The TCJA and state considerations for business

Editor: Catherine Stanton, CPA  

It has been over a year since the law known as the Tax Cuts and Jobs Act (TCJA)¹ was passed. Taxpayers and tax advisers are continuing to peel back its layers of complexity to understand the various provisions. Taxpayers with state tax obligations and state tax practitioners face an additional challenge of understanding the implications of the new or amended federal provisions on state taxation.

This column discusses state tax considerations focusing on certain domestic tax provisions with recent guidance issued by Treasury and the IRS. As TCJA guidance evolves, taxpayers and practitioners should continue to evaluate any potential state tax impacts. This column also briefly discusses other domestic provisions that could have significant state impacts. Although this column does not address international tax provisions under the TCJA, such as global intangible low-taxed income (GILTI), these provisions could also have a significant impact on business taxpayers for state purposes.

State conformity

The key to understanding how state tax regimes may be impacted by federal tax law changes is understanding how the state incorporates or conforms to the Internal Revenue Code (the Code). Generally, conformity fits into one of three categories:

• Rolling conformity: The state conforms to the Code currently in effect;
• Static conformity: The state conforms to the Code in effect as of a certain date; or
• Selective conformity: These states do not incorporate the Code but specifically conform to selected provisions.

Overall, of the states that impose a corporate income tax, approximately half are rolling conformity states,² a significant portion are static conformity states,³ and four are selective conformity states.⁴ Since the TCJA passed, many states have enacted legislation addressing conformity.

However, general conformity is only the beginning of the analysis. States are sovereign authorities and thus adopt or tailor federal provisions to meet state goals. Although a rolling conformity state might automatically incorporate any change to the Code, the state can legislatively decide to not adopt (or decouple from) any provision. Similarly, static conformity states may update their conformity to current versions of the Code but can specifically decouple from various provisions.

For example, South Carolina and Wisconsin recently updated conformity to the current Code post-TCJA⁵ but specifically decoupled from provisions such as Secs. 965, 951A, 163(j), and 168(k).⁶ Virginia, another static conformity state, further highlights the potential complexity and differences in state treatment. Virginia updated its conformity date to Feb. 9, 2018, but decouples from provisions that affect taxable income for tax year 2018.⁷

Selective conformity states add another layer of complexity as these states conform to only designated federal provisions and adopt these provisions in current form or as in effect on a certain date. For example, Alabama and Mississippi conform to the Code currently in effect but only for specified provisions.⁸ Similarly, California conforms to specified sections of the Code; however, as a complicating factor, it conforms to the Code in effect as of Jan. 1, 2015.⁹ Distinct from all these states is Arkansas, which specifies different Code conformity dates based on the specific Code section being adopted.¹⁰

The TCJA amended Sec. 163(j) to set a new limitation on deductible business interest expense (BIE) paid to non-consolidated affiliates and third parties. For tax years beginning after Dec. 31, 2017, a taxpayer’s deduction for BIE is limited to the sum of: (1) the taxpayer’s business interest income (BII); (2) 30% of the taxpayer’s adjusted taxable income (ATI); and (3) any floor plan financing interest expense (generally for auto dealers). This limitation applies to all taxpayers with the exception of certain small businesses. The limitation also applies to all trades or businesses, with limited exceptions, including electing real property trades or businesses, certain regulated utilities business, and an electing farming business. Any BIE limited under Sec. 163(j) is carried forward as a disallowed BIE carryforward indefinitely and will be treated as paid or accrued in the succeeding tax year and deducted to the extent BIE falls below the limit imposed by Sec. 163(j).

On Nov. 26, 2018, Treasury released proposed regulations under Sec. 163(j) and certain related provisions.¹¹ Due to the complexity of Sec. 163(j) and the proposed regulations, only a few key areas of the proposed regulations are discussed in this column. Specifically, the proposed regulations contain special rules for calculating the Sec. 163(j) limitation for federal consolidated filing groups and partnerships.

The proposed regulations under Sec. 163(j) make clear that a federal consolidated group has a single Sec. 163(j) limitation resulting from the consolidated group’s aggregate amount of BIE, BII, and ATI, computed without regard to intercompany obligations. The consolidated group’s Sec. 163(j) limitation is applied to consolidated group members with BIE under a methodology in the proposed regulations to determine the amount of each member’s BIE, if any, that may be deducted in a tax year. For states that conform to Sec. 163(j), state-filing methodologies may affect how the limitation is computed. Absent guidance from the states, separate-company Sec. 163(j) calculations may be required based on legal entity BIE, BII, and ATI, with full regard for intercompany obligations, in separate reporting and certain combined reporting states.

Most combined filing states do not adopt the federal consolidated return regulations, with New York and Oregon as notable exceptions, or, otherwise, they treat the combined filing group as a single legal entity for purposes of computing combined taxable income or loss.¹² Further, select combined filing states require each group member to compute separate-company taxable income or loss before combined group adjustments are applied (e.g., Massachusetts). Accordingly, separate-company Sec. 163(j) calculations may be required for the majority of the states and can be expected to result in wide variances to the federal consolidated Sec. 163(j) limitation amount, any resultant BIE carryover attribute, and the ability to use the BIE carryover attribute in future tax years.

States may enact legislation or promulgate administrative guidance on Sec. 163(j) in 2019. Legislative developments may include the application of the federal consolidated return treatment of Sec. 163(j) to state filings that would otherwise require analysis of the Sec. 163(j) limitation on a separate-company basis or decoupling completely from the current version of Sec. 163(j).

Regarding passthrough entities, the proposed regulations reiterate the Sec. 163(j) limitation is calculated at the partnership level, but any BIE carry-forward is only usable at the partner level. This approach may present challenges for passthrough entities and their partners at the state level, particularly in states that impose an entity-level tax on partnerships and other passthrough entities. Since a BIE carryforward is a partner item, this carryforward may not affect the calculation of entity-level unincorporated business taxes in jurisdictions such as Illinois.¹³ This different level of calculation of the limitation and use of any BIE carryforward can also affect the calculation of nonresident tax liabilities that are subject to direct withholding by a passthrough entity or paid on composite tax returns on behalf of nonresident partners. As the carryforward exists at the partner level, barring other guidance, it appears these carryforwards may not be available for calculating composite return liabilities¹⁴ or nonresident withholding, which is required in many states.

Another potential area of state complexity relates to the potential interplay of Sec. 163(j) and state related-party interest addback statutes. Sec. 163(j), and the proposed regulations thereunder, take an expansive view of interest, which could create challenges in ascertaining the scope of current state addback statutes for income tax purposes. Currently, it appears the federal limitation would be applied first, as state addbacks generally apply to federally deducted interest expense amounts; however, additional guidance is needed from the states on the proper methodology to compute the interest addback under state law and the tracking and use of any related-party component of a state-computed BIE carryforward amount.

Sec. 199A was promulgated to provide a deduction of up to 20% of qualified business income (QBI) from a domestic business operated as a sole proprietorship, partnership, or S corporation. This deduction may be claimed only by individuals, estates, or trusts. On Aug. 8, 2018, Treasury and the IRS released proposed regulations under Sec. 199A, which provide computational, definitional, and anti-avoidance guidance.¹⁵ As highlighted in the proposed regulations, the calculation of the Sec. 199A deduction is complex and structured around several limitations. On Jan. 18, 2019, Treasury and the IRS released new guidance under Sec. 199A, including final regulations.¹⁶

For state purposes, the primary inquiry centers upon the type of taxpayer, e.g., an individual, and in conjunction, the state starting point. Federally, the deduction is applied after adjusted gross income (AGI) for individual U.S. income tax. The majority of states use AGI as the starting point for calculating state individual income taxes and in those instances, the deduction generally will not be available, unless specifically adopted by the state. A limited number of states have historically used federal taxable income (FTI) as the starting point for individual income tax. Starting for tax year 2018, Vermont moved from FTI as the starting point for individual income tax to AGI.¹⁷ In addition, Oregon and South Carolina have chosen to specifically decouple from Sec. 199A.¹⁸ Thus, individuals may be able to claim the deduction in only a handful of states, either due to the mechanics of calculating individual income tax or specific adoption of the provision.¹⁹

In addition to the provisions detailed above, other changes in the TCJA could significantly affect domestic businesses. Although this column does not explore these items in depth, it is important to be aware of potential state tax ramifications of these provisions.

Full asset expensing

The TCJA also expanded bonus depreciation rules under Sec. 168(k) to generally allow 100% bonus depreciation expense for qualified property placed in service on or after Sept. 27, 2017, with a phaseout beginning in tax year 2023. The TCJA also modified the definition of property eligible for bonus depreciation under Sec. 168(k).

Most states have historically decoupled from federal bonus depreciation rules under Sec. 168(k), which is generally accomplished through a state-specific modification for state income tax purposes. In addition to the loss of a deduction, nonconformity can lead to differences in federal and state asset basis. Thus, a taxpayer may need to track a separate basis in various assets for state purposes.

Even in states that may allow bonus depreciation, there is also another potential area of nonconformity related to the modified definition of qualified property, as a state may conform to a pre-TCJA version of bonus depreciation. For example, applicable for tax years beginning on or after Jan. 1, 2018, Minnesota Department of Revenue guidance indicates it recognizes federal bonus depreciation at 40%, which is applied over multiple periods and does not conform to the new definition of qualified property as Minnesota conforms to the Code as of Dec. 16, 2016.²⁰

Limitation on NOLs

The TCJA also significantly changed the net operating loss (NOL) deduction rules under Sec. 172 for tax years beginning after Dec. 31, 2017. The TCJA repealed the carryback provisions under Sec. 172, with certain exceptions, and limited the use of NOL carryforwards to 80% of federal taxable income, although the new carryforward period is indefinite.

For U.S. income tax purposes, these provisions immediately trigger additional recordkeeping requirements for taxpayers to track and use NOLs generated pre-2018 and post-2017. Similarly, for state income tax purposes, additional recordkeeping will apply; however, there is added complexity as states may or may not conform to the new provisions (such as the 80% limitation). Further, many states have specific NOL provisions, which may cause further departure between federal and state NOL calculations. (See Boyle, Lenns, and Boyle, “Managing Corporate State Net Operating Losses,” 50 The Tax Adviser 146 (February 2019)).

The TCJA also repealed the domestic production activities deduction (DPAD) under Sec. 199, although the Consolidated Appropriations Act, 2018,²¹ reinstated Sec. 199 DPAD treatment for certain agricultural and horticultural cooperatives. Historically, most states have decoupled from DPAD and required taxpayers to add back the deduction claimed federally. For states that conform to the pre-TCJA Code, the state may still recognize a DPAD for state purposes; however, this is likely a limited population.

Repeal of corporate AMT

The TCJA repealed the federal corporate alternative minimum tax (AMT) under Sec. 55; however, certain states have similar minimum tax provisions. Accordingly, while an entity may no longer be subject to federal AMT, it could generally be subject to a minimum tax in certain states, such as California or Minnesota.²²

As highlighted above, the TCJA has led to significant complexity in not only the federal provisions, but also state taxation for taxpayers subject to these provisions. Even for states that conform to the Code after the TCJA, taxpayers and practitioners may face new considerations and calculations for state income tax purposes, as illustrated by the Sec. 163(j) discussion. Further, states may conform only to certain provisions in the TCJA. For nonconforming states, taxpayers and tax practitioners may face further complexity, as there is the potential for conformity to prior versions of the federal provisions, thus potentially necessitating additional modifications.

This article does not constitute tax, legal, or other advice from Deloitte Tax LLP, which assumes no responsibility with respect to assessing or advising the reader as to tax, legal, or other consequences arising from the reader’s particular situation. Copyright 2019 Deloitte Development LLC. All rights reserved.

Footnotes

¹P.L. 115-97.

²Alaska, Colorado, Connecticut, Delaware, District of Columbia, Illinois, Kansas, Louisiana, Maryland, Massachusetts, Michigan, Missouri, Montana, Nebraska, New Jersey, New Mexico, New York, North Dakota, Oklahoma, Oregon, Pennsylvania, Rhode Island, Tennessee, and Utah.

³Arizona, Florida, Georgia, Hawaii, Idaho, Indiana, Iowa, Kentucky, Maine, Minnesota, New Hampshire, North Carolina, South Carolina, Texas, Vermont, Virginia, West Virginia, and Wisconsin.

⁴Alabama, Arkansas, California, and Mississippi.

⁵S.C. Code §§12-6-580 and 12-6-40(A)(1)(a); Wis. Stat. §71.22(4)(k)1.

⁶Id.

⁷Va. Code §58.1-301(B).

⁸Ala. Code §40-18-1.1(b)(3); Miss. Code §§27-7-5(1), 27-7-13(1), and 27-7-103.

⁹Cal. Rev. & Tax. Code §§23051.5(a) and 17024.5(a)(1)(P).

¹⁰See, e.g., Ark. Code §§26-51-403, 404, and 423(a)(1).

¹¹REG-106089-18.

¹²N.Y. Tax Law §210-C; Or. Rev. Stat. §317.710.

¹³35 ILCS 5/201(c)-(d) and 5/205(b).

¹⁴Most states do not require composite returns; however, a few states mandate that a partnership file a composite return. See, e.g.,Ala. Code §40-18-24.2(b), which requires the filing of a composite income tax return on behalf of its nonresident members.

¹⁵REG-107892-18.

¹⁶As of this writing, the final regulations have not been published in the Federal Register.

¹⁷Vt. Stat. tit. 32, §5811(21).

¹⁸2018 Or. S.B. 1528, §10, effective for tax years beginning on or after Jan. 1, 2018; S.C. Code §12-6-50(19).

¹⁹See, e.g.,Colo. Rev. Stat. §§39-22-103(5.3), 39-22-202(1), and 39-22-203(1)(a); Idaho Code §63-3004(b); N.D. Cent. Code §§٥٧-٣٨-٠١(١٣) and 57-38-30.3; N.D. Admin. Code §81-03-01.1-02. Iowa allows a deduction of 25% of the federal Sec. 199A deduction beginning in 2019, which then increases to 75% of the federal deduction beginning in 2022. See Iowa Code §§422.3(5) and 422.4(16)(e).

²⁰Minn. Dep’t of Rev., 2018 Schedule M4NC Instructions, p. 14; seealso Minn. Stat. §290.0133(11); Minn. Stat. §290.0134(13).

²¹P.L. 115-141.

²²Cal. Rev. & Tax. Code §§23400 and 23455(d); Minn. Stat. §290.0921(1).