How Federal Income Tax Changes Impact State Taxesby
Changes made to federal income tax policies are frequently adopted by state governments. In addition to addressing changes in the economy and evolving fiscal practices, states are motivated to remain in sync with federal tax requirements because it makes tax compliance simpler for residents and businesses.
Congruous definitions and policies reduce compliance costs and improve overall compliance, especially for businesses with liability in multiple states. However, adoption of revised federal tax policies is less widespread when revenue losses are associated with the tax changes. Instead, adoption of tax code changes at the state level is more likely if the changes will result in higher revenue.
Here is an outline of the major ways federal tax changes can impact a state’s business tax codes to ensure you’re prepared to help your clients navigate the impending federal tax changes and the likely changes at the state level.
Changes to Definitions
Currently, 41 states conform to federal definitions of corporate income, either before or after net operating losses. Changes to how the federal government calculates taxable income and adjusted gross income, defines expenses, or specifies what can be credited, can trigger changes at the state level to maintain conformity and simplify its own collection of taxes.
If a state does not use the federal government’s definitions, it will have to define and calculate its own. Twenty states and the District of Columbia automatically adopt any changes to the federal tax code as they occur.
Changes to Tax Collected
The federal government updates tax brackets, tax rates and other variables to increase the tax revenue and whom tax revenue is collected from, often referred to as “broadening the tax base.” Changes such as these, especially when they result in more revenue being collected, are frequently mirrored in state tax laws.
The government can make changes to what counts as taxable and when, especially in light of today’s digital, service and subscription-driven marketplace. Changes to what is and what is not taxable are often carried through to the state level to collect additional revenue.
A federal shift to a value-added tax, or to making the corporate tax a cash flow tax, would very likely affect any state-level tax code. These changes are easier copied than created from scratch because they are supported by the calculations and efforts of the IRS.
The tax treatment of U.S.-based multinational companies would also affect state taxable income. A change in tax treatment could add more revenue, increasing the likelihood of adoption at the state level. The government could move to a territorial system or border adjustment.
Finally, changes to the tax collected from defined tax brackets would likely be adopted at the state level. Appropriate compliance with human resource software and employee pay reporting will be required of businesses, should changes occur.
Changes to Business Deductions and Credits
Federal tax requirements relating to expenses, tax credits or deductions will likely impact states in two ways: states will not adjust to prevent loss of revenue, or states will mirror the change to collect more revenue. States often use tax policies to create a business-friendly environment to attract more businesses to their state.
The states that depend on sales tax revenue will likely see the biggest impact from new federal changes because eliminating the federal deduction for state sales taxes is a likely change coming in the near future. States may need to make changes to their tax code because businesses will likely look to reduce their tax bills if they cannot deduct state sales tax.
One proposed tax plan would allow the immediate expensing of business investment, but disallow the deduction for interest costs. Although most states rely on the federal calculation of income, many do not conform to regulation relating to the treatment of business expensing.
Changes for Small Businesses
Particular attention has been given to micro-to-small businesses in new federal tax plan proposals. Small businesses that serve as pass-through entities, such as partnerships, limited-liability companies, sole proprietors and other arrangements, whose earnings are passed directly to owners and then taxed as personal income, will most likely see more favorable tax treatment in the coming year.
Changes to tax requirements for S corps, especially pass-through entities, could influence the way businesses decide to organize themselves and which tax requirements they pay. States may decide to devise more strict definitions or develop additional taxes if they anticipate a loss of revenue.
Other Relevant Changes
Under current law, rather than taxing corporations based on where they produce their goods, corporations could be taxed based on where they sell their products. A change such as this could impact state tax regulation, which often differentiates between online orders picked up in stores or orders made and received in stores. Such a shift could simplify use tax requirements for states as well.
Current federal tax changes contain numerous additional elements that would affect businesses at the state tax level. The current tax plan proposals aim to eliminate the federal estate and gift taxes, and much has been discussed about changing the ability of states to tax online and catalog sales. In addition, the Mobile Worker State Income Tax Simplification Act would limit the ability of states to tax transient workers who spend less than a month in their jurisdictions.
Preparing for Changes
States conform to federal tax changes on either a static or rolling basis. Static conformity means adapting to the Internal Revenue Code (IRC) by a specific date, such as Jan. 1 or Dec. 31. Rolling conformity means adopting each IRC change as they occur. U.S. states are split between these two types of conformity, should they choose to conform at all.
Among the states with static conformity, the dates of conformity vary widely. Thus, I believe the impact of decreased federal taxes, will result in an increase of taxes at the state and local level.
Judy Vorndran leads the state and local tax practice (SALT) at TaxOps, developing efficient SALT management functions and advising businesses in all aspects of state and local tax compliance. She is a recognized leader in SALT solutions and is focused on providing the highest level of...