State Tax Implications of Federal Tax Reform

Although there isn’t a final tax reform bill yet, several provisions in the federal tax reform proposal will have a direct or indirect impact on state and local tax liabilities.

By Jeff Glickman, SALT partner

Within the last few days, it appears as if leaders of the House and Senate have agreed to a tax reform bill. Although nothing is final yet, there is plenty in the tax reform proposal that will no doubt have a direct or indirect impact on state and local tax liabilities. Below is a brief summary of some of those impacts.

Tax Base Expansion [1]

For both businesses and individuals, one of the main themes of this tax reform is the elimination of many deductions. While the bills are not identical in their approach, there is no doubt that many corporations will see higher federal taxable income (“FTI”) and many individuals will see higher federal adjusted gross income (“FAGI”). Almost all states incorporate federal tax law changes into their state tax codes by using FTI and FAGI as their starting points for calculating state taxable income. Therefore, taxpayers should expect to have higher state tax liability as a result.

Two points to note:

1. First, states do vary regarding their conformity date to the Internal Revenue Code (“IRC”). Of the states that impose an income tax, roughly half automatically conform to IRC changes and the other half conform as of a fixed date. For those states that use fixed date conformity, any tax reform will not be effective in those states unless the legislature updates the conformity date.
2. Second, both versions agree to reduce the tax base by permitting taxpayers, for five years, to deduct 100 percent of the cost of qualifying property, such as machinery and equipment (as opposed to capitalizing and depreciating that cost over a period of time), and by increasing the Section 179 expense cap (the versions differ as to the cap amount). It is worth noting that many states have specifically decoupled from these types of accelerated depreciation provisions in the past, so it would not be surprising if states continued to do so, meaning that these federal tax benefits would not reduce the state tax base.

State and Local Tax Deduction

The tax reform proposal would cap the state and local tax deduction for individuals at $10,000, for any combination of state property tax and income tax (or sales tax). Essentially, for taxpayers whose combined state and local taxes exceed $10,000, they may be able to choose how they arrive at the $10,000 limit, although the details on that are not yet final.

However, there are a few indirect impacts from the limitation of this deduction. First, some states do not allow taxpayers a deduction for income taxes paid (some disallow generally, others disallow all except their state’s income taxes), but do allow deductions for other state taxes, such as property taxes, if deducted on the federal return. For taxpayers whose state tax deduction is limited by the $10,000 cap, how they arrive at that deduction will be important. For example, if a taxpayer pays $8,000 of property taxes and $8,000 of state income taxes, it would make sense to allocate all $8,000 of property taxes and $2,000 of income taxes (or even sales tax instead of income tax) to the $10,000 deduction.

Second, although a taxpayer’s actual state tax liability will likely not go up as a result of this change, it may feel as if the liability has increased. That’s because taxpayers often consider the federal deduction when considering their state income tax cost. For example, assume a taxpayer pays a 6 percent state individual income tax and is in a 33 percent tax bracket for federal purposes. Currently, the taxpayer may really view the effective state income tax rate as being 4 percent. Under the tax reform proposal limiting the deduction, the effective state income tax rate will be closer to 6 percent.

Finally, some states offer credits to taxpayers that choose to make a contribution to a particular organization, with the most notable being the tax credit scholarship programs. These and other similar types of programs may see a further increase in popularity since they would allow a taxpayer to make a deductible charitable contribution in lieu of a nondeductible state tax payment (if the taxpayer already exceeds the $10,000 limit).

Standard vs. Itemized Deduction

This is an interesting one. It certainly isn’t obvious that increasing the standard deduction from $13,000 (for married couples) to $24,000 could increase your state income tax liability. However, depending on the state, that’s exactly what could happen for some taxpayers.

In some states, like Georgia, you are only permitted to deduct your itemized deductions for state purposes if you itemized on your federal return; if you take the standard deduction for federal purposes, you must use the state standard deduction. That may be a problem for some taxpayers depending on the amount of their itemized deduction.

For example, assume in 2018 that a Georgia resident taxpayer in the 25 percent federal tax bracket files a joint return and has $20,000 in itemized deductions. If no reform is enacted, the taxpayer would get to deduct those itemized deductions for both federal and state tax purposes. Under the proposed tax reform, the taxpayer is better off for federal tax purposes to use the $24,000 standard deduction. That increased deduction of $4,000 is worth $1,000 in federal tax savings.

However, by using the federal standard deduction, the taxpayer must now use Georgia’s standard deduction, which for joint filers is currently $3,000. So instead of deducting $20,000 for Georgia purposes, the taxpayer can only deduct $3,000. At 6 percent, that loss of $17,000 costs the taxpayer $1,020 in Georgia income taxes. Therefore, for federal tax purposes, some taxpayers may elect to itemize, even though those deductions are less than the standard deduction, if the federal tax cost of doing so is more than offset by the state tax benefit of itemizing.

Note that this is not a new issue. Currently without tax reform, a Georgia resident with allowable itemized deductions approaching but not in excess of $13,000 would have to determine the total federal and state tax cost/benefit of itemizing versus taking the standard deduction. The proposed tax reform just shifts consideration of this issue to a different set of taxpayers (i.e., those with itemized deductions somewhere between $20,000 and $24,000).

Increased Attention to State Tax Liabilities

The joint tax reform proposal will reduce the corporate tax rate to 21 percent (from 35 percent). Combining that with base expansion discussed above, a taxpayer’s state corporate income tax liability will be a greater percentage of the taxpayer’s overall income tax liability. This is likely to cause taxpayers to pay more attention to state taxes and could lead to more planning, as well as protests/litigation involving state tax audit adjustment.

There are numerous other provisions that could have a direct or indirect impact on state taxes, including but not limited to, net operating loss changes, potential elimination of certain federal credits and the taxation of foreign source income. We recommend that taxpayers speak with their tax advisors to see if there are moves they should make now in anticipation of tax reform.

Contact Jeff Glickman, partner-in-charge of Aprio’s SALT practice, at jeff.glickman@aprio.com for more information.

This article was featured in the November/December 2017 SALT Newsletter.

[1] While this article focuses on tax base expansion through the elimination of deductions, there are numerous other provisions in both versions that would change FTI and FAGI. Each of these, if states conform, could impact state tax liability.

Any tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or under any state or local tax law or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. Please do not hesitate to contact us if you have any questions regarding the matter.