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SALT Impacts of Federal Tax Reform

The Federal tax reform signed into law by President Trump on December 22, 2017, not only puts the IRS and Federal tax practitioners into a new world that has to be interpreted, planned for and administered. It also has the potential for significant, but less certain, implications on the states and state and local tax (SALT) practitioners. The SALT team at Rehmann has been analyzing the Federal tax reform to understand these potential implications, and we want to share our thoughts regarding how your state taxes may be affected by the Federal tax reform.

 

 

Individual Tax Reform Provisions

$10,000 Cap on Itemized Deductions for Property Taxes and State/Local Income Taxes (or Sales/Use Tax) – This Federal-level cap on itemized deductions doesn’t have a direct impact in many states, as a lot of states either don’t allow itemized deductions at all or have their own state-specific rules for which taxes are allowed as an itemized deduction. But the loss of ability to deduct state and local taxes as Federal itemized deductions for individuals has some states concerned about the impact on the cost of living in those states, and looking for a way to convert now non-deductible taxes into some other payment that would be deductible. For instance, California’s very high individual income tax is now much less tolerable since it is not deductible, so a California state senator is introducing a bill to try to allow individuals to circumvent this issue by making charitable donations (still deductible as a Federal itemized deduction) to the state in exchange for a dollar-for-dollar credit against their California individual income tax. Another idea being explored in New York is to reduce or eliminate the individual income tax and replace it with an entity-level payroll tax, because the state and local taxes paid by companies are still fully deductible. These are just two early examples of ideas for the states to substantially reform their taxing structures to prevent what they fear could be a mass exodus of residents to states with lower taxes. We will be keeping tabs on these ideas as they progress.

 

 

Pass-Through Entity Reform Provisions

Deduction for 20 percent of Qualified Pass-Through Income – This new Federal provision is an attempt to maintain general equivalence between the tax rates imposed on C corporations vs. individuals receiving income from pass-through entities, but it was ultimately done as a deduction from income instead of as a preferential tax rate on such pass-through income. Had it been a preferential tax rate, there would have been no state impact, but the deduction will affect some states. Most states start their individual income tax calculation using Federal Adjusted Gross Income (AGI). Thankfully for the states, but not for taxpayers, Congress wrote this law as a deduction from taxable income instead of an above-the-line deduction in arriving at AGI. This means that only states that start their individual income tax calculation with Federal Taxable Income (FTI) will be affected by this new provision. Those states appear to be Colorado, Idaho, North Dakota, Oregon, South Carolina and Vermont. Each of these states will need to consider whether to allow this Federal deduction or decouple from this provision. For taxpayers with pass-through income in all other states, this means that their state taxable income will automatically be higher than their Federal taxable income.

 

 

Business Expense Reform Provisions

Full Expensing of Fixed Asset Purchases – “Bonus depreciation” has generally been around in one form or another since 2001, allowing for increased expensing of fixed assets beyond the normal MACRS depreciation. For a little over a year after the housing market crisis, this bonus depreciation allowed for full expensing of new equipment purchased. Now Federal tax reform has brought full expensing of new and used equipment purchased from September 28, 2017 to December 31, 2022, followed by a phase-out of this expensing provision through 2026. While this will undoubtedly save current Federal income tax dollars for businesses purchasing equipment, the state income tax savings will generally be delayed. This is because, with Federal bonus depreciation already in place, many states have chosen to decouple from the Federal rules, instead requiring businesses to continue to depreciate the full cost of that equipment over a number of years. It is expected that the relatively long-term jump in Federal expensing from 50 percent to 100 percent will cause even more states to decouple from the Federal rule, meaning taxpayers will face not only higher state income tax bills relative to their Federal taxes, but they will also face increased tax compliance costs of maintaining multiple depreciation schedules to comply with Federal vs. state depreciation laws.

Increased Section 179 Limitations to $1,000,000 – For small businesses that qualified for Section 179 expensing, this was often favorable to using the bonus depreciation deduction, since that was generally capped at 50 percent of the cost of equipment and could only be used on new equipment, while Section 179 allowed full expensing and was available for used equipment. Now with bonus depreciation being a true full expensing of equipment, it would seem Section 179 serves less of a purpose. But at the state level, this might not be the case. Already, some states that decoupled from Federal bonus depreciation still allowed for the Federal Section 179 limits, and this situation may continue or even increase. That is, states might be willing to allow full expensing via Section 179 for small businesses but prevent full expensing via bonus depreciation for large businesses. If there is an increased differentiation by the states between their adherence to Federal law for each of these expensing mechanisms, this will necessitate more careful planning to make sure that the proper Federal elections are made in order to get maximum state benefit for each taxpayer.

Cap on Deductions for Interest Expense – With the Federal allowance of full expensing of fixed assets came a trade-off to limit many businesses’ ability to deduct interest on the money they borrow to buy those fixed assets. Generally, this limitation will be that a business averaging over $25 million of annual gross receipts will have its Federal deduction for interest expense capped at 30 percent of EBITDA. It is widely expected that, while many states will decouple from the full expensing of fixed assets provision, the states will generally conform to this provision limiting interest expense. Thus it is likely that many states will have their cake and eat it too, with taxpayers unable to immediately deduct the full cost of the fixed assets they bought or the interest on the money they borrowed to buy those assets. Thankfully there is a carryforward of any disallowed interest expense, so this should end up just being a timing difference, although the nature of state income taxation nexus and apportionment rules can often turn timing differences into permanent differences as businesses change their economic footprint over time.

International Tax Reform Provisions

Deemed Repatriation of Foreign Earnings – In an attempt to get companies to bring to the U.S. the money they have stockpiled overseas in foreign subsidiaries, the Federal tax reform will immediately tax these undistributed earnings via a deemed repatriation in 2017. This will be done Federally via what is called a Subpart F income inclusion, but with an available election for taxpayers to pay the tax on this income over an 8-year period. This deemed repatriation has several moving parts at the state level with a lot of unknowns at this point until states react by amending their laws and releasing guidance. Below are the key questions we see and our early thoughts on the state impacts. Also, while not discussed further below, this one-time deemed repatriation will be followed by an ongoing annual inclusion of income related to intangible assets located in low tax jurisdictions (e.g. Ireland, Bermuda, Cayman Islands). This income inclusion, called GILTI, is expected to have some of the same state-level issues as discussed below.

Will the deemed repatriation be taxable income at the state level? Many states allow a subtraction of Subpart F income from Federal taxable income to determine state taxable income, so it is likely that only about 10 states (the most prominent of which is New York in some instances) will count this deemed repatriation as income. However, some states that allow a subtraction for Subpart F income might have to amend their laws to have this deemed repatriation also be subtracted. For instance, Michigan corporate income tax law allows a subtraction for “amounts determined under … sections 951 to 964 of the internal revenue code.” Those sections were Subpart F, until tax reform just added section 965 to the internal revenue code for these deemed repatriations, meaning Michigan likely has to amend its law, or else the deemed repatriation will not be in Michigan income. However, it is possible that Michigan, and any other similarly-situated states, might choose to include this income, even though they exclude all other Subpart F income.

If the deemed repatriation is in state taxable income, will it be apportionable business income or allocable nonbusiness income? Even though New York, for instance, might include the deemed repatriation in state income, it doesn’t mean New York will get to tax all or even some of the income. The income will need to be assigned to a state or states using allocation and apportionment rules. The trend is for states to try to consider every bit of income as apportionable business income, in order to pull in as much tax revenue from companies domiciled outside of the state as possible. But the states can only go so far in considering income to be apportionable, and it remains to be seen whether this one-time event triggered by a change in Federal tax law can be considered to create apportionable business income or if this income will be considered nonbusiness income that is allocable to the state where a business is domiciled. For companies domiciled in, say, Florida, which does allow a subtraction for Subpart F income, they will want to consider a deemed repatriation to be allocable business income, as it would then escape tax completely instead of having that income apportioned to any states that don’t allow a subtraction for Subpart F income (e.g. New York).

If the deemed repatriation is apportionable business income, how might it affect a company’s sales apportionment factor? Continuing with the example of New York as a state that could likely treat the deemed repatriation as apportionable income, the question then turns to whether the income affects the apportionment factor or just gets apportioned using the factor as calculated based on the current year operational sales of the company. It appears the deemed repatriation income would not impact the apportionment factor calculation, as New York considers only amounts earned in the regular course of business for purposes of the apportionment calculation, and this income inclusion is arguably not in the regular course of business (although the earnings being deemed repatriated were earned in the regular course of business of the foreign corporations over a period of time). This means the income, which likely would have been sourced outside of New York for apportionment, might get disproportionately taxed in New York since the apportionment just based on regular operations will be higher. It is possible in this type of scenario to request alternative apportionment methodologies to mitigate this issue.

To the extent the deemed repatriation increases state taxable income, will the tax be able to be paid over an 8-year period as can be elected at the Federal level? Probably not. The Federal law was written to cause the income inclusion all in 2017, with an election to pay the tax over time. It is likely that states would prefer to both simplify their administration of this and receive the tax revenue more quickly by not allowing such an election. If they were to allow an election, it most likely would need to be something their legislatures affirmatively did, as many states’ conformity to the internal revenue code does not encompass provisions like this.

Summary

The Federal tax reform is going to have far-reaching impacts on the states, whether it be in the immediate decisions they need to make about conforming to new Federal provisions, or in the longer run if Federal deficits result in less revenue-sharing to the states and a need for the states to increase their own taxes to balance their budgets. As the states react to this new landscape, we will be there to guide you through how these changes impact you and your business. Much of the above information is speculative, as states are just beginning to consider these issues, but if you want to have a discussion about the potential state tax impacts on your specific situation, please reach out to your Rehmann advisor.

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