.

The application of these rules to state income taxes presents an opportunity for taxpayers to review their legal entity structures and debt structures to understand and mitigate the impact of IRC Section 163(j) now and in advance of more restrictive limitations coming in 2022.

100 percent bonus depreciation – The Tax Act allows 100 percent bonus depreciation on certain property acquired and placed in service after Sept. 27, 2017, and before Jan. 1, 2023.8 The bonus depreciation is reduced 20 percent annually over the subsequent five years.

Many states already either decouple from or significantly modify the existing 50 percent bonus depreciation deduction, and are expected to continue or expand their decoupling provisions to avoid negative fiscal impacts. Pennsylvania Corporation Tax Bulletin 2017-02 provides the Department of Revenue’s guidance that no depreciation will be allowed on 100 percent bonus assets, and that cost recovery is deferred until the property is sold or otherwise disposed of. This position, applicable solely to corporate net income taxpayers, places Pennsylvania as the only state to completely disallow depreciation on certain property. As of the time of this article’s submission, legislation has been introduced in Pennsylvania to allow modified acceleration cost recovery system depreciation (H.B. 2017) or 100 percent bonus depreciation (S.B. 1056).

Section 179 depreciation – The maximum amount a taxpayer may deduct under IRC Section 179 has increased to $1 million, and the phaseout threshold amount has been increased to $2.5 million.9 Thirty-six states currently adopt IRC Section 179 expensing allowances and investment limits, while seven states offer small-business expensing regimes with their own expensing limits.10 Section 179 applies to businesses on the basis of the volume of capital expenditures, not entity formation, and is thus available to small corporations as well as pass-through businesses. Similar to bonus depreciation, states will view this as a potential revenue reduction, and may consider decoupling from this provision, requiring taxpayers to continue to track basis and depreciation for state purposes.

Deemed repatriation – Under the Tax Act, unrepatriated foreign earnings from most subsidiaries are treated as Subpart F income subject to a one-time transition tax in 2017 of 15.5 percent for cash and cash equivalents and 8 percent for other assets.11 Deductions are provided in IRC Section 965(c) to achieve these reduced rates. Taxpayers may elect to pay the resulting federal income tax over an eight-year period, a position that is not expected to be adopted by most states. S corporations may elect to maintain deferral on the deemed repatriation until a triggering event, such as a change in S corporation status or a sale of substantially all of its assets or stock.12

On March 13, 2018, the IRS issued guidance that this one-time tax will be reported on a separate schedule and not through the regular income tax calculation.13 It remains unclear for most states whether this IRS guidance will ultimately avoid the complex analysis of how the one-time tax is calculated for state income tax purposes. Regardless, states may view the deemed repatriation as included in federal taxable income, thus forcing taxpayers to determine myriad issues, including the amount of state repatriation, treatment under Subpart F, dividends receiving deduction treatment, availability of the IRC Section 965(c) deduction, nonbusiness income treatment, and impact on apportionment factors. Each issue may impact the amount of 2017 tax to be remitted with upcoming tax returns or extensions. (See Pennsylvania Information Notice 2018-1, scheduled to be released in late April 2018.)

Global intangible low-taxed income – Beginning in 2018, shareholders in the United States are required to include as income the global intangible low-taxed income (GILTI) of controlled foreign corporations (CFCs), with a corresponding 50 percent deduction14 of the GILTI inclusion amount. GILTI is defined as the excess net CFC “tested income” over a routine return on certain qualified tangible assets.15 Calculation is on a consolidated federal basis, allowing loss entities to offset others with tested income. The state calculations of GILTI may differ where CFCs are owned by different U.S. taxpayers.

Unlike deemed repatriation income, GILTI is codified in a new IRC section, which may not result in Subpart F income and may not be addressed by the existing state dividends received deduction provisions. If any part of the GILTI is included in a state’s taxable base, fair apportionment issues may arise if there is no apportionment factor representation from the CFC creating the GILTI income. Some increase in the apportionment denominators may cure the fair apportionment issues, but it is unclear under what mechanism this could occur or how it would be calculated for states that traditionally include only the taxpayer’s income from normal operations in the sales factor.

Foreign-derived intangible income – A new incentive was added for most domestic C corporations that earn foreign-derived intangible income (FDII),16 generally providing a deduction of 37.5 percent of the sum of a taxpayer’s FDII plus 50 percent of its GILTI. This results in a 13.125 percent effective tax rate on excess returns on certain foreign-derived income.

States may decouple from this provision or impose significant limitations. Some states have already taken legislative action, including Idaho and Illinois.

Base erosion and anti-abuse tax – Beginning in 2018, the base erosion and anti-abuse tax (BEAT) operates as a minimum tax on certain large multinational corporations engaged in excessive base erosion as a means to prevent companies from pulling earnings out of the U.S. through payments to foreign affiliates.

BEAT operates as a separate tax system, and would require states to enact their own similar systems. This currently seems unlikely given the number of states that currently impose addback provisions on intangible payments to related parties (including foreign related parties).

Pass-Through Entities and Individual Taxes

The reduction in the federal corporate tax rate to 21 percent makes corporate rates lower than the highest individual rates.17 Even with the 20 percent deduction for qualified business income (QBI), owners of pass-through entities may be subject to tax at a rate higher than the corporate rate.

Many states begin their individual income tax calculations with either federal taxable income or adjusted gross income. Pennsylvania does not. It is important to note that the QBI deduction is taken after adjusted gross income, and would only be a benefit in states that use federal taxable income as a starting point.

To obtain the lower 21 percent tax rate, pass-through entities are considering converting to or electing C corporation status for federal income tax purposes. There are, however, critical state tax consequences that must be considered before making this decision, including tax rate and apportionment differences. Pennsylvania, for example, taxes pass-through entity owners at a 3.07 percent personal income tax rate, compared with a corporate net income tax rate of 9.99 percent. Other states do not impose individual income taxes on pass-through entity owners, but do tax C corporations. Further, there are differences in apportionment formula weighting and sourcing rules that can yield significantly different results if pass-through entities elect C corporation taxation. For example, Pennsylvania personal income tax requires equally weighted apportionment factors and cost of performance receipts sourcing for services compared with single sales factor apportionment and market-based service receipts sourcing for C corporations. These rate and apportionment differences can significantly affect the analysis, and need to be considered in conjunction with the federal analysis.

State and local tax deduction of individual taxes – One of the most significant revenue raisers in the Tax Act is the $10,000 federal limitation on state and local tax deductions.18 This limitation greatly impacts high-tax states, such as California and New York.

In Pennsylvania, this change inspired some to prepay 2018 real estate taxes to generate deductions in 2017. While a deduction for any prepayment of 2018 state and local income taxes is expressly prohibited by the Tax Act, it does not explicitly prohibit a deduction for prepaid 2018 real estate taxes. Notably, on Dec. 27, 2017, the IRS issued an advisory opinion on the prepayment of property taxes that said, in part, “In general, whether a taxpayer is allowed a deduction for the prepayment of state or local real property taxes in 2017 depends on whether the taxpayer makes the payment in 2017 and the real property taxes are assessed prior to 2018.”19

The limitation has generated a substantial amount of controversy in high-tax states, such as New Jersey, New York, and California.20 States are considering a variety of options to preserve the deductions, including converting employee wage withholding to employer-paid payroll tax, allowing taxpayers to make charitable contributions to the state in lieu of personal income taxes, and taxing pass-through entities at the entity level, rather than at the individual owner level.

Conclusion

Most states are beginning to project increased revenue due to federal tax reform. The states expect to benefit from base broadening provisions without corresponding rate reductions. A recent study estimated a 12 percent average increase in state taxes, with Pennsylvania projecting the highest increase at 14 percent.21

The balance between state and federal taxes is likely to undergo a major shift. A reduction in federal tax rates and overall collections necessarily leads to the increased importance of state taxes – not only state income taxes, but also nonincome taxes such as sales and property taxes, which make up the majority of state tax collections. The value of well-executed state tax planning formerly offset by a 35 percent federal corporate tax effect will now only be reduced by the new 21 percent federal corporate rate.

The potential outcomes will take time to analyze and digest. As states wrestle with how to address, incorporate, or decouple from certain Tax Act provisions, taxpayers and practitioners should take action to determine the impacts and opportunities.

1 H.R. 1, Public Law No. 115-97 (2017).
2 “Tax Reform Moves to the States: State Revenue Implications and Reform Opportunities Following Federal Tax Reform,” Tax Foundation, No. 242, January 2018.
3 Id.
4 IRC Section 172.
5 72 Pa. Cons. Stat. Section 7401(s).
6 72 Pa. Stat. Section 7401(3)1(m); 72 Pa. Stat. Section 7401(3)4(c).
7 IRC Section 163(j)(1) and (2).
8 IRC Section 168(k).
9 IRC Section 179.
10 “Tax Reform Moves to the States: State Revenue Implications and Reform Opportunities Following Federal Tax Reform,” Tax Foundation, No. 242, January 2018.
11 IRC Section 965. Specified foreign corporations are defined to include all CFCs and all other foreign corporations (which are not passive foreign investment corporations) with at least one United States corporation as a shareholder.
12 IRC Section 965.
13 “Questions and Answers about Reporting Related to Section 965 on 2017 Tax Returns,” IRS, March 13, 2018.
14 IRC Section 250(a)(1)(B).
15 IRC Section 951A.
16 IRC Section 250(a)(1)(A).
17 IRC Section 11(b).
18 IRC Section 164.
19 “IRS Advisory: Prepaid Real Property Taxes May Be Deductible in 2017 if Assessed and Paid in 2017,” IR-2017-210 (Dec. 2017). https://www.irs.gov/newsroom/irs-advisory-prepaid-real-property-taxes-may-be-deductible-in-2017-if-assessed-and-paid-in-2017.
20 Grant Thornton, State and Local Tax Alert: SALT Outlook, Trends, and Predictions for 2018, Jan. 16, 2018.
21 The Impact of Federal Tax Reform on State Corporate Income Taxes, Council on State Taxation and State Tax Research Institute (2018).

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Matthew D. Melinson, CPA, is a partner in Grant Thornton LLP’s Philadelphia office, leads the Atlantic Coast State & Local Tax Practice, and is a member of the Pennsylvania CPA Journal Editorial Board. He can be reached at matthew.melinson@us.gt.com.

Drew VandenBrul, CPA, is a managing director in Grant Thornton’s Philadelphia state and local tax practice. He can be reached at drew.vandenbrul@us.gt.com.

Katherine M. Piazza, JD, is an associate in Grant Thornton’s Philadelphia state and local tax practice. She can be reached at katie.piazza@us.gt.com.

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