December 21, 2017 Final federal tax reform bill has state tax implications On December 15, 2017, House and Senate conferees released their agreed to final version of the "Tax Cuts and Jobs Act" (H.R. 1) (hereafter referred to as the Conference Agreement), reconciling the differences between the versions approved earlier by the House and Senate. On December 19, the House approved by a 227-203 vote the Conference Agreement. Later, on December 19, the Senate also approved the Conference Agreement by a 51-48 vote after a budget point of order required the removal of three insignificant provisions that were determined to violate the Byrd Rule of the budget reconciliation process. The House then had to vote again on the changed measure, and on December 20, the House approved by a 224-201 vote the changed Conference Agreement. The final version of the bill (hereafter referred to as the Final Bill) now awaits President Trump's signature. Most commentators agree that the Final Bill contains the most significant changes to the federal income tax laws since 1986 and will affect individuals, pass-through entities (PTEs) and corporations. Since most state income tax laws are inextricably tied to federal tax determinations, it is anticipated that the Final Bill changes will likely have significant implications for US state and local (collectively, state) personal, corporate and business taxes as well, although those implications could be radically different depending upon state conformity to the new federal rules. This Alert focuses on the state tax implications of the Final Bill, including conformity issues, the transition tax, anti-deferral provisions, the anti-base erosion provision and the interest expense limitation. Summary of key tax reform provisions Key business provisions in the Final Bill: — Permanently reducing the 35% corporate income tax rate to 21%, effective January 1, 2018 — Repealing the corporate alternative minimum tax (AMT), effective for tax years beginning after 2017 — Limiting deductions for net interest expense to 30% of earnings before interest, taxes, depreciation and amortization through 2021 and of earnings before interest and taxes thereafter (the final bill does not contain a second, global limitation based on comparative debt levels between US and non-US affiliates, which had been in the Senate bill) — Allowing businesses to expense 100% of the cost of certain new and used "qualified property" placed in service after September 27, 2017, and before 2023, and gradually phasing down the increased expensing starting in 2023 by 20 percentage points for each of five following years — Imposing a one-time transition tax on post-1986 tax-deferred foreign earnings of 15.5% for liquid assets and 8% for illiquid assets — Establishing a participation exemption system by allowing a 100% dividends received deduction (DRD) on qualifying dividends paid by foreign corporations to 10% US corporate shareholders — Imposing new anti-deferral rules to ensure that the imputed "intangible" returns of controlled foreign corporations (CFCs) are subject to a minimum rate of US and/or foreign tax — Creating an incentive for US companies to sell goods and provide services abroad by effectively taxing income from those activities at a reduced rate — Imposing a new "base erosion and anti-abuse tax" that would be calculated by reference to all deductible payments made to a foreign affiliate for the year and apply to certain US corporations that are members of a global group with three-year average annual gross receipts of at least $500 million and have made related-party deductible payments totaling 3% (2% in the case of banks and certain security dealers) or more of the corporation's total deductions for the year — Limiting the net operating loss (NOL) deduction to 80% of taxable income, eliminating NOL carrybacks for most taxpayers and allowing indefinite carryforwards for losses arising in tax years beginning after 2017 — Reducing the amount of deduction allowable against the dividends received from a domestic corporation (dividends received from other than certain small businesses or those treated as "qualifying dividends" would be reduced from 70% to 50%, and dividends received from 20% owned corporations would be reduced from 80% to 65%) — Repealing the domestic production deduction under Internal Revenue Code (IRC) Section 199, effective for tax years beginning after 2017 — Allowing individual owners of certain PTEs to deduct from federal taxable income 20% of "qualified business income," effective for tax years beginning after 2017 and before 2026, resulting in a lower effective federal tax rate for individual PTE owners — Limiting the nonrecognition of gain in like-kind exchanges to those involving real property only, thereby repealing rules allowing deferral of gain on like-kind-exchanges of business personal property and investment property (a transition rule would apply to like-kind exchanges currently underway), effective for exchanges completed after 2017 — Changing the one-year holding period under IRC Section 1222 to a three-year holding period in order for certain capital gains attributable to carried interests to be treated as long-term capital gain — Retaining current law with respect to both the Work Opportunity Tax Credit and the New Markets Tax Credit (both of which expire after 2019) Key provisions in the Final Bill affecting individuals, all of which generally would be effective for tax years beginning after 2017 and would expire at the end of 2025 (unless otherwise noted), include: — Modifying the current seven income tax brackets for individual taxpayers to rates of 10%, 12%, 22%, 24%, 32%, 35% and 37% — Increasing the "exemption amounts" for the individual AMT, including significant increases in the amounts at which the exemption phases out — Limiting deductibility of interest on new home mortgages of $750,000 or more — Eliminating the ability to deduct interest on home equity lines of credit — Limiting the itemized deduction for state taxes to $10,000 for the aggregate amount of property tax and income tax (or sales taxes) — Doubling the child tax credit to $2,000 (and increasing the age limit for a qualifying child by one year to age 18), generally with up to $1,400 of the credit refundable — Retaining the estate tax but doubling the exclusion and adjusting it for inflation — Extending the medical expense deduction floor of 7.5% of adjusted gross income (AGI) in 2017 and 2018, and expenses that exceed 10% of AGI thereafter — Effectively repealing the "shared responsibility payment" (or individual mandate tax penalty) under the Affordable Care Act by reducing to zero the tax that applies to individuals who fail to purchase health insurance, beginning in 2019 The following discussion outlines the key state tax consequences of these dramatic federal tax law changes. For a more in-depth summary of the Final Bill, see Tax Alert 2017-2130. For a more detailed discussion of the Final Bill's corporate and international provisions, please see Tax Alert 2017-2166. For a more detailed discussion of the Final Bill's business and individual provisions, see Tax Alert 2017-2168. For a more detailed discussion of the Final Bill's PTE deduction provisions, see Tax Alert 2017-2141. For a more detailed discussion of the Final Bill's impact on employers, see Tax Alert 2017-2132. For a more detailed discussion of the Final Bill's impact on credits and incentives, see Tax Alert 2017-2169. Select state income tax implications The Final Bill, if enacted, will affect the corporate and personal income taxes imposed by state governments. Generally, most state income tax systems use federal taxable income or adjusted gross income as a starting point for state income tax computations, but do not automatically conform to federal tax rate changes. Thus, state income taxes would rise (immediately or in the near term) as the federal tax base expands, unless states align their tax rates with federal tax rate reductions. States that do not adjust their rates could significantly increase their tax revenues (and taxpayers would pay more in state taxes) without the states taking any action at all. Conformity is key States generally conform to the IRC in one of several ways: (1) they automatically tie to the federal tax law as it changes (known as "rolling" conformity states); (2) they tie to the federal tax law as of a specific date (known as "fixed" conformity states); or (3) they pick and choose different federal tax law provisions and dates to which they will conform (known as "selective" conformity states). Most states generally define "state taxable income" as either federal taxable income or adjusted gross income, plus or minus certain additions or subtractions (such as adding back federal depreciation and substituting their own methods of depreciation). A handful of states, however, select sections of the IRC to which they will conform and then modify the actual provision (Arkansas, California and Mississippi are examples of states whose tax laws work in this selective manner), meaning that the state's taxable income is computed independently of the federal computations. Twenty-two states1 currently adopt a "rolling" IRC conformity date and, as such, automatically conform to the IRC as enacted. Accordingly, if federal tax reform were to occur, these states generally would automatically adopt the federal tax changes unless the state chose to decouple from the new federal provisions (for example, when facing significant IRC changes in the past, states have often enacted special provisions to decouple from some of the federal measures they sensed would be too costly, such as accelerated depreciation). Absent any change in state conformity or the state tax rate, taxpayers generally would see an immediate impact on their state effective tax rate. In contrast, another 20 states2 currently adopt a "fixed" IRC conformity date and thus generally would only incorporate changes to the IRC if they changed their conformity date to a date on or after the effective dates of the corresponding federal tax reform provisions. Accordingly, for the federal changes to apply, these states generally would have to update their IRC conformity date.3 As such, taxpayers in these states generally will continue using the pre-federal tax reform version of the IRC to determine their state effective tax rate unless the state takes specific action to update its conformity date. The remaining five states4 with an income tax use a "selective" approach and adopt only specific provisions of the IRC, typically as of a specific fixed date. In these states, taxpayers generally could see a hybrid of the approaches used in the "rolling" and "fixed" conformity states that would affect their state effective tax rates. Regardless of which method a state uses, federal tax reform could have an assortment of effects at the state level depending not only on how they conform but also how each state responds to these federal tax law changes and even depending upon how a particular group of related taxpayers files returns in the state (e.g., water's edge combined, worldwide, consolidated, separate-entity reporting). For example, many states have had a robust history of proactively decoupling from federal bonus depreciation provisions. Considering the Final Bill provides for immediate expensing of 100% of the cost of "qualified property" under IRC Section 168(k), such decoupling efforts are expected to continue, which will further exacerbate the differences between federal and state asset basis determinations. Companies should be prepared to monitor and assess the effects of federal tax reform on their state tax profile across multiple financial reporting periods because the state approaches could be very different from what occurs for federal income tax purposes, depending upon how and when the states conform. Business interest expense limitation The Final Bill would limit the interest expense deduction for all businesses by amending IRC Section 163(j). The new limitation would generally apply to both related- and unrelated party debt. Unlike the House and Senate bills, however, the Final Bill does not include the additional interest expense limitation that would have been imposed through a worldwide debt cap under what would have been new IRC Section 163(n). The revised IRC Section 163(j) limitation would deny a deduction for business interest expense that exceeds 30% of adjusted taxable income (ATI), plus any business interest income. For the first four years, ATI generally would be computed without regard to depreciation, amortization or depletion (which was originally included in the House bill). Beginning in 2022 and thereafter, ATI generally would be decreased by those items, thus making the 30% business interest expense limitation computation based only on the ATI equivalent of earnings before interest and taxes (EBIT) (which was originally included in the Senate bill). ATI would otherwise be defined similarly to how it is defined under current IRC Section 163(j). Deductible interest expense would need to be related to a "business," which generally means the interest is properly allocable to a trade or business. For purposes of this provision, certain activities would be excluded from being a trade or business (e.g., performing services as an employee, a real property trade or business, and certain activities of regulated utilities). A small business exception is keyed to businesses satisfying a gross receipts test of $25 million. The provision is effective for tax years beginning after 2017. The Final Bill does not contain a "grandfathering" clause. Accordingly, interest on existing indebtedness would be subject to this new 30% business interest expense limitation. Under the Final Bill, the determination of ATI would be made at the tax-filer level. For example, for a partnership, the limitation would be determined at the partnership level, not at the partner level; for corporate filers, the limitation would be determined at the consolidated tax return filing level (i.e., after netting of all income and business interest expense and income among members of the federal consolidated group). The Final Bill follows the Senate bill by providing for an unlimited carryforward of any disallowed interest. The provision also includes special rules to allow a PTE's owners to use the unused interest limitation for the tax year and to ensure that net income from PTEs would not be double-counted at the partner level. The provision would not apply to businesses with average annual gross receipts of $25 million or less during the prior three-year period, nor would it apply to certain regulated public utilities or real property trades or businesses unless they elected to do so. The Final Bill also provides a special exception for interest on "floor plan financing indebtedness" (which is common among automobile and agricultural equipment dealers and other businesses). Since this new business interest expense limitation would be part of the computation of a deduction used to determine federal taxable income (or adjusted gross income for individuals), and most states use federal taxable income as the starting point to determine state taxable income, absent legislative decoupling, the states would generally follow the provision, presumably including its carryforward period. How the rule applies in specific states will depend upon how the state conforms to the IRC and, in particular, IRC Section 163(j) (i.e., a "rolling" conformity state generally would automatically conform to the change unless the state chose to decouple from the provision; a "fixed" conformity state generally would not apply the change until the state updated its IRC conformity date; and a "selective" conformity state generally would similarly have to incorporate the provision for it to apply). In addition, the creation of a new carryforward attribute for disallowed interest creates uncertainty as to whether states will apportion it and whether they will impose limitations under IRC Sections 381 and 382 consistent with the Final Bill. Further, the Final Bill provides that for corporate filers the limitation would be determined at the consolidated tax return filing level. Since most states, even those that require or allow combined or consolidated returns, don't follow the federal consolidated return regulations, the states might deviate from the federal treatment and seek to determine any limitation at the individual entity level, conceivably resulting in wide disparities in the business interest deduction limitations at the state level, compared to the federal level (and even among the states) even if the state incorporates the federal provision directly or indirectly into its law. Moreover, to the extent that a state already provides for the addback of interest paid to related parties, the intersection of that state's related-party interest expense addback rule could introduce increased complexity that may need to be addressed by the state's legislature. Another interesting issue involved with this new limitation is the netting of certain interest income with interest expense as part of the overall net effect of the limitation calculation in the context of a federal consolidated group. Might there be benefits in separate-return states, for example, in locating interest income and interest expense within the same income tax entity to limit the impact of the limitation? Finally, the application of these new net interest expense deduction limitations to S corporations, partnerships and other PTEs raises a variety of state income tax issues, including state conformity to federal PTE treatment and states' disparate treatment of corporate versus individual-owned PTEs. International tax reform Transition tax/future distributions A significant objective of federal tax reform is to make the US international tax regime more competitive with its foreign competitors. To further that objective, the Final Bill would move the US from its current worldwide system of taxation to the more prevalent territorial system, prospectively providing under new IRC Section 245A a 100% deduction for the foreign source portion of dividends received from foreign corporate subsidiaries (other than a passive foreign investment company (PFIC) that is not also a CFC) in which the US parent corporation owns at least a 10% stake (a 10% US corporate shareholder). A deduction generally would not be allowed for any dividends received by a 10% US corporate shareholder from a CFC if the dividend were deductible by the foreign corporation when computing its taxes. Further, a foreign tax credit or deduction generally would not be allowed for any taxes paid or accrued with respect to any portion of a distribution treated as a dividend that qualifies as a DRD. A deduction, however, would generally be allowed for a US corporation's distributed share of a dividend received by a partnership in which the US corporation is a partner if the dividend would have been eligible for the exemption had the US corporation directly owned stock in the foreign corporation and qualified as a 10% US corporate shareholder. These rules generally apply to distributions made after 2017. The Final Bill also includes a one-time transition tax (located in amended IRC Section 965) whereby certain previously untaxed accumulated foreign earnings currently held by foreign corporate subsidiaries of US multinational corporations would be deemed repatriated under a special inclusion of Subpart F income and subject to tax at lower tax rates. The tax rates would be 15.5% for the portion of earnings held in cash, cash equivalents or certain other short-term assets or 8% (in the case of accumulated earnings invested in illiquid assets, such as property, plant and equipment). (The stated rates are obtained through immediate inclusion of all of the Subpart F income under amended IRC Section 965(a) and then a deduction mechanism under amended IRC Section 965(c) against that amount resulting in a 15.5% tax rate (or 8% tax rate, as the case may be) depending upon the particular US shareholder's own tax rate as of the date of the return filed for a tax year beginning before 2018. Under the Final Bill, this one-time Subpart F income inclusion would apply to a foreign corporation's last tax year beginning before 2018, but measured by the post-1986 tax-deferred accumulated earnings and profits (E&P) as of November 2, 2017, or December 31, 2017, whichever amount of accumulated E&P is greater. The relevant tax-deferred accumulated earnings deficits of any CFC is generally allowed to offset relevant tax-deferred accumulated earnings of other CFCs when calculating the resulting Subpart F income inclusion for the US corporate shareholder(s). The Final Bill would also generally allow the netting to be done among all affiliated group members (via amended IRC Section 965(b)'s reference to IRC Section 1504). In addition, the portion of post-1986 E&P subject to the transition tax generally does not include E&P that was accumulated by a foreign company before attaining its status as a specified foreign corporation. The Final Bill retains both the prior House and Senate versions of the provision which would allow a US shareholder to elect to pay the transition tax over eight years but following the percentage payment schedule set forth in the Senate bill (i.e., at an increasing rate as follows: 8% of the net tax liability for each of the first five installments, 15% of net tax liability in the sixth installment, 20% of net tax liability in the seventh installment and 25% of net liability in the eighth installment). Further, under the Final Bill, a US corporation would be required to pay the full tax on the deferred foreign earnings (less the taxes it already paid) at a 35% rate if the US corporation inverted within 10 years after enactment. No foreign tax credits would be available to offset the tax in this instance. Currently, states approach existing categories of Subpart F income, and foreign dividends for that matter, in a variety of ways. While many states today exclude Subpart F income and foreign dividends from the tax base by way of a state modification to federal taxable income or through their own DRD,5 the states' disparate treatment of Subpart F income and foreign dividends, as well as the application of state-specific rules that disallow the deduction of certain expenses related to non-taxable income, might result in unanticipated state income tax liabilities that differ from their federal treatment even under the Final Bill's new rules. Moreover, the direct percentage ownership of the foreign subsidiary from which the Subpart F income or dividends is derived, as well as the taxpayer's own state income tax return filing method (e.g., worldwide unitary combined, water's edge unitary combined, separate), could significantly affect how a taxpayer might be subject to state tax on such foreign-source income. In addition, the "mechanics" of how this new Subpart F income and deduction under amended IRC Section 965 will be reflected on the federal income tax return may impact how states apply their own DRD or expense disallowance rules. Also, existing relevant state-specific subtraction modifications or state-specific DRD statutes that otherwise apply to current categories of Subpart F income might not be worded broadly enough to incorporate amended IRC Section 965 Subpart F income. Finally, while the federal provision allows the netting of E&P deficits from one CFC with other affiliated CFCs, the states, including combined reporting states, might not conform to the federal affiliation rules of IRC Section 1504, which appear to be crucial to the applicability of this new E&P provision. Regardless, companies will need to carefully consider how the states in which they file returns and pay tax will conform to these significant changes to the federal taxation of international income and in which particular entity that income will be recognized. As companies begin to consider the federal income tax impact of these new rules, they also should immediately and concurrently consider the impact of the state tax treatment of these transactions, particularly since the magnitude of the resulting Subpart F income that would be recognized under the transition tax could be significant, and future distributions from foreign subsidiaries could be treated very differently by the states than they have in the past. For example, under current California law, Subpart F income initially is not taxable at all although that state's unique water's edge group Subpart F inclusion ratio would have to be considered to determine if the non-US members of a water's edge group would have to be includable in the water's edge group return from which they might otherwise be excluded. Further, future actual distributions from CFCs, including actual distributions that are excluded from federal taxable income under the federal previously-taxed income (PTI) regime, would be subject to a gauntlet of unique and complicated California DRD rules that could result in all, some (i.e., 75% DRD for distributions from foreign members that are over 50% owned and not included in the water's edge return) or none of the distribution being subject to an immediate California tax. New anti-deferral provisions The Final Bill follows the Senate bill in creating a new anti-deferral regime that appears aimed at imposing a global minimum tax on certain excess returns of a CFC on presumed "intangible" income. The Final Bill would create both a "carrot" and a "stick" for the taxation of earnings from certain foreign sources. The "stick"would be in the form of a new category of CFC income under new IRC Section 951A called "global intangible low-taxed income" (or GILTI), and the US shareholder of any CFC would include in gross income for a tax year its GILTI inclusion in a manner generally similar to inclusions of Subpart F income. The calculation is complicated, but the GILTI inclusion generally would be computed at the US shareholder level on an aggregate basis, taking into account certain net "tested income" and "tested loss" of all of its CFCs. The GILTI inclusion would be the excess, if any, of the US shareholder's aggregate "net CFC tested income" over a deemed return on its CFC's depreciable tangible assets used in the production of "tested income." The corresponding "carrot" in the Final Bill would be the generation of a new deduction for US corporations for their "foreign-derived intangible income" (FDII) and GILTI inclusion (including any corresponding IRC Section 78 dividends). Similar to the GILTI inclusion, the FDII calculation is complicated. However, this new deduction generally would be calculated as 37.5% of a US corporation's FDII and 50% of the sum of its GILTI inclusion and corresponding IRC Section 78 dividends such that under the new 21% corporate income tax rate, it would generally subject a US corporation's FDII and GILTI inclusion (including corresponding IRC Section 78 dividends) to a federal effective tax rate of 13.125% and 10.5%, respectively, for tax years beginning after 2017 and before 2026, and a lower deduction for tax years beginning after 2025, resulting in a federal effective tax rate of 16.406% and 13.125%, respectively. Taking the impact of these two "carrot" and "stick" provisions together, it would appear the objective is to encourage the realization of such excess returns related to the sale of goods and services to foreign customers directly through US operations. How the deduction under new IRC Section 250 will be reflected on the federal income tax return could impact the resulting state income tax treatment. For example, if this new deduction is reflected on the federal income tax return as a new deduction in calculating federal taxable income before the NOL deduction and special deductions (such as the IRC Section 199 deduction), then to the extent a conforming state uses federal taxable income as its starting point, it is generally expected that the new deduction will be included in the state tax base unless that state chooses to decouple from the provision. However, since new IRC Section 250 is included in Part VIII of the IRC which "houses" many (but not necessarily all) "special deductions," is it possible that the new deduction might ultimately be reflected on Page 1, Line 29b, of the federal income tax return as a "special deduction?" If so, the analysis and resulting state impact could be very different in certain states (similar to the "mechanical" considerations under the transition tax). The GILTI inclusion, however, may be more problematic from a state income tax perspective since how a state treats it may not necessarily depend solely on how the state treats existing Subpart F income under IRC Section 951(a). Remember that the GILTI inclusion is not an IRC Section 951(a) inclusion and instead is a separate inclusion under new IRC Section 951A. In fact, the Final Bill specifically indicates a GILTI inclusion "shall be treated in the same manner as an amount included under [IRC Section] 951(a)(1)(A) for purposes of applying [only certain specific sections of the IRC]." How a state conforms and its resulting treatment will require a careful analysis of its statutory conformity to the federal determination of taxable income and especially the Subpart F provisions. For example, with respect to a particular state's Subpart F income subtraction modification statute or its own DRD statute, does it matter that a GILTI inclusion is a separate inclusion under new IRC Section 951A rather than a regular Subpart F income inclusion under IRC Section 951(a)? While the FDII income would be relatively easy to trace for state apportionment factor purposes, because the GILTI inclusion is recognized by a US shareholder that did not itself directly earn the income, questions arise as to how it would be treated for apportionment factor representation purposes (as well as raising potential allocation and unitary issues). Furthermore, in those states that have adopted tax haven legislation (e.g., Alaska, Connecticut, the District of Columbia, Montana, Oregon, Rhode Island, West Virginia), special carve outs for the GILTI inclusion generally would have to be made in their water's edge reporting arrangements to avoid a double tax. Lastly, the treatment of foreign income in conforming states raise new questions as to whether a state can impose such taxes in light of Constitutional limitations, especially under the Foreign Commerce Clause,6 as well as the possibility that such taxes operate as tariffs and may be precluded under the Import-Export Clause. New anti-base erosion provision for certain payments to related foreign parties As part of anti-base erosion efforts, the Final Bill adopts the Senate bill's base erosion rules for certain payments to related foreign parties — the new base erosion and anti-abuse tax (BEAT) provision. The BEAT, codified under a new IRC Section 59A, would constitute a new tax under the IRC, similar to the "built-in gains" tax or the AMT. It would apply to corporations (other than regulated investment companies (RICs), real estate investment trusts (REITs) and S-corporations) that are subject to US net income tax with average annual gross receipts of at least $500 million over a rolling three-year period, and have made related-party deductible payments totaling 3% (2% in the case of banks and certain security dealers) or more of the corporation's total deductions for the year. A corporation subject to the BEAT generally would determine the amount of tax owed under the provision (if any) by adding back to its adjusted taxable income for the year all deductible payments made to a foreign affiliate (base erosion payments) for the year (the modified taxable income). Base erosion payments would not include cost of goods sold, certain amounts paid with respect to services, and certain qualified derivative payments. The excess of 10% (5% in the case of one tax year for base erosion payments paid or accrued in tax years beginning after 2017) of the corporation's modified taxable income over its regular tax liability for the year (net of an adjusted amount of tax credits allowed) would be the base erosion minimum tax amount that is owed. For tax years beginning after 2025, the rate would increase to 12.5% (from 10%). The Final Bill also makes a notable modification to the Senate bill provision, which would mostly eliminate the penalty in the BEAT calculation for companies that take advantage of certain business tax credits, including the Low-Income Housing Tax Credit and certain renewable electricity production tax credits. The new BEAT appears to be a completely new tax regime that would not be directly incorporated into a determination of federal taxable income and, thus, not directly incorporated into the state tax bases. However, many states already incorporate certain measures intended to limit the impact of "state tax base" erosion, such as combined reporting and related-party addback payments. It is questionable whether a state would want to enact a similar regime considering the other tools they already have available to combat base erosion matters. Changes to NOLs For losses arising in tax years beginning after 2017, the Final Bill would significantly modify the treatment of such federal corporate NOLs by eliminating NOL carrybacks for most taxpayers,7 allowing NOLs to be carried forward indefinitely for most taxpayers, and limiting usage of NOL carryforwards to 80% (rather than 100%) of the taxpayer's taxable income for the year to which they are carried, similar to the limitation now imposed under the current AMT (which would be repealed for corporate taxpayers). Most of these changes would not be picked up by the states since most states either use federal taxable income before the NOL deduction to determine state taxable income, or they compute the state NOL deduction separately. Most states, however, have long disallowed carrybacks of NOLs, and many have implemented at one time or another similar limitations on the utilization of NOL carryforwards. (In 2016, Louisiana, for example, implemented a 72% limitation similar to the Final Bill; California, New Jersey, Illinois and Colorado have either limited or suspended entirely NOL deductions for a period of time to close budget shortfalls; and since adoption of its revised franchise tax in 2007, Texas has not allowed an NOL carryover at all.) Consequently, these new federal NOL limitations will affect only a handful of states that follow the federal NOL directly (e.g., Maryland and Virginia) or otherwise directly conform to IRC Section 172, unless those states enact amendments to their tax laws to decouple from the new federal rules. Changes to the DRD Under the Final Bill, to reflect the lower corporate tax rate, the current federal DRD percentages would be reduced to 65% (from the current 80%) for dividends received from a corporation of which the recipient corporation owned 20% or more, and to 50% (from the current 70%) for other dividends. "Qualifying dividends" (essentially from 80%-or-more-owned corporations) would continue to qualify for a 100% DRD deduction, while dividends received from within a federal consolidated group would continue to be eliminated. From a state income tax perspective, these changes generally would only affect the state tax determination in those few states that conform to the federal DRD rules — that is, those states that directly rely upon federal taxable income after special deductions and NOL carryforwards (e.g., Virginia, Maryland and Delaware) or that incorporate or follow the federal provisions. Most states have their own DRD rules, and these vary widely from state-to-state. Moreover, since the stated intention of the conferees was to reduce the DRD rates in response to the reduction in the overall federal tax rates, it seems disingenuous that state tax policymakers could justify a similar approach in the absence of a reduction in their own state corporate tax rates. Consequently, in many states, unless the states choose to conform, it seems unlikely that this measure by itself would change the determination of state taxable income. Individual deduction for PTE income Under new IRC Section 199A, effective for tax years beginning after 2017 and before 2026, an individual (and trusts and estates) with income from partnerships (including limited liability companies (LLCs)), S corporations and sole proprietorships (including LLCs disregarded from an individual owner) (each a PTE) would be allowed to claim a 20% deduction for "qualified business income" from PTEs.8 This special PTE individual deduction would generally not be available for income from certain specified service businesses (which include the performance of services in the fields of health, law, consulting, athletics, financial services and brokerage services, among others but, through a special exception in the Final Bill, does not include engineering and architectural services). In spite of these limitations on the deductibility of PTE income from these specified services businesses, a special rule would permit an individual to claim the PTE deduction if the individual's income does not exceed certain amounts. The Final Bill also contains a cap on the amount eligible for the 20% deduction that would be based on the W-2 wages paid by the business, plus in certain cases, the "unadjusted basis" of certain property used in the business. The W-2 wage limitation would not apply to individuals with income that does not exceed certain amounts. Investment income and capital gains income also would be excluded from this deduction. The provision is intended to reduce the difference between the federal income tax rate applicable to PTE income and the new rate applicable to C corporation income (i.e., decrease in the highest marginal federal corporate income tax rate from 35% to 21%) under the Final Bill. The intended effect is to provide owners of PTEs a rate reduction that approximates the income tax rate reduction for C corporations. For example, assuming an individual could use the entire amount of the PTE deduction of 20%, PTE income would generally be subject to an effective federal rate tax of 30% instead of 37% (and 28% instead of 35%, for example). A last minute addition to the Final Bill that was not contained in either the House or Senate bills clarifies that the 20% PTE deduction is not allowed in computing adjusted gross income but instead, is allowed as a deduction in reducing taxable income.9 This last seemingly insignificant definitional distinction is of critical importance in assessing whether the states will conform to the PTE deduction. According to a schedule prepared by the Federation of Tax Administrators, as of January 1, 2017,10 the starting point for determining state taxable income in nearly every state that imposes a personal income tax is federal "adjusted gross income" (click here to see the schedule). The following seven states, however, start with federal "taxable income": Colorado, Idaho, Minnesota, North Dakota, Oregon, South Carolina and Vermont. The schedule also indicates that among the remaining states that impose a personal income tax (i.e., Alabama, Arkansas, Mississippi, New Hampshire, New Jersey and Pennsylvania), none use the federal tax base as a starting point. Lastly, nine states (i.e., Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington and Wyoming) don't impose a general personal income tax at all. Thus, it appears that tax policy leaders in only the seven states that start with federal "taxable income" will have to consider whether they wish to subscribe to the new IRC Section 199A 20% deduction for PTE owners. Consequently, the benefit of the 20% PTE deduction may not to be followed in any of the states other than the seven that use federal "taxable income" as the starting point for their personal income tax. In those states, tax policy makers would have to consider whether to follow the policy benefit. Individual state tax deduction The Final Bill, effective for tax years beginning after 2017 but before 2026, would limit the itemized deduction for state taxes (SALT deduction) for individuals (as well as estates and trusts) to $10,000 for the aggregate amount of property tax, war profits, excess profits tax and income tax (or sales taxes). This cap generally would not apply to state or foreign taxes paid or accrued in carrying on a trade or business or otherwise incurred for the production of income. The prior Senate version would have eliminated the SALT deduction entirely, while the prior House version would have retained up to a $10,000 SALT deduction but only for real property taxes. While the elimination of the SALT deduction will have a significant impact on individuals at the federal level, the new limitation would have very little direct impact on individuals at the state level because most states require deducted state income taxes to be added back to federal taxable income to determine state taxable income under current law. Despite these state and federal differences, the cap of the state tax deduction for federal individual income tax purposes, coupled with federal income tax rate changes (decreases for some, increases for others), will likely have the indirect effect of making taxpayers feel as if they are paying much more in state taxes. As a result, these taxpayers could be more likely to pay greater attention to their state tax liabilities. In addition, due to the severity of this provision on owners of PTEs, certain businesses may want to evaluate whether operating as a C corporation is more beneficial. Additionally, some large operating PTEs might inquire with state governments about changing the state income tax structure to replace income taxes imposed on the owners with an entity-level tax that would remain deductible. Retention of credits Except for the research and development tax credit, the Low-Income Housing Tax Credit (LIHTC) and certain foreign tax credits, the House bill would have eliminated virtually every tax credit, including the Work Opportunity Tax Credit (WOTC), among others. The Senate bill, however, would generally have preserved these credits. While the Final Bill would make numerous changes to various tax credit programs, a vast majority of the programs would remain materially unchanged. For example, both WOTC and the New Markets Tax Credit (NMTC) are unchanged from current law and continue through 2019. In addition, the LIHTC is largely unchanged with only a couple of small non-tax related changes. The Historic Rehabilitation Tax Credit saw the "so-called" 10% credit repealed and had the 20% credit for certified historic structures change, so rather than getting the benefit of the credit in the year it is placed in service, it will now be taken pro-rata over a five-year period. In addition, the ability of the government to issue "tax credit bonds," like the qualified zone academy bonds and the Build America Bonds, has been repealed. Other federal credits retained and generally unchanged from current law include the following: — Production Tax Credit under IRC Section 45 (will continue its current phase-out) The Final Bill would add a new credit under IRC Section 45S, which would allow for a general business credit on a portion of wages paid while qualifying employees are on family and medical leave. This credit would only be available for wages paid in 2018 and 2019. Had certain of these credits been repealed (as proposed under the House bill), significant uncertainty would have existed as to the impact on corresponding state-developed tax credit programs that "piggyback" on such federal tax credits (i.e., state programs that generally adopt most, if not all, of the rules that apply to the federal tax credits program and commonly rely on the IRS for oversight). Further, impacted companies should consider recalculating their federal income tax liability utilizing the provisions in the Final Bill (such as AMT, BEAT, immediate expensing and a lower corporate tax rate) to determine how these provisions may impact their ability to utilize the federal tax credits mentioned above. Other changes Select other changes in the Final Bill that could have state income tax implications depending upon how a particular state conforms to the IRC include the following: — Bonus depreciation generally would be increased from 50% to 100% for "qualified property" placed in service after September 27, 2017, and before 2023. The Final Bill follows the House bill in that the original use of the property need not commence with the taxpayer. The increased expensing would gradually phase-down starting in 2023 by 20 percentage points for each of the five following years. Qualified property would be defined to exclude — as with the amended and new IRC Section 163(j) 30% business interest limitation described above — certain public utility property and floor plan financing property. A transition rule would allow for an election to apply 50% expensing for the first tax year ending after September 27, 2017. It is anticipated that many states will decouple from this provision as they have in the past, although state tax policy makers should be made aware that this provision should be coupled and considered concurrently with the 30% business interest limitation in amended IRC Section 163(j). — The Final Bill would increase the depreciation limitations for listed property and remove computer or peripheral equipment from the definition of listed property. The changes would be effective for property placed in service after 2017, in tax years ending after such date. — IRC Section 179 expensing would be increased to $1 million for "qualified property" (i.e., tangible personal property used in a trade or business) placed in service in tax years beginning after 2017, with a phase-out beginning at $2.5 million; additionally, the term "qualified property" would be expanded to include certain depreciable personal property used to furnish lodging, and improvements to nonresidential real property (such as roofs, heating, and property protection systems). States may decouple from this provision by providing different thresholds. — The Final Bill would limit like-kind exchanges to those involving real property, thereby repealing rules allowing deferral of gain on like-kind-exchanges of business and investment property (a transition rule would apply to like-kind exchanges currently underway), effective for exchanges completed after 2017. Current law would continue to apply for like-kind exchanges if the property disposed of by the taxpayer in the exchange is disposed of before 2018, or the property received by the taxpayer in the exchange is received on or before 2018. — The domestic production deduction relating to deductions for qualifying receipts derived from certain activities performed in the US would be repealed for tax years after 2017, following the House bill's effective date. Almost half the states with a corporate income tax have already decoupled from this provision. — The Final Bill does not repeal IRC Section 118 under which, generally, a corporation's gross income does not include contributions to capital. Rather, it preserves the provision, but provides that the term "contributions to capital" would not include: a) any contribution in aid of construction or any other contribution as a customer or potential customer, and b) any contribution by any governmental entity or civic group (other than a contribution made by a shareholder as such). Summary As federal tax reform nears enactment, taxpayers should keep the parallel state income tax implications in mind. Consequently, all taxpayers should focus in the coming months on utilizing a state-specific model to quantify the potential impacts of federal tax reform, as well as to identify and implement any applicable mitigation strategies (with particular time-sensitive focus on the transition tax, which would impact the 2017 tax year). Corporate taxpayers also should educate their governmental affairs group as to the potential impact of federal tax reform from a state income tax perspective on their businesses so that the appropriate message can be conveyed to state legislatures, particularly since state legislatures may act quickly in early 2018 during their regular legislative sessions (or in special legislative sessions) to respond to enacted federal tax reform measures. Moreover, taxpayers in certain regulated industries, such as public utilities, should start planning proactively with their regulators to identify mechanisms to recover additional state income taxes (if any). Finally, the lower federal corporate income tax rate and the repatriation of foreign earnings may result in increased inbound business investment into the US for which state income tax, credits and incentives, and other state tax issues and opportunities should be considered. ———————————————
——————————————— 1 States that currently use a "rolling" IRC conformity date are: Alabama, Alaska, Colorado, Connecticut, Delaware, the District of Columbia, Illinois, Kansas, Louisiana, Maryland, Massachusetts, Missouri, Montana, Nebraska, New Mexico, New York, North Dakota, Oklahoma, Oregon, Rhode Island, Tennessee and Utah. 2 States that currently use a "fixed" (or static) IRC conformity date are: Arizona, Florida, Georgia, Hawaii, Idaho, Indiana, Iowa, Kentucky, Maine, Michigan (note: taxpayers can elect to use the current IRC date), Minnesota, New Hampshire, North Carolina, Ohio (personal income tax), South Carolina, Texas, Vermont, Virginia, West Virginia and Wisconsin. 3 A majority of fixed conformity states annually update their date of conformity to the IRC and usually do so within the first few months of each year. These states generally conform to the IRC on either the last day of the prior year or the first day of the current year, with a couple of states opting to conform to the date the state bill updating the IRC conformity date was enacted. Though it is likely that most of the fixed conformity states will update their date of conformity in order to couple to the proposed federal tax reform changes, especially those changes broadening the tax base, it is equally likely that some, if not most, of these states will decouple from certain taxpayer-friendly provisions to which they may not be able to afford to conform. 4 States that currently use a "selective" IRC conformity approach are: Arkansas, California, Mississippi, New Jersey and Pennsylvania (but Pennsylvania arguably could be classified as "rolling" in certain circumstances). 5 Such modification may be in response, at least in part, to precedent established in Kraft General Foods, Inc. v. Iowa Dept. of Rev. & Fin., 505 U.S. 71 (1992). In Kraft, the US Supreme Court held that Iowa violated the Foreign Commerce Clause of the US Constitution by taxing dividends received from foreign subsidiaries differently than dividends received from domestic subsidiaries. 6 See discussion of the Foreign Commerce Clause concerns in footnote 5. 7 Losses incurred by a farming trade or business would generally be allowed a two-year carryback and NOLs of a property and casualty company would generally continue to be subject to a two-year carryback and 20-year carryforward. 8 Final Bill §11011. The provision also generally applies to certain REIT dividends, cooperative dividends and publicly-traded partnership income received by individuals. 9 Final Bill §11011(b)(1) amending IRC Section 62(a) defining "adjusted gross income." ("For purposes of this subtitle [IRC Subtitle A "Income Taxes"], the term 'adjusted gross income' means in the case of an individual, gross income minus the following deductions: [list of various deductions available to individuals]. … The deduction allowed by section 199A [PTE deduction] shall not be treated as a deduction described in any of the preceding paragraphs of this subsection [IRC Section 62(a)]") [bolded language is new]. Final Bill §11011(b)(2) amending IRC Section 63(b) defining "taxable income." ("In the case of an individual who does not elect to itemize his deductions for the taxable year, for purposes of this subtitle [IRC Subtitle A "Income Taxes"], the term 'taxable income' means adjusted gross income, minus — (1) the standard deduction, (2) the deduction for personal exemptions provided in [IRC Section 151], and (3) the deduction provided in [IRC Section] 199A") [bolded language is new]. Final Bill §11011(b)(2) amending IRC Section 63(d) defining "itemized deductions." ("For purposes of this subtitle [IRC Subtitle A "Income Taxes"], the term 'itemized deductions' means the deductions allowable under this chapter [IRC Chapter 1, "Normal Taxes and Surtaxes"] other than — (1) the deductions allowable in arriving at adjusted gross income, (2) the deduction for personal exemptions provided by [IRC Section] 151, and (3) the deduction provided in [IRC Section] 199A") [bolded language is new]. 10 Federation of Tax Administrators, "State Personal Income Taxes: Federal Starting Points (as of January 1, 2017)" (available on the internet at https://www.taxadmin.org/assets/docs/Research/Rates/stg_pts.pdf (last accessed Dec. 20, 2017)). | |||||||||||||||||||||||||||||||||||
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