With Republicans in control of both the White House and Congress, comprehensive federal tax reform likely is on the horizon. Both the tax reform plan outlined by President Donald J. Trump during his campaign (the Trump Plan) and the Blueprint released by House Republicans (the Blueprint, together, the Plans) envision, at a high level, broadening the corporate and individual income tax bases and reducing the corporate and individual tax rates.

If significant parts of the Trump Plan and/or the Blueprint become law, taxpayers should be aware of the effects of the federal changes on state taxes and potential reaction by the states.

Why does federal tax reform affect state income taxes?

Nearly all states that impose corporate and personal income taxes conform their tax bases, in some way, to the tax base determined by reference to the Internal Revenue Code. While the majority of states conform to the current Code, others use the Code as effective on a specific date in the past (so-called "static conformity"). The vast majority of states also have federal conformity with respect to the treatment of pass-through entities (S corporations, partnerships, and LLCs), imposing income tax on the owners (at the applicable corporate or individual rates) and not on the entities themselves.

Because, both Plans envision a broader federal tax base and because many states adopt the federal tax base, if large parts of either plan are enacted without reaction by the states, state taxes likely would increase at a broad level. However, as is true of any tax reform, there would be winners and losers. Additionally, while some states may savor the idea of an immediate revenue influx, states also will be forced to consider their business climates and may be forced to react to federal reform to avoid chasing taxpayers and jobs into other states.

What should businesses expect?

The vast majority of states that impose a corporate income tax begin the computation of state corporate taxable income with federal taxable income. While states require additions to and subtractions from the federal tax base, the state corporate tax base typically bears a strong resemblance to a corporate taxpayer's federal tax base.

There are important differences between the federal tax base and many states' tax bases that could be magnified if either plan becomes law. First, many states have "decoupled" from federal bonus depreciation provisions, thereby requiring taxpayers to recover capital expenditures over a longer period of time than they do for federal tax purposes. Second, many states limit corporate taxpayers' ability to use net operating losses (NOLs) by restricting the carryforward period, capping the amount of NOLs that a taxpayer can use in a tax year, or both. Many states require corporations that are part of the same consolidated federal return group to file separately and thus force such companies to deal with intercompany transactions. Finally, many states prohibit or limit deductions for expenses paid to affiliates.

While the Trump Plan and Blueprint differ in many material respects, both propose to eliminate many deductions for corporate expenditures, including substantial limitations (if not the complete elimination) of deductions for interest and, in the case of the Blueprint, the elimination of "special interest" corporate deductions like the Section 199 domestic production deduction. In lieu of such deductions, both Plans propose allowing some or all taxpayers to immediately deduct capital investments in tangible personal property (such as equipment and buildings) and intangible assets, but not land. Additionally, the Blueprint would allow the indefinite carryforward of NOLs, but would limit the NOL deduction to 90% of net taxable income before application of the NOLs.

In the international area, both Plans would scale back or eliminate the current Subpart F rules that govern whether and when earnings of foreign subsidiaries are subject to U.S. corporate income tax. Both Plans would provide for an immediate deemed repatriation of existing foreign earnings held abroad, but would apply reduced federal tax rates to such earnings. Going forward, the Trump Plan generally would end deferral for earnings of foreign subsidiaries and retain the foreign tax credit. The Blueprint, on the other hand, would enact a territorial corporate tax system, potentially allowing a 100% exemption on dividends paid to a U.S. corporation by its foreign subsidiaries.

Another important feature of both Plans is a "border tax adjustment." Based on the Blueprint, the proposal would exclude income and gain from exported products from the federal tax base while disallowing deductions for purchases of imported property.

Finally, while the details are unclear, both the Trump Plan and the Blueprint propose to limit the tax rate applicable to business income earned directly or through a pass-through entity. Based on the Blueprint, the shift away from deductible expenses and toward immediate deduction of capital expenditures likely also would be applied to pass-through entities at the entity level. Thus, tax partnerships would expect to see similar adjustments to the net income that is passed through to their owners and the owners would see corresponding adjustments to their income subject to tax.

Both Plans therefore envision—at a high level—an increased federal tax base offset by lower tax rates. However, taxpayers would not be affected equally. Taxpayers in capital-intensive industries (like manufacturers) may benefit more from immediate deductions for capital expenditures. Likewise, if dividends from foreign subsidiaries are exempt from tax, U.S. corporations with a large overseas presence may benefit in relation to other taxpayers. On the other hand, real estate developers may see a disproportionate increase to their tax bases if NOLs can be used to offset only 90% of their taxable income.

At first glance, it would seem that taxes in states with federal conformity will increase as a result of the trend toward base broadening because current rates would be applied to a larger tax base. However, the results certainly will differ—states with different mixes of corporate taxpayers will see different results and some states may even see a decrease in revenues if they take no action.

Some states may feel compelled to lower rates or otherwise respond to federal changes in an effort to retain business and jobs. Retaining federal conformity while reducing rates likely would cause the least disruption to taxpayers on a broad level, but it is unlikely that all states would reduce rates proportionally to the federal reductions. 

Because of the uncertainty that would arise in the immediate aftermath of federal tax reform, there could be a state-level shift toward static conformity or even the adoption of state-specific tax codes that resemble current taxing regimes. Such a shift would essentially result in two completely separate taxing systems and would require state tax authorities to interpret tax law without reliance on federal authorities. One of the primary benefits of federal conformity is that it provides a reasonable and understandable starting point for determining tax liability. A shift away from federal conformity could result in numerous interpretations of the same rules across state lines, leading to uncertainty and different rules in different states even when the states have the same or similar statutory language. Such a change would lead to complexity for taxpayers because of the necessity to comply with multiple tax regimes and a greater need for state tax planning.

Alternatively, states could retain large parts of federal conformity but decouple from specific provisions of a revised Code. As described above, many states currently decouple from federal depreciation rules and many states limit the deductibility of NOLs and could adopt similar laws following tax reform. States could choose to reduce NOL deductions, either by capping the amount that can be deducted in each tax year or limiting the carryforward period. Similarly, states could choose to decouple from the exemption for dividends from foreign corporations and increase the state tax base for corporations that have significant income from foreign sources. Finally, because the Blueprint disallows interest deductions to avoid the doubling of deductions if full expensing is permitted, if states limit a taxpayer's ability to immediately expense capital costs by retaining some form of depreciation, decoupling presumably would require states to allow interest deductions to avoid a dramatic and distortive increase to the corporate tax base.

States that retain federal conformity but require separate company reporting also would need to address how intercompany deductions would be affected if existing corporate deductions are limited. For example, the elimination of the federal interest deduction would render state addback schemes irrelevant. However, states may need to identify new distortions among related parties (e.g., immediate expensing for capital expenditures paid to a related party) and adopt new laws to address such distortions.

What should individual taxpayers expect?

Nearly all states that impose personal income taxes also begin with either adjusted gross income (AGI) or federal taxable income (thereby incorporating the federal standard deduction). Additionally, states that allow itemized deductions typically follow the federal itemized deduction rules in the Code. Both the Trump Plan and the Blueprint take a similar approach to personal income taxes as they do to corporate taxes and envision the broadening of the tax base and reduction of tax rates.

The Trump Plan would increase the standard deduction, repeal the personal exemption allowance, cap itemized deductions, repeal the alternative minimum tax (AMT) and increase benefits for dependent care and child care. The Blueprint would:

  • consolidate the standard deduction and personal exemption into a larger standard deduction;
  • entirely eliminate itemized deductions except for charitable deductions and home mortgage interest;
  • eliminate the AMT;
  • exclude from income up to 50% of investment income (thereby reducing the effective tax rate on investment income to 50% of a taxpayer's marginal tax rate); and
  • increase the child and dependent care credit.

The Blueprint would eliminate the deduction for state and local taxes and the Trump Plan would include the deduction for state and local taxes in the itemized deduction cap. Under current law, the deduction for state and local taxes is the largest federal deduction claimed by individual taxpayers (although, it should be noted that many states do not permit a deduction for taxes).

While the federal tax base for many individuals would increase, the effect on the state personal income tax base likely would be less pronounced for wage earners than in the corporate tax area and states may be able to react more easily. Although not entirely clear, both Plans seem to anticipate continuing to exclude some contributions to retirement plans (e.g., 401(k) plans) and employer-paid health insurance from AGI. In addition to considering rate reductions, states that currently adopt federal AGI could adopt or increase a state-level standard deduction to offset the loss of other deductions. Alternatively, states could continue to start with federal AGI or taxable income, but allow state-specific deductions or credits to (at least partially) offset a higher starting point.

However, for taxpayers who earn business income from pass-through entities and/or as sole proprietorships, many of the corporate tax issues described above would come into play. Both Plans apparently continue to begin the determination of personal income tax liability with net income from a pass-through business or a sole proprietorship. Consequently, the changes to business taxation described above (immediate expensing, disallowance of many deductions, etc.) would affect self-employed individuals and pass-through business owners in a similar fashion and would require similar reaction by states to avoid an immediate increase in the personal income tax base.

What happens next?

Whether major federal tax reform actually happens remains uncertain and, as is true of any tax changes, the devil will be in the details. However, if Congress and the president move forward with tax reform using either plan as the foundation for reform, taxpayers would expect to see a broader federal tax base and lower federal tax rates. Because virtually all states have some federal conformity, generally taxpayers also should expect that tax reform would initially broaden their state tax bases, but without the corresponding rate decreases. However, because of existing differences between federal and state tax bases, even if states retain federal conformity, the winners and losers at the state level could differ from the winners and losers at the federal level. State tax planning, along with the availability of state-specific credits and incentives, likely would take on greater importance.

Ultimately, if there is a major overhaul of the Code, it is unlikely that the states will react immediately or that all states will react in the same way. Taxpayers should be aware of the impact on the states and how the action (or inaction) of the states will affect their tax liability.

Ballard Spahr's Tax Group will continue to monitor both federal and state tax reform efforts, keep you informed of any developments, and work with you to plan for changes.

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This alert is a periodic publication of Ballard Spahr LLP and is intended to notify recipients of new developments in the law. It should not be construed as legal advice or legal opinion on any specific facts or circumstances. The contents are intended for general informational purposes only, and you are urged to consult your own attorney concerning your situation and specific legal questions you have.

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Christopher A. Jones
Wendi L. Kotzen

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