Conformity to the Tax Cuts and Jobs Act
This year, states were forced to digest the impact of the Tax Cuts and Jobs Act (TCJA or the Act). A state’s method of conformity to the Internal Revenue Code (IRC) dictated how much of the massive federal tax overhaul will apply to its state income tax code. States may conform to the IRC in the following four ways:
- Rolling conformity states automatically adopt the current IRC as it is updated and revised, unless the state has pre-existing law that provides for decoupling from specific code provisions.
- Annual conformity states adopt the IRC as of a certain date (e.g., Dec. 31, 2017) and generally do so on an annual basis.
- Fixed conformity states, at the end of their 2018 legislative sessions, will affirmatively adopt the IRC as of Dec. 31, 2017. However, from a practical perspective it may take some of these states (e.g., Texas) several years to adopt the IRC as of Dec. 31, 2017.
- Remaining states will continue to follow or decouple from specific code sections as they have historically done.
To control the effects of the TCJA, most states reviewed their tax conformity laws and made determinations whether to adopt or decouple from various provisions of the Act. The new capital cost recovery and some of the foreign tax provisions took effect in 2017 and required rapid responses by tax authorities. While some moved quickly to release administrative guidance or obtain legislative direction, others left taxpayers in the dark as to whether and how to comply with the 2017 federal changes.
Some of the more relevant TCJA provisions with the largest state impact in 2018 are discussed below.
Repatriation transition tax under section 965
The one-time deemed repatriation dividend under the new section 965(a) falls under the provisions for Subpart F income. As a result, states generally treated income associated with section 965(a) in the same manner as Subpart F income and/or foreign dividends received. Nevertheless, there were wide variations among states in the degree to which the repatriation amounts were subject to tax, reported on state forms and the guidance afforded to state taxpayers.
For corporate income and franchise tax purposes, some states, including Alabama, required taxpayers to report the gross deemed foreign income inclusion amount under section 965(a) and the deduction under section 965(c) separately. Other states (e.g., Michigan and Illinois) required corporations to report the net inclusion amount. States, such as Florida and Wisconsin, which do not tax Subpart F income excluded it entirely from their tax base. In certain instances, e.g., New Jersey, separate state forms need to be completed with the returns showing the impact of section 965 on the state income tax base.
Even in states that flow through the full or net repatriation amount, a dividends received deduction (DRD) often applied if ownership requirements were met. Connecticut provided a limited dividends received deduction; taxpayers can only deduct 95 percent of dividends received from their wholly owned subsidiaries. The taxable 5 percent is deemed to be expenses incurred to manage and maintain the foreign equity investments that generated the deductible section 965 income.
Illinois extends its corporation income tax treatment of section 965 income to pass-through entities subject to the replacement tax. Consequently, S corporations, limited liability companies, partnerships and trusts must report the net section 965 amount with the foreign dividend exclusion available if the applicable ownership standards are met.
Most states exclude deemed repatriation income from their apportionment formula. However, if such income is included, state sourcing rules should be considered.
The majority of states have decoupled from the section 965(h) installment payment provisions, which allow certain taxpayers to elect to pay the transition tax in installments over an eight-year period. Only Oklahoma and Utah conform to section 965(h) and allowed taxpayers to pay their repatriation tax liability in installments.
While deemed repatriation income may not be subject to state corporation net income tax, such income may be subject to tax under personal income tax provisions (e.g., Michigan). Other states, like Pennsylvania, will not subject this income to personal income tax until an actual distribution of cash or property out of earnings and profits is made to the taxpayer. The federal tax deferral provisions generally do not extend to the state level. For instance, Illinois, New York and Rhode Island announced that S corporation shareholders cannot defer payment of their tax liability until some triggering event under section 965(i).
For taxpayers that have underreported their tax liabilities associated with the repatriation tax, several states provide for waiver of underpayment of estimated tax penalties. Special schedules or documentation could be required.
Prior to the TCJA, numerous states decoupled from sections 168(k) and 179. They required all or a portion of federal bonus depreciation and immediate expensing deductions to be added back to their measure of taxable income. States have taken a similar approach with respect to TCJA’s full expensing and immediate expensing deduction provisions. For instance, Georgia in its conformity legislation noted that it will continue to decouple from section 168(k) and the new increased expensing allowed by section 179 related to qualifying real property. In addition to decoupling from section 168(k), Arkansas did not adopt the TCJA section 179 allowance by conforming to section 179 that was in effect on Jan. 1, 2009.
Pennsylvania reversed prior policy that required an addback of 100 percent of depreciation deductions for qualified property acquired and placed in service after Sept. 27, 2017, taken for federal income tax purposes. The state now permits a deduction for depreciation of qualified property placed in service after Sept. 27, 2017, which is limited to the depreciation amounts under the Modified Accelerated Cost Recovery System (MACRS). Any unused bonus depreciation may be deducted in the tax year in which the corporation disposes of the assets.
Wisconsin continued the policy it had in place for tax years beginning after Jan. 1, 2014, of full federal conformity with section 179, including the TCJA expansion, but disallowing bonus depreciation and the new section 168(k) provisions.
Dividends received deduction
Prior to tax reform, approximately 25 states and the District of Columbia conformed to the federal DRD, either by starting with line 28 or line 30 of Form 1120 and providing for a subtraction modification. However, about 20 of the remaining states do not conform to the pre-federal DRD and instead provide for their own state-specific deduction. For instance, Massachusetts only permits corporate taxpayers who own at least 15 percent of the voting stock of the distributing corporation to deduct 95 percent of dividends received. Arkansas continues to exempt only dividends from 80 percent or greater directly owned subsidiaries. California conforms to the IRC as of Jan. 1, 2015, and thus decouples from the TCJA’s amended section 243 and new section 245A provisions.
The TCJA created section 245A, which permits a U.S. C corporation that is a 10 percent or more shareholder of a specified foreign corporation to receive a 100 percent DRD. Section 245A falls within the IRC’s special deductions, generally reported on line 29b of Form 1120. For states that have not specifically addressed this provision, the starting point for calculating its state income tax base, line 28 or 30, will likely drive the conformity determination. Case in point, Minnesota conforms to the IRC through Dec. 16, 2016, and as a line 30 state, will require an addback for dividends deducted under section 245A unless it updates its Code reference for 2018. Georgia provides that the deduction under section 245A will not apply to the extent income has been subtracted through Georgia’s own DRD. This provision intends to avoid allowing taxpayers a double deduction. Wisconsin amended the corporate income and franchise tax statutes to exclude section 245A from the state’s Code update. Wisconsin’s DRD historically has not included sections 243-246A.
Corporate businesses should also be aware of the sometimes-complex interactions between state DRD provisions and state combined reporting (both water’s-edge and worldwide) and consolidated return rules. Generally, dividends among affiliates are deductible or eliminated but the ownership percentages often vary from federal consolidated return rules and other conditions may apply. California authorizes a DRD for dividends from corporations that the recipient corporation is currently or was in the past a member of the same unitary group, regardless of whether the distributing member is still subject to California tax.
Net operating losses
Most states historically decoupled from section 172, dealing with net operating losses (NOLs) and their carryover for corporate income and franchise tax purposes. States, like Arkansas and Illinois, provide their own treatment for NOLs through limited carryforward periods or, as is the case for Alabama, Connecticut and others, the disallowance of carrybacks. State rules applied in unitary combined filing situations (e.g., California and Minnesota) often produce different NOL outcomes than under federal consolidated return rules. Other states, including Louisiana and Pennsylvania, have imposed annual caps or otherwise restricted the use of NOL carryovers based upon budget constraints.
One of the main factors accounting for the lack of conformity to the federal NOL provisions is that many states measure NOLs on a post-apportionment basis. Consequently, they cannot automatically flow through a taxpayer’s federal NOL carryforward or carryback deduction.
Conformity to the TCJA’s repeal of carryback provisions and allowance of NOL carryforwards to offset only up to 80 percent of taxable income (although carried over indefinitely) may potentially increase a state’s tax base. Certain states such as Colorado, Florida, Georgia, Maryland, Kentucky and West Virginia have conformed to this TCJA provision. Other states continue to provide for their own state’s specific carryforward limitations, for example, Illinois (12 years), Louisiana (20 years) and Massachusetts (20 years).
For individuals, there is a high likelihood of a state adopting the TCJA NOL provisions. This is because many states rely on federal adjusted gross income or taxable income with modifications for their own tax base.
Business interest limitation under section 163(j)
Application of section 163(j) under the TCJA raises several interesting state income tax questions. To a great extent, the new federal limitation on business interest expense deductions was designed to prevent taxpayers from using leverage to take advantage of the new generous capital cost recovery allowances and thus double up on the tax benefit. Consequently, state tax policymakers had to weigh whether it was equitable to decouple from section 179 and section 168(k) but then also adopt the TCJA restrictions on business interest expense.
It is important to understand whether section 163(j) is calculated on a separate company or on a group basis (in states that require combined or consolidated reporting). Second, states need to address how they will treat a new tax carryover attribute. For compliance and provision purposes, an adjustment may be needed for states that decouple from the section 163(j) provision permitting a disallowed interest expense to be carried forward indefinitely. States should also determine whether this attribute applies on a pre- or post-apportioned basis and if their conformity to sections 381 and 382 limits the attribute’s use.
In response to the TCJA, Florida, Idaho, Kentucky and West Virginia have conformed to section 163(j), while Connecticut, Georgia, Indiana and Wisconsin have decoupled from it.
Business income deduction under section 199A
The TCJA created a new deduction under section 199A for income received by individuals and certain estates and trusts from a U.S. business operated as a sole proprietorship, a partnership, an S corporation or through an estate or trust. The deduction ranges up to 20 percent of a measure defined as qualified business income or 20 percent of taxable income less net capital gains. A complex series of phase-in and limitation rules apply to the deduction which was enacted to roughly compensate individual business owners for the reduction in the federal effective tax rate Congress enacted for C corporations. Not surprisingly, few states follow section 199A. The federal rationale does not apply when states have not cut their C corporation tax rates and some were already experiencing revenue losses due to the adoption of the TCJA capital cost recovery provisions. According to Bloomberg BNA, only Colorado, Idaho and North Dakota allow the federal deduction for qualified business income.
The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely. The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.