Many state legislatures are now in session. One of the major issues that state lawmakers face this year is whether to conform their state income tax systems to the many changes included in the Tax Cuts and Jobs Act (TCJA). Some states are giving consideration to, or have already adopted legislation to address the following key provisions of the new tax law.
There has been a lot of attention by the media to certain provisions in the TCJA, including the new limit on federal income tax itemized deductions for personal state and local taxes (SALT). The maximum deduction for the combined total of state and local income and property taxes is $10,000 for 2018 through 2015 ($5,000 for married people filing separately). This new federal limit puts pressure on some states to lower residents’ state income tax burdens or find other ways to work around the rules.
However, the bigger issue is whether all the other changes made by the TCJA will be conformed to by state tax systems. In order to simplify filing your state income taxes, many states “piggyback” their state personal and corporate income tax rules onto the federal rules. But when legislation like the TCJA makes big changes to the federal rules, states must decide whether to conform or “decouple.”
TCJA Provisions that Could Potentially Reduce State Tax Collections
Unless the state decouples from the changes, several TCJA changes threaten to reduce state taxable income, resulting in lower tax collections for the state. Examples of pro-taxpayer TCJA provisions that state legislatures will need to decide whether to conform to (reducing the state’s tax base) or decouple from (maintaining the tax base) include:
Bigger standard deductions. In many states, the individual taxpayers state taxable income is based on federal taxable income. Since the TCJA almost doubled the federal standard deductions, federal taxable income decreases for many taxpayers.
Elimination of itemized deduction phaseout rule. Previously, up to 80% of the most common federal itemized deductions — mortgage interest, state and local taxes, and charitable donations — could be phased out for high-income taxpayers. The phaseout rule increases state taxable income, creating more tax revenue for the state if state taxable income is based on federal taxable income. The TCJA eliminates the itemized deduction phaseout rule for 2018 through 2025.
Higher gift and estate tax exemption. The TCJA essentially doubles the unified federal gift and estate tax exemption for 2018 through 2025. For a married couple, the exemption is effectively $22.36 million for 2018 ($11.18 million each). Several states and the District of Columbia tie their state death tax exemptions to the federal exemption.
Liberalized rule for Section 529 plans. The TCJA liberalizes the Sec. 529 plan rules to allow federal-income-tax-free withdrawals of up to $10,000 a year to cover tuition at a public, private, or religious elementary or secondary school. This is a permanent change, for qualifying withdrawals made after December 31, 2017.
Deduction for pass-through business income. The TCJA allows individual taxpayers to claim a deduction for up to 20% of qualified business income (QBI) from so-called “pass-through” businesses for 2018 through 2025. This includes sole proprietorships, partnerships, S corporations and limited liability companies (LLCs) treated as sole proprietorships or partnerships for tax purposes. Limitations apply at higher income levels.
First-year expensing and depreciation for business assets. Under the TCJA, for qualifying property placed in service in tax years beginning after December 31, 2017, the maximum Section 179 deduction is increased to $1 million (up from $510,000 for tax years beginning in 2017), with inflation adjustments after 2018.
Under the TCJA, 100% first-year bonus depreciation is also allowed for qualified property generally placed in service between September 28, 2017, and December 31, 2022. Bonus depreciation is now allowed for both new and used qualifying property.
TCJA Provisions that Could Potentially Boost State Tax Collections
Taxpayers do not benefit from all TCJA provisions. Additional federal taxable income, and for conforming states, additional state income tax revenue, will be generated by some of the changes. Examples include:
Elimination of personal and dependent exemption deductions. The TCJA eliminates exemption deductions for 2018 through 2025. Many states are affected by this change since the number of exemptions they allow a taxpayer to claim for state income tax purposes is tied to the number of exemptions claimed on the federal return.
New limits on business interest deductions. Starting with tax years beginning after December 31, 2017, affected corporate and noncorporate businesses generally can not deduct interest expense in excess of 30% of “adjusted taxable income,” under the TCJA. For tax years beginning in 2018 through 2021, adjusted taxable income is calculated by adding back allowable deductions for depreciation, amortization, and depletion. After that, these amounts aren’t added back in calculating adjusted taxable income.
Business interest expense that’s disallowed under this limitation is treated as business interest arising in the following taxable year. Those amounts that can not be deducted in the current year can generally be carried forward indefinitely. Small and medium-size businesses and certain real estate and farming ventures are exempt from this anti-taxpayer change.
Reduced or eliminated business deductions for business meals and entertainment. Under the TCJA, deductions for most business-related entertainment expenses are not allowed for amounts paid or incurred after December 31, 2017. Meal expenses incurred while traveling on business remain 50% deductible, but the 50% disallowance rule now also applies to meals provided via an on-premises cafeteria or otherwise on the employer’s premises for the convenience of the employer. After 2025, the cost of meals provided through an on-premises cafeteria or otherwise on the employer’s premises will be nondeductible.
Eliminated deductions for certain employee fringe benefits. The TCJA cancels employer deductions for the cost of providing commuting transportation to an employee (such as hiring a car service), unless the transportation is necessary for the employee’s safety. The law also eliminates employer deductions for the cost of providing qualified employee transportation fringe benefits (for example, parking, mass transit passes and van pooling).
Wait and See
As these examples show, state legislatures have plenty of tax conformity issues to consider this year. Both individual taxpayers and businesses will be affected by tax conformity outcomes. Your tax advisor is atop the latest developments and, as your state tackles these issues, can help determine how you, your family and your business will be affected.