It is going to be a busy summer for those in state and local tax (SALT). There

Transcription

1 The SALT Implications of Federal Change: It s Going to Be a Long, Hot Summer By Bruce Nelson Bruce Nelson examines the impact of the Tax Cuts and Jobs Act on individuals, businesses and international taxes. It is going to be a busy summer for those in state and local tax (SALT). There is the new Tax Cuts and Jobs Act (TCJA or the Act ) to study, the U.S. Supreme Court will hand down its decision in Wayfair, and state legislators and tax administrators will be issuing a flood of legislation, amendments, policy statements, rulings, and regulations in reaction to the TCJA. 1 You might as well cancel that vacation now. Given the variation in state tax regimes, the elements of ambiguity in the TCJA, and the inherent linkage between state and federal income taxes, no one article can possibly address all that can be covered. It is possible, however, to identify the key elements that practitioners should watch for in untangling the SALT implications of TCJA. Let s give it a try by dividing those implications into three parts: individual, business, and international. Individual Tax Changes and SALT Implications BRUCE NELSON, M.A., CPA, is a Director in the EKS & H State and Local Tax group. The key federal changes for individuals include the following: Increase in the standard deduction [Code Sec. 63(c)(7)]; Elimination of the personal exemption [Code Sec. 151(d)]; Expansion of the Child Tax Credit [Code Sec. 24(h)]; Elimination of the moving expense deduction [Code Sec. 217(k)]; Elimination of the deduction and income inclusion for alimony [Code Secs. 71 and 215]; Several changes to itemized deductions including: Decrease in medical expense deduction threshold from 10% to 7 1/2 [Code Sec. 213(f)], SUMMER B. NELSON 25

2 THE SALT IMPLICATIONS OF FEDERAL CHANGE Capping the SALT deduction at $10,000 [Code Sec. 164(b)(6)], Reducing the cap on the mortgage interest deduction [Code Sec. 163(h)(3)], Restricting the deduction for casualty losses to federally declared disasters [Code Sec. 165(h)(5)], and Suspending all deductions for miscellaneous expenses subject to the 2% AGI floor [Code Sec. 67(g)]; Increase in the AMT exemption and thresholds [Code Sec. 55(d)]; and Doubling of the estate tax exemption [Code Secs. 2010(c)(3)(C) and 2001(g)]. It is going to be a busy summer for those in state and local tax (SALT). For SALT purposes, where you end up with the individual federal tax, will change depending upon where you begin, and that varies by state. For example, while almost all states link their individual state returns to the federal 1040 form, they differ in their starting point. First, the starting point varies depending upon whether the state automatically adopts federal changes, often called rolling conformity, or whether the state must annually adopt any changes, often called static conformity. At least 18 states and the District of Columbia have adopted rolling conformity, while the balance have adopted some form of static conformity. 2 The differences, however, do not stop there. Static conformity states have not all adopted the same date for conformity. For example, California tax law conforms to the Internal Revenue Code (the Code ) as of January 1, 2015; Hawaii, Indiana, Maine, and South Carolina, as of January 1, 2016; Minnesota as of December 16, 2016; and Massachusetts (with numerous exceptions) as of January 1, It is common among the static conformity states to find specific federal code sections to which they never conform or conform automatically. In addition to differences in conformity, states starting points for individual income taxation also differ as to whether they begin with federal taxable income (line 43, form 1040) or federal adjusted gross income (AGI, line 37, form 1040). Only four state returns truly start with federal taxable income: Colorado, Minnesota, North Dakota, and South Carolina. 4 Other states such as Pennsylvania begin with gross compensation, and several states such as Alabama and Massachusetts begin with separate calculations of total income. The majority of states begins with federal AGI, but each state has its own additions and subtractions to arrive at a taxable state base. Some states that begin with AGI end up roughly at federal taxable income because they directly tie themselves to both the federal standard deduction and personal exemptions. 5 The significance of this variation among states is important for understanding the impact of the TCJA because a state s starting point determines the impact the federal change will or will not have on taxpayers in that state. For example, only two subtractions move a taxpayer from AGI to federal taxable income, and those are the subtraction for either itemized deductions or the standard deduction, and the subtraction for personal exemptions. Thus, those states that tie themselves to federal taxable income, or otherwise link to the federal standard deduction, itemized deductions, or personal exemptions, will be directly impacted by the TCJA changes to the standard deduction and personal exemptions. The impact of the changes to the standard deduction and personal exemption for most states will be a positive broadening of the tax base. While the increase in the standard deduction will narrow the tax base over 10 years by about $737 billion, the elimination of the personal exemption will broaden it by nearly $1.2 trillion. 6 The impact of eliminating the deductions for moving expenses and alimony is small but will also broaden the tax base as will the repeal of the itemized deductions for miscellaneous expenses, the reduced cap on mortgage interest, and restriction on casualty losses. The most significant change to itemized deductions is capping the state and local income tax deduction at $10,000. While the measure will certainly broaden the federal tax base, it will have a negative effect on those taxpayers in states with high income tax rates. 7 New York has already responded by enacting legislation to circumvent the federal cap by creating an optional payroll tax and charitable contribution deduction. In brief, employers will pay a 5% deductible payroll tax on employees making over $40,000, and their employees will receive a corresponding tax credit. In addition, the legislation creates a new state tax credit of up to 85% of donations for healthcare and education. The legislation will be phased in over three years beginning January 1, Whether the legislation will pass legal scrutiny is already being debated. Other changes with little effect on state taxes include the increased exemption amount for the individual AMT, the increase in the federal child tax credit, and the doubling of the estate tax exemption. Only six states impose an AMT, which is generally not calculated as a percentage of the federal AMT liability. 9 Only three states, Colorado, New York, and Oklahoma, tie their child tax credit to a 26 JOURNAL OF STATE TAXATION SUMMER 2018

3 percentage of the federal credit. Finally, the Tax Policy Center estimated that prior to the passage of the TCJA, 5,500 estates would owe estate tax. That estimate dropped to 1,700 with passage of the TCJA. 10 A final unknown impact on SALT is the change in Code Sec. 529 plans. Prior to the passage of the TCJA, those plans were used only for college savings. Under the new law, distributions from such plans may now be used for elementary and secondary public, private, or religious tuition up to a maximum of $10,000 per child. Thirty-one states offer a deduction for such plans, but it is not clear whether state definitions of qualified expenses are consistent with the expanded federal definition. If not, many states may have to enact conforming legislation to expand their definition to allow withdrawals for elementary and secondary education. Nebraska has already introduced a bill to do so. 11 Business Tax Changes and SALT Implications The key federal changes for businesses include the following: Reduction in corporate tax rate [Code Sec. 11(b)], Increases to 179 expensing and bonus depreciation [Code Secs. 179 and 168(k)], Adjusting the net operating loss (NOL) provisions [Code Sec. 172], Repeal of 199 deduction for domestic production [Code Sec. 199], Repeal of the corporate AMT [Code Sec. 55], Adjustment to the dividends received deduction (DRD) [Code Sec. 243], Limits in deducting interest expense [Code Sec. 163(j)], Addition of a 20% passthrough deduction [Code Sec. 199A], 1031 like-kind exchanges limited to real property [Code Sec. 1031], and Changes to contribution to capital by governmental entities [Code Sec. 118]. According to the U.S. Census Bureau, individual income taxes account for 23.5% of state government revenue, while corporate income taxes account for only 3.7%. 12 Nevertheless, the federal changes at the business entity and corporate tax level may create significantly more complexity for taxpayers and practitioners than those at the individual level. The reduction in the federal corporate tax rate will have no impact on state corporate tax because the states set their own tax rates. However, the decrease in the federal rate to 21% prompted a reduction in the federal DRD. The DRD for a 20%-owned corporation was reduced from 80% to 65% and for a less-than-20%-owned corporation from 70% to 50%. This reduction in the DRD will impact the majority of states because most states conform to the federal DRD. The most significant impact of the TCJA on SALT will be in the changes to depreciation, the limitation on interest expense, and the 20% passthrough deduction. State legislators, tax administrators, practitioners, and taxpayers are faced with significant challenges this year. The distinction discussed earlier between rolling conformity and static conformity carries over to business entity taxes. States with rolling conformity will automatically include the TCJA changes to depreciation, interest expense limitation, and the 20% passthrough deduction. There will be no impact on static conformity states until they legislatively adopt the changes. In addition, some states begin with line 28 of the federal corporate form 1120, taxable income before NOLs and special deductions, and others begin with federal taxable income on line 30. Regardless of where they begin, rolling or static, line 28 or 30, states have traditionally been very selective in conforming to specific federal provisions. State modifications to federal taxable income are many, and the state tax base is often dramatically different from that of the federal return. 13 Beginning with the Job Creation and Worker Assistance Act of 2002, states began to decouple from Code Sec. 179 expensing and bonus depreciation. Today, more than 30 states have decoupled in some fashion from these accelerating provisions largely because of the hit to their state budgets. The TCJA increased bonus depreciation expensing from 50% to 100%, expanded it to include used property, and made it retroactive to September 27, Immediate expensing under Code Sec. 179 was increased to $1,000,000 for tax years after 2017 with a phase-out beginning at $2,500,000 for qualifying assets. It is likely that the same states that have decoupled in the past will continue to do so, and it is possible that other states may join them. The TCJA limited the deduction for business interest expense to the amount of business interest income plus 30% of the taxpayer s adjusted taxable income. The latter is defined for the first four years as earnings before interest, taxes, depreciation, and amortization (EBITDA) and after four years to earnings before interest and taxes (EBIT). SUMMER

4 THE SALT IMPLICATIONS OF FEDERAL CHANGE Unused amounts can be carried forward indefinitely, and taxpayers with a three-year average of $25 million or less in gross receipts are excluded from the limitation. Taxpayers and practitioners should expect problems in attempting to apply the interest limitation rules given the state s different filing methods, specifically separate, consolidated, and combined filing. It is unclear at what level the interest limitation should be applied or even how it should be applied to those states in which the composition of a consolidated or combined return differs from that of a federal consolidated return. Further complications should be expected in the 20 plus states that require addbacks for interest paid to related parties. The federal provision does not distinguish between third-party and related-party interest. It is clear that the next year s SALT preparation will be fraught with indecision, doubt, vacillation, and ambiguity coupled with a disquiet wariness. In other words, just like this year, only more so. Most states do not allow NOL carrybacks. Carry forwards can vary. Prior to 2018, federal law provided for a two-year carryback and 20-year carryforward of NOLs. The TCJA modifies those NOL rules for years beginning after December 31, 2017, by repealing the NOL carryback and allowing for an indefinite carryforward but limiting the carryforward deduction to 80% of the taxpayer s income determined without regard to the deduction. Again, states that have rolling conformity but have decoupled in the past from the federal NOL rules at Code Sec. 172 will probably continue to do so, and those states with static conformity will be unaffected unless they choose to be so. In any case, the ongoing confusion and controversy over the differences between federal and state treatment of NOLs will continue. The TCJA eliminated the domestic production deduction under Code Sec. 199, which will broaden the tax base for those states that included it in their linkage to federal taxable income. Given the beneficial changes in international tax (discussed below), Congress indicated that the deduction was no longer needed. The narrowing of Code Sec like-kind exchanges to real property only should also broaden the SALT base. Congress added a new provision, Code Sec. 199A, which allows individuals receiving qualified business income from a partnership, S corporation, or sole proprietorship a 20% deduction against such income. The deduction is available to any individual filing a joint return with income below $315,000 or $157,500 for those filing separately. 14 For those with incomes exceeding that threshold, the deduction is limited to the greater of either (1) 50% of the W-2 wages paid, or (2) 25% of the W-2 wages paid plus 2.5% of the acquisition cost of qualified property. Qualified income (unless below $315,000/$157,500) does not include certain service providers in accounting, health, and law. Income earned by engineers and architects does meet the definition of qualified income. 15 Curiously enough, the deduction is not an above-the-line deduction for AGI but is a deduction from AGI available to both those who itemize deductions and those who take the standard deduction. The federal revenue impact of the Code Sec. 199A deduction is significant, about $415 billion over eight years. 16 Thus, for those states with rolling conformity that begin with federal taxable income, the blow to the state budget could really hurt. Given that most states tie to AGI rather than federal taxable income, the impact will be limited to only a handful of states. In any event, the new code section has already generated at the federal level wide confusion and controversy over some of its definitions, terminology, and calculation. 17 We should expect that confusion to spill over into SALT. The repeal of the corporate AMT will probably have little effect on SALT because there are only eight states with a corporate AMT, and none of them calculate their AMT as a percentage of the federal AMT. 18 Other changes with only little effect on SALT include the repeal of certain meals and entertainment (say goodbye to the country club) and transportation fringe benefits (really, you ride a bike to work?). More significant is the change to capital contributions by governmental entities. Prior to the passage of the TCJA, such contributions to corporations were excluded from gross income. No longer. The new law now requires any contribution by a customer or potential customer and any capital contribution by a governmental entity to a corporation be included in income. According to Reg , the exclusion applies to the value of land or other property contributed to a corporation by a governmental unit or by a civic group for the purpose of inducing the corporation to locate it business in a particular community, or for the purpose of enabling the corporation to expand its operating facilities. While the revenue generated by the provision is small compared to many of the other TCJA changes (it is $6.5 billion over 10 years), it will have a dampening effect on SALT incentives. Given that the U.S. Supreme Court 28 JOURNAL OF STATE TAXATION SUMMER 2018

5 has four times addressed the scope of what constitutes a contribution to capital, it is almost certain that litigation will follow challenging the statutory change. 19 The change was prompted by those who believed that the exclusion under Code Sec. 118 was little more than a federal tax subsidy for state and local governments to offer incentives and concessions to businesses to locate in their jurisdiction. International Tax Changes and SALT Implications The key federal changes in international tax include the following: Modifications of subpart F income, and Deemed repatriation of overseas income. It is likely that the TCJA changes in international tax will trigger the most confusion and litigation of all the changes in the new tax bill. The primary goal in reforming international tax was to move the United States from a worldwide system of taxation closer to a territorial system. Under worldwide taxation, a U.S. corporation conducting a multinational business would have to pay tax to the United States on all of its income. However, if the U.S. corporation created a controlled foreign corporation (CFC) in which it conducted all of its foreign business operations, the foreign income of the CFC would not be subject to tax until it was repatriated back to the U.S. corporation as a dividend. 20 Subpart F was enacted in 1962 to prevent just that sort of deferral. In brief, Subpart F identifies certain categories of income that must be included in the CFC s shareholder s income regardless of whether the income was distributed to the shareholder or not. 21 The categories are investment income in the form of dividends, interest, rents, and royalties (called foreign personal holding company income or FPHCI); income from the purchase or sale of property with a related party (called foreign base company sales income) and the performance of services by a related party (called foreign base company services income). Active business income arising from sales of good and services to third parties is generally not defined as Subpart F income. To move the United States closer to a territorial system, the TCJA did several things. First, it required an immediate repatriation and taxation of currently deferred foreign earnings and profits called the Repatriation Transition Tax (RTT). Second, it provided a deduction against the repatriated income so that it would be taxed at reduced rates. Third, it allows the taxpayer to elect to pay the RTT tax liability over eight years. The RTT raises several SALT questions. First, the RTT does not fall within the definition of Subpart F income in Code Sec. 952 but is simply added to the taxpayer s Subpart F income. Many states exclude Subpart F income from their tax base; others do not. Taxpayers should anticipate arguments over whether the RTT income is included or excluded from the tax base. Second, is the RTT deduction a special deduction for federal income tax purposes? As noted earlier, some states start with line 28 before NOLs and special deductions, and others start with line 30. Special deductions are found in subtitle A, chapter 1, subchapter B, Part VIII, currently Code Secs. 241 through 250. The RTT deduction is imposed by Code Sec. 965, not Part VIII, and thus arguably not a special deduction. As such, it would be a deduction against taxable income in the state tax base. There is a risk that a state may have to exclude the RTT income as Subpart F income while including the deduction or vice versa, it may have to include the income but not be able to claim the deduction. Arguments are sure to follow. The TCJA also provides for a tax on a portion of the CFC s non-subpart F income called the global intangible low-taxed income (GILTI). The tax is imposed at a reduced rate and, like the RTT, has two components. First, the taxpayer must include the GILTI in taxable income pursuant to a new code section, Code Sec. 951A. Then, the taxpayer is allowed a deduction under new Code Sec While the GILTI income might be excluded in some states as dividend income, it is more likely to be included in the state s tax base. However, the GILTI deduction under Code Sec. 250 is a special deduction, and its inclusion is again going to be determined by the state s starting point, either line 28 or line 30. Finally, the TCJA provides for a new Base Erosion and Anti-Abuse Tax or BEAT. Since this is a tax assessed on a corporation s federal taxable income and not an adjustment or modification to that income, it is unlikely to have an effect on SALT. Apart from the question of defining the state tax base, the international provisions of TCJA raise other troubling questions: Is a taxpayer entitled to factor representation for the RTT and GILTI included in its tax base? Since the RTT was deemed repatriated in the 2017 calendar year, can a state retroactively revise its application of Subpart F income and special deductions to include the additional revenue in its tax base? Can a state include either RTT or GILTI if there is no unitary relationship between the relevant entities? Must a state that excludes 80/20 companies from its unitary group (companies that have more than 80% of SUMMER

6 THE SALT IMPLICATIONS OF FEDERAL CHANGE their property and payroll outside the United States) exclude the RTT and GILTI income? If a state, in conforming to the TCJA, discriminates against foreign source income, will this be a violation of the foreign commerce clause? 22 State legislators, tax administrators, practitioners, and taxpayers are faced with significant challenges this year. They are confronted with the largest, most complex federal tax changes in a generation and given limited time and resources with which to address those changes. Their options include trying to maintain or increase their current tax conformity, decouple even further from the federal tax base, perhaps embrace a complete overhaul of their state tax regime, or do nothing. It is clear that the next year s SALT preparation will be fraught with indecision, doubt, vacillation, and ambiguity coupled with a disquiet wariness. In other words, just like this year, only more so. ENDNOTES 1 Technically, the TCJA title is To provide for reconciliation pursuant to titles II and V of the concurrent resolution on the budget for fiscal year 2018, P.L , 131 Stat (Dec. 22, 2017). But who are we kidding? No one, including this author, is going to call it that. 2 The states with rolling conformity include Alabama, Colorado, Connecticut, Delaware, Illinois, Kansas, Louisiana, Maryland, Michigan, Missouri, Montana, Nebraska, New Mexico, New York, North Dakota, Oklahoma, Rhode Island, and Utah. 3 Cal. Rev. & Tax Cd (a)(1); Haw. Rev. Stat ; Ind. Code ; Me. Rev. Stat. 111(1-A); S.C. Code (A)(1)(a); Minn. Stat. 289A.02; Mass. Gen. L See state forms Colorado Form DR 0104, Minnesota Form M1, North Dakota Form ND-1, and South Carolina Form SC 1040 and the relevant statutes: Colo. Rev. Stat (1); Minn. Stat ; N.D. Code (13); and S.C. Code Vermont is sometimes included with these four, but the state return actually requires a taxpayer to begin by completing two lines, one for federal taxable income and the other for federal adjusted gross income, an approach confusing to everyone outside the state of Vermont. 5 See, for example, Colorado, Idaho, Minnesota, North Dakota, and South Carolina. 6 Joint Committee on Taxation, Estimated Budget Effects of the Conference Agreement for H.R. 1, The Tax Cuts and Jobs Act, JCX67-17 (Dec. 18, 2017). 7 For those of you who believe that all government actions cloak dastardly deeds, you will be happy to note that the states most impacted by the elimination of the SALT deduction include New York, New Jersey, Connecticut, California, Maryland, Oregon, Rhode Island, Massachusetts, and Minnesota all of which went for Clinton in the past election. Area 51 was unaffected. 8 See S.B. 7509, enacted as part of New York s budget. For details on the mechanics of how the legislation will work, see Richard Call, Peter Faber, Alysse McLoughlin, and Mark Yopp, New York s Response to Federal Tax Reform: Optional Payroll Tax, National Law Review, available online at (Apr. 18, 2018), accessed April 22, The states with an AMT include California, Colorado, Connecticut, Iowa, Minnesota, and Wisconsin. 10 Howard Gleckman, Only 1,700 Estates Would Owe Estate Tax in 2018 Under TCJA, available online at estates-would-owe-estate-tax-2018-undertcja (Dec. 6, 2017), accessed April 23, Nebraska L.B U.S. Census Bureau, 2015 Annual Survey of State and Local Government Finances, available online at accessed April 23, Nevada, Ohio, Texas, and Washington have departed from a traditional income tax, adopting instead different forms of gross receipts taxes. Neither South Dakota nor Wyoming impose either an income tax or gross receipts tax. 14 The benefit phases out between $315,000 and $415,000 or $157,500 and $257, Apparently, engineers and architects had better lobbyists than the accountants and attorneys. 16 Joint Committee on Taxation, Estimated Budget Effects of the Conference Agreement for H.R. 1, The Tax Cuts and Jobs Act, JCX67-17 (Dec. 18, 2017). 17 See, for example, C. Wells Hall III, New Code Sec. 199A and the Configurations of Qualified Business Income: Leveling the Playing Field for Pass- Thru Entities After the C Corporation Rate Cut, Taxes, Wolters Kluwer, Mar. Apr. 2018, at 55 64; Robert Keatinge, Taxation of Compensatory Income: We May Be Lost but We re Making Really Good Time, Taxes, Wolters Kluwer, March 2018, at ; and Jane Livingston, New Deduction for Qualified Business Income of Pass-Through Entities: A First Look, Practical Tax Strategies 4 13, WGL (March 2018). 18 The states are Alaska, California, Florida, Iowa, Kentucky, Maine, Minnesota, and New Hampshire. 19 See Chicago, Burlington & Quincy R.R. Co., SCt, 73-1 ustc 9478, 412 US 401, 93 SCt 2169; Brown Shoe Co., SCt, 50-1 ustc 93,48A, 339 US 583, 70 SCt 820; Detroit Edison Co., SCt, 43-1 ustc 9418, 319 US 98, 63 SCt 902; and Texas & Pacific R.R. Co., SCt, 3 ustc 936, 286 US 285, 52 SCt 528 (1932). The Supreme Court specifically ruled in Edwards v. Cuba Railroad Co., 268 US (1925) that such contributions to capital were not income under the 16th Amendment to the U.S. Constitution. 20 A foreign corporation is a CFC if U.S. shareholders own more than 50% of the total combined voting power of the CFC s stock and more than 50% of the total value of all classes of the corporation s stock. 21 Code Sec. 951(a). 22 In Kraft General Foods v. Iowa, SCt, 505 US 71, 112 SCt 2365 (1992), the U.S. Supreme Court held that Iowa s conformity to the federal dividends received deduction was unconstitutional as a violation of the foreign commerce clause. Because Iowa had adopted the federal DRD deduction, it by definition discriminated against dividends received from foreign affiliates, which it included in income, compared to dividends received from domestic affiliates that were excluded. This article is reprinted with the publisher s permission from the Journal of State Taxation, a bimonthly journal published by Wolters Kluwer. Copying or distribution without the publisher s permission is prohibited. To subscribe to the Journal of State Taxation or other Wolters Kluwer journals please call or visit CCHGroup.com. All views expressed in the articles and columns are those of the author and not necessarily those of Wolters Kluwer or any other person. 30 JOURNAL OF STATE TAXATION SUMMER 2018