The White House and Republican congressional leadership released an outline this week to guide forthcoming legislation on federal tax reform. The states conform to the federal tax laws to varying degrees and the extent to which they will adopt any federal changes is uncertain. This memorandum outlines some of the key areas—individual taxation, general business taxation and international taxation— with which the states will be concerned as details continue to unfold.
On September 27, 2017, the White House and Republican Congressional leadership released a nine-page outline (Framework) to guide the coming legislative effort on comprehensive tax reform. The Framework offers few surprises and leaves critical details open, but it is likely to be the starting point as Congress addresses federal tax reform issues in the coming months. The states conform to the federal tax laws to varying degrees and the extent to which they will adopt any federal changes is uncertain. This memorandum outlines some of the key areas with which the states will be concerned.
The compression of tax brackets from seven to three and the reductions in individual income tax rates will not have an immediate impact on the states, but the increased standard deduction amount could affect state revenues.
The Framework indicates that there will be a broader use of indexation throughout the Internal Revenue Code, and this would affect the state income tax base to the extent that states choose to conform to this concept.
The elimination of an income tax deduction for state and local taxes would dramatically affect the impact of those taxes on individual taxpayers. For many individuals, this is the largest itemized deduction that they take. A loss of deductibility would obviously increase the out-of-pocket burden of state taxes on individuals and produce political pressures in high-tax states to lower their rates. It would also eliminate tax planning involving the prepayment of January 15 estimated state income tax payments in December of the preceding year.
The Framework proposes to repeal the federal estate and generation-skipping transfer taxes (although not the gift tax). States that impose estate taxes that are based on the federal estate tax or the federal taxable estate would have to draft new estate tax statutes if they planned to continue to impose an estate tax. States might also have to reconsider their estate tax rates because the impact of the state estate tax would no longer be offset by it being deductible in calculating the federal taxable estate. This would increase the burden of state estate taxes and might lead to pressure to lower those taxes.
General Business Taxation
The proposed reduction in the corporate income tax rate would not have an immediate effect on the states, but the proposed reduced tax rates for income from pass-through entities could because any federal legislation would include adjustments to prevent abuses of the use of pass-through entities by wealthy individuals and investors. These adjustments could lead to a recharacterization of certain income received from flow-through entities and this recharacterization could have state and local tax consequences because states and localities often tax or apportion different types of income differently.
The Framework includes a full deduction for the cost of certain capital expenses by businesses for at least a five-year period. Related to that would be limitations (as yet unspecified) on deducting interest payments. In the past, many states have refused to adopt federal accelerated depreciation rules, reasoning that these were special incentives that were unrelated to the calculation of actual net income. Full expensing would be the ultimate manifestation of accelerated depreciation, and it is likely that some states would decide to decouple from it. If they did, logic would indicate that they would also decouple from limitations on deducting interest, but whether logic would prevail remains to be seen. Depreciation has the effect of reducing taxes over the property’s recovery period. The state and local tax impact of depreciation deductions is affected by varying apportionment factors in different states over the recovery period. In a full expensing regime, the state and local tax benefit would depend entirely on a company’s apportionment factors for the year in which the property was placed in service.
President Trump has announced that he would like to close the “carried interest loophole.” This refers to income received by managers of hedge funds and other partnerships, and limited liability companies that is disproportionate to their capital investments. This would have the effect of converting investment income to business income. States often apportion investment income of a multistate business differently from business income, so any such change could affect the managers’ apportionment factors. It could also subject carried interest income to special state and local taxes on business income such as the New York City tax on unincorporated business income. (There is now a statutory exemption from the New York City tax for carried interest income, which McDermott was instrumental in drafting, but that may be overridden by any forthcoming federal change.)
The Framework would exempt from tax 100 percent of dividends received from foreign subsidiaries, defined as being companies in which a US parent owns at least 10 percent of the stock. There would be a transition tax on currently accumulated foreign earnings under a deemed repatriation model, using a bifurcated rate. Here, too, the states would have to decide whether to conform to the federal approach. Many states have a full or partial deduction for dividends received from subsidiaries and the states would have to consider the extent to which they would conform to the new federal approach.
Observations and Likely Next Steps
The Framework is a very high-level outline with few details. The old saying that “the devil is in the details” is even more important in the tax area than it is generally. Further, it can be expected that the political process will result in many changes before final legislation is enacted and, indeed, it is possible that, politics being what they are, no significant tax reform legislation will be adopted. The congressional tax-writing committees will be hard at work during the coming months in developing detailed legislative language to implement the Framework’s high-level concepts. As these details are filled in, hard choices will have to be made in order to fit a tax reform package within any realistic budget parameters. Many technical, timing and transitional issues will have to be addressed.
It is likely that state legislatures will hold up on any changes until federal changes are finalized. When that happens, however, the legislatures may move quickly and there may not be much time for input by affected taxpayers. Accordingly, companies and individuals should be thinking about how federal changes might affect them.