15 July 2025 Final federal reconciliation legislation has state income tax implications
The July 4, 2025 enactment of H.R. 1 (the Act)1 will likely affect income taxes imposed by US state and local (collectively, state) governments. These effects stem from the fact that most state income tax laws adopt the Internal Revenue Code (IRC) for purposes of defining income. This Alert identifies provisions in the Act with state tax implications. For a more detailed discussion of these provisions, please see Tax Alert 2025-1432 (on provisions affecting federal accounting method considerations); Tax Alert 2025-1394 (on the provisions affecting individuals); and a forthcoming Tax Alert on the Act's international provisions. The Act includes numerous provisions that impact the calculation of federal taxable income for businesses and their owners. The provisions most notable from a state income tax perspective modify the IRC as follows:
Most state income tax systems use federal taxable income (corporate) or adjusted gross income (individual) as a starting point for state income tax computations, so changes to the federal income determinations can affect state taxes. By contrast, states do not automatically conform to federal tax rate changes, and most do not adopt minimum tax regimes that exist outside of the general taxes imposed under IRC Sections 11 and 1 (for corporations and individuals, respectively). Only one state5 currently adopts the IRC Section 59A base erosion and anti-abuse tax (BEAT), for example, so the Act's changes to BEAT do not directly affect tax computations in the other states. The Act's state income tax implications largely depend on how each state generally conforms to the IRC and specifically conforms to affected provisions. States conform to the IRC in various ways. Most either automatically incorporate the federal tax law as it changes (known as "rolling" conformity) or adopt the federal tax law as of a specific date (known as "fixed" conformity). Several "selective" conformity states adopt a hybrid of rolling and fixed conformity. Upon enactment of a change in the IRC, rolling-conformity states that incorporate relevant IRC sections generally automatically adopt the federal tax changes — unless the state later chooses to selectively decouple from any of those provisions. When facing significant IRC changes in the past, states have often decoupled from federal measures that their legislatures sensed would be too costly, such as accelerated depreciation. By contrast, states with fixed-conformity statutes generally incorporate federal tax law changes only when new state legislation adopts an IRC conformity date that is on or after the effective date of the corresponding federal law. Most fixed-conformity states annually update their date of conformity to the IRC and usually do so within the first few months of each calendar year. Like the rolling-conformity states, the fixed-conformity states may choose to selectively decouple from federal tax provisions. Because states adopt differing policies that modify federal income and deductions, taxpayers must consider each state's specific conformity to IRC provisions in addition to its general adoption of the IRC. The following discussion examines some of the significant conformity issues arising from federal tax law changes included in the Act. The Tax Cuts and Jobs Act (TCJA) brought into effect new rules concerning the deduction of key business expenses: interest, bonus depreciation on qualified property investment, and R&E expenditures. As enacted under the TCJA, IRC Section 163(j) limits the business interest expense that may be deducted in a tax year to the sum of (i) the taxpayer's business interest income, as defined in IRC Section 163(j)(6), (ii) 30% of the taxpayer's adjusted taxable income (ATI), as defined in IRC Section 163(j)(8), and (iii) the taxpayer's floor plan financing interest, as defined in IRC Section 163(j)(9). For tax years beginning before January 1, 2022, a taxpayer's ATI was based on earnings before interest, taxes, depreciation, depletion and amortization (EBITDA). Thereafter, a taxpayer's ATI is generally based on earnings before interest and taxes (EBIT)). The Act reverts to the EBITDA measure of the 30% limitation, which will generally result in a higher limitation, and potentially higher interest-expense deductions, for federal and state purposes, as the majority of states adopt a post-TCJA version of IRC Section 163(j).6 The Act also establishes new IRC Section 163(j) ordering rules under which the IRC Section 163(j) limitation applies before elective interest capitalization provisions (i.e., interest capitalization provisions other than IRC Sections 263A(g) and 263A(f)). This means that taxpayers experiencing structural limitations in deducting interest expense in separate company reporting states (e.g., taxpayers that, on a separate company basis, incur interest expense but have minimal sources of taxable income and therefore cannot fully deduct interest expense) may no longer be able to remedy their limitations via interest capitalization elections. States have historically decoupled from federal expensing rules in pursuit of their own tax policies. During the first two decades of federal bonus depreciation, most states chose not to allow the accelerated deductions. In a recent policy shift, however, states have enacted laws offering new elections to expense qualified property and qualified improvement property in the year that property is placed in service. States similarly have brought into effect elections to expense R&E expenditures that would otherwise be subject to capitalization and amortization under IRC Section 174. These state elections allow taxpayers to make different expensing decisions for federal and state purposes. For example, taxpayers with foreign R&E expenditures may benefit from these state elections, given that the Act makes permanent the federal expensing of domestic R&E expenditures for expenditures incurred in tax years beginning after December 31, 2024. As enacted under the TCJA, IRC Section 951A requires a US shareholder of a CFC to include GILTI in gross income. GILTI is the excess of a US shareholder's net CFC tested income over its net deemed tangible income return (NDTIR). The NDTIR is the excess of 10% of the US shareholder's pro-rata share of each CFC's QBAI, reduced by certain interest expense. For tax years beginning before January 1, 2026, IRC Section 250(a)(1)(B) permits a domestic corporation to deduct 50% of its GILTI, including the corresponding deemed-paid foreign taxes treated as a dividend under IRC Section 78. Today, a majority of states that adopt Subpart F of the IRC treat GILTI as a dividend, which may be fully or partially deducted in most such states (i.e., a dividends-received deduction or DRD). In states that tax GILTI, the Act's changes to the GILTI regime may increase state tax for some taxpayers. For example, the Act eliminates the NDTIR for QBAI from the GILTI calculation, which means GILTI now equates to net CFC tested income (NCTI). For taxpayers that benefit from the NDTIR, IRC Section 951A inclusions may increase for federal and state purposes in the relevant states. Additionally, the Act's 40% deduction for NCTI — which is a decrease from the 50% deduction for GILTI — may impact taxable income in the minority of states that conform to IRC Section 250(a)(1)(B). The TCJA also created the deduction under IRC Section 250(a)(1)(A), which generally allows a domestic corporation to deduct 37.5% of the corporation's FDII for tax years beginning before January 1, 2026. To calculate its FDII in a year, a domestic corporation first determines its gross deduction eligible income (gross DEI) for the year by excluding from its total gross income certain enumerated categories of income.7 Gross DEI is then reduced by the deductions that are "properly allocable" to that income to arrive at the corporation's DEI. The corporation then determines its deemed intangible income by reducing its DEI by its deemed tangible income return (DTIR), which is 10% of the domestic corporation's QBAI. Finally, the corporation's FDII is the amount that bears the same ratio to deemed intangible income as the ratio of (i) the foreign-derived portion of the corporation's DEI (FDDEI) to (ii) its DEI. Since the enactment of the TCJA, few states have conformed to the federal FDII regime; for those that have, taxpayers benefiting from the FDII deduction may see changes in state tax benefits as a result of the Act. For example, the Act eliminates the DTIR for QBAI from the FDII calculation, which means FDII now equates to FDDEI and increases the overall deduction in many circumstances. However, the Act also reduces the IRC Section 250(a)(1)(A) deduction from 37.5% of FDII to 33.34% of FDDEI. The Act's changes to the current GILTI and FDII regimes also create new state reporting complexities. In fixed-conformity states, it is possible that affected taxpayers could be required to calculate pre-Act GILTI and FDII — in addition to the post-Act NCTI and FDDEI — for state purposes, if IRC conformity dates are not advanced for tax years beginning after December 31, 2025. The Act includes provisions that create federal tax benefits for certain US domestic business activity. For example, new IRC Section 168(n) provides a 100% special depreciation allowance for certain US real property (or portion thereof) used in a qualified production activity.8 Additionally, the Act changes the treatment of domestic IRC Section 174 costs by allowing immediate expensing (as well as the option to capitalize and amortize R&E expenditures over different periods) under new IRC Section 174A (foreign R&D expenditures must still be capitalized and amortized over 15 years). These federal provisions may become part of longstanding controversies concerning the constitutionality of state conformity to federal provisions that encourage domestic activity — specifically whether the resulting impact on state tax impermissibly discriminates against foreign commerce in violation of the Commerce Clause of the US Constitution.9 The Act does not incorporate from the House-passed version of the reconciliation bill certain changes to P.L. 86-272, a federal law that prohibits states from imposing state income tax on out-of-state sellers whose in-state activities do not exceed soliciting orders of tangible personal property, subject to additional requirements. The House-passed bill would have defined "solicitation of orders" to include "any business activity that facilitates the solicitation of orders even if that activity may also serve some independently valuable business function apart from solicitation." This development occurs after the Multistate Tax Commission (MTC) in 2021 revised its policy statement concerning P.L. 86-272,10 adding a section on activities conducted over the internet, in which certain internet activities that are not "entirely ancillary to solicitation" are deemed unprotected activities.11 The Act also does not change the deductibility of PTE taxes (PTET) as it currently exists. Following the TCJA's enactment, many states adopted PTET regimes that allow a partnership or S corporation to pay state taxes at the entity level, with each participating owner receiving a credit against their state tax liability. For federal purposes, this generally has allowed individuals to deduct their distributive share of state PTET (the so-called PTET deduction). The House and Senate in 2025 considered proposals that, in differing ways, would have limited PTET deductions that are otherwise allowed under Notice 2020-75. The effects of the Act will depend, in the immediate term, on how the states currently conform to federal tax law. Thereafter, state lawmakers may modify their tax laws in response to the IRC changes. In this respect, state legislatures will need to understand how these federal tax developments, in concert with the Act's changes to federally funded programs, will affect their state budgets. As of today, most states have already concluded, or are near to concluding, their 2025 legislative sessions. Businesses and their owners should monitor state legislative responses to the Act and anticipate corresponding guidance from state tax administrators, in assessing the Act's impact on their state taxes.
Document ID: 2025-1487 | ||||||||
