October 3, 2017 Federal tax reform framework has state tax implications The "Unified Framework for Fixing Our Broken Tax Code" (the Framework), released on September 27, 2017, by the Trump Administration and Congressional Republican leaders, is meant to serve as a legislative template for federal tax-writing committees. The legislative priorities listed in the Framework are intended to simplify the US federal income tax code and lower corporate and individual income tax rates. This Alert focuses on the US state and local (collectively, state) tax implications of the Framework. For a more detailed discussion of the Framework's individual provisions, see Tax Alert 2017-1598. For a more detailed discussion of the Framework's corporate and international provisions, see Tax Alert 2017-1588. For a more detailed discussion of the Framework's business and individual provisions, see Tax Alert 2017-1563. Summary of key tax reform provisions Key aspects of the Framework affecting businesses include: — Reducing the corporate income tax rate to 20% — Replacing the current US worldwide tax system with a territorial system that would exempt from US tax 100% of dividends from foreign subsidiaries in which the US parent owns at least a 10% stake — Imposing a one-time transition tax on accumulated foreign earnings currently held by US multinational companies with the resulting tax liability spread "over several years" — Creating anti-base erosion rules to prevent companies from shifting profits to "tax havens" — Allowing immediate expensing of the cost of new investments made after September 27, 2017, in depreciable assets (not structures) for at least five years — Aiming to repeal the corporate alternative minimum tax (AMT) — Limiting the deduction for net interest expense — Repealing or restricting special exclusions and deductions, including repealing the Internal Revenue Code (IRC) Section 199 domestic production deduction — Preserving the research credit and low-income housing tax credit — Modernizing special tax regimes for certain industries and sectors The Framework also calls for limiting the tax rate on business income of small and family-owned businesses conducted as sole proprietorships, partnerships and S corporations to 25%. The Framework would also include anti-avoidance rules to prevent the recharacterization of personal income into business income. Key aspects of the Framework affecting individuals include: — Reducing the income tax rate brackets from seven to three (i.e., 12%, 25% and 35%) — Doubling the standard deduction (for individuals, from $6,000 to $12,000, and for married couples, from $12,000 to $24,000) — Eliminating personal exemptions — Eliminating most itemized deductions, including the deduction for certain state taxes paid, but leaving in place the deductions for mortgage interest and charitable donations — Repealing the individual AMT — Retaining tax benefits that encourage work, higher education and retirement security — Repealing the estate and generation-skipping transfer taxes State income tax implications The proposals contained in the Framework (or parts thereof) give valuable insight into the types of tax reform that the Trump Administration and Congressional Republican leaders are considering. Emerging themes from the Framework include corporate and individual income tax rate reductions coupled with base expansion and a move to a territorial tax system. Federal tax reform will affect states unless states change their income tax laws. Generally, state income tax systems are inextricably tied to the federal income tax system; if federal tax base expansion occurs, state taxes would rise (immediately or in the near term) unless states decrease their tax rates in step with federal tax rate reductions. Unlike the federal government budget, all state government budgets (with the exception of Vermont) must be balanced each year. Accordingly, states will be more sensitive to the potential revenue effects of federal tax law changes. When federal tax changes increase state tax revenue, states are less inclined to decouple. Focus on IRC conformity In general, states conform to the IRC in one of several ways. Some states define "state taxable income" as federal taxable income plus or minus certain additions or subtractions, while other states may define certain terms like income, deduction, etc. as being the same as the IRC. In either event, states adopt a "federal conformity date" to determine which federal provisions apply for state tax purposes. Twenty-one states1 currently adopt a "rolling" conformity date and, as such, automatically conform to the IRC as enacted. Accordingly, these states would automatically adopt the federal tax changes that are ultimately enacted under tax reform and, if so desired, would have to proactively decouple from the enacted provisions. In contrast, another 21 states2 use a "fixed" (or "static") IRC conformity date, only incorporating changes to the IRC that occurred as of a certain date. These states would have to proactively update their IRC conformity date to adopt the federal tax changes that are ultimately enacted under tax reform. The remaining five states3 with an income tax use a "selective" approach and adopt only specific provisions of the IRC. Nevertheless, before adopting or decoupling from a federal tax change that is ultimately enacted, states will need to determine the revenue impact each provision will have on their respective budgets. If the federal tax base expands as expected under the proposed tax reform and if relevant states do not reduce their tax rates, taxpayers could face increased state business tax burdens without any further state legislative action. As each state's taxing system varies in its approach and conformity to federal tax law changes, businesses should address the impact the proposed federal tax law changes will have not only on their federal tax liabilities, but on their state business tax liabilities as well. Doing so will put such businesses in the best position to identify approaches that can reduce the state tax impact of the proposals while enabling them to utilize relevant attributes efficiently. In addition, such businesses will be in a better position to engage state lawmakers as they too begin to respond to forthcoming federal tax reform. Shift to territorial tax system A significant objective of federal tax reform is to make the US international tax regime competitive with its foreign competitors. To further that objective, the Framework would move the US from its current worldwide system of taxation to the more prevalent territorial system, prospectively allowing a 100% exemption for dividends from foreign subsidiaries in which the US parent owns at least a 10% stake. To get there, accumulated foreign earnings currently held by US multinational companies would be treated as repatriated (presumably under the Subpart F income regime) and subject to a one-time transition tax at lower tax rates, with the resulting tax liability possibly spread out over several years. Will the states conform for corporate income tax purposes? Currently, there is disparate treatment of Subpart F income (and foreign dividends, for that matter) among the states. In fact, the states may be subject to limitations under the US Constitution that prohibit them from following the regime even if they wanted to do so. The Framework leaves many open questions on how the mechanics of the transition tax would apply, including effective dates and which earnings and profits would be relevant for purposes of applying the transition tax. Nonetheless, businesses will need to carefully understand how the states conform to these particular rules, model the federal and state tax impact of the transition tax, and identify and implement opportunities to reduce the resulting state tax impact. Moreover, businesses will need to monitor the "anti-base erosion rules" as draft legislative language comes to light in order to better understand and respond to any resulting state tax implications. State tax deduction The Framework's proposed elimination of the federal individual income tax deduction for state income taxes (which has been part of the IRC since 1913) would significantly affect individuals at the federal level. At the state level, however, it would have little direct impact on individuals because most states require deducted state income taxes to be added back to federal taxable income to determine state taxable income. Likewise, the elimination of the alternative deduction for state sales taxes would have little direct impact at the state level as taxpayers that generally benefit from this deduction reside in states that do not impose a personal income tax. For deductible state property taxes, the result could be very different depending upon the state; many states, such as New Jersey, provide special and separately determined benefits for in-state property taxes as part of state-specific property tax relief. Despite these state and federal differences, the elimination of the state tax deduction for federal individual income tax purposes, coupled with reduced federal income tax rates, will likely have the indirect effect of making taxpayers feel as if they are paying much more in state taxes (in effect, for some taxpayers a nearly 50% increase in their overall state tax burden). As a result, these taxpayers could be more likely to pay greater attention to, and possibly be more emboldened to challenge, their state tax liabilities. ———————————————
——————————————— 1 States with a "rolling" conformity date are: Alabama, Alaska, Colorado, Connecticut, Delaware, District of Columbia, Illinois, Kansas, Louisiana, Maryland, Massachusetts, Missouri, Montana, Nebraska, New Mexico, New York, North Dakota, Oklahoma, Rhode Island, Tennessee and Utah. 2 States with a "fixed" (or static) IRC conformity date are: Arizona, Florida, Georgia, Hawaii, Idaho, Indiana, Iowa, Kentucky, Maine, Michigan (note: taxpayers can make an election to use the current IRC date), Minnesota, New Hampshire, North Carolina, Ohio (personal income tax), Oregon, South Carolina, Texas, Vermont, Virginia, West Virginia and Wisconsin. 3 States with a "selective" conformity approach are: Arkansas, California, Mississippi, New Jersey and Pennsylvania. | |||||||||||||||||||||||
| |||||||||||||||||||||||
