Corporate Close-Up: Impending Federal Tax Reform and its Rippling Effect on State Corporate Taxation

The House Ways and Means Committee released its much anticipated tax reform proposal on Nov. 2. The proposal, also known as H.R. 1 or the Tax Cuts and Jobs Act, makes sweeping changes to the taxation of businesses small and large. Key provisions include a 20 percent corporate tax rate (down from a top rate of 35 percent); a 25 percent tax rate for individual owners of pass-through entities (down from a top rate of 39.6 percent), with a nine percent tax rate on the first $75,000 of net business income passed through to an active owner or shareholder earning less than $150,000 in taxable income per year;[1] a cap on interest expense deductibility (capping expenses above 30 percent of an entity’s “adjusted taxable income”); and a shift to territorial taxation on American corporate earnings worldwide (particularly relevant amidst the recent Apple “Paradise Papers” controversy).

The Senate Committee on Finance released its tax proposal on Nov. 9, and it appears largely similar to the House’s proposal, with some key differences. The Senate’s proposal includes a delayed 20 percent corporate tax rate cut with an effective year of 2019, trailing one year behind the House’s version, and a 17.4 percent deduction on qualifying pass-through entity income (which does not technically qualify as a tax cut but effectively lowers the pass-through entity tax rate to 31.8 percent, given the top individual tax rate of 38.5 percent). Although the Senate’s proposal is vague on the details of pass-through entity tax rates, it largely follows the House’s proposal when it comes to the cap on interest expense deductibility and shifting worldwide corporate earnings to a territorial system through a 100 percent foreign dividend exemption. [2] For more on the key differences between the House and Senate proposals, click here

As is, the Tax Cuts and Jobs Act would massively reduce the federal corporate tax base, with an estimated reduction in revenue across the next decade of $1.456 trillion from the proposed corporate tax rates and $596.6 billion from the proposed pass-through entity tax rates.[3] These reductions present a host of legislative challenges for states largely conforming to the federal tax base who are seeking to preserve their revenue streams.

State Implications Amid All This Reform Talk        

Conformity can be a tricky topic, as states generally tie themselves to the federal tax code in one of three ways: 1) rolling conformity to the current version of the federal rules; 2) static conformity to a version of the federal rules that existed on a specific date; and 3) selective conformity, choosing to conform statically or on a rolling basis to specific provisions of the federal code.

Although most states conform to the federal tax base as a starting point for state income tax purposes, they do not automatically follow federal tax rate changes.[4] This means that states that conform to the Internal Revenue Code (IRC) on a rolling basis will lose out on revenue from the proposed corporate and pass-through entity income tax cuts in the Tax Cuts and Jobs Act, while states with static and selective conformity risk producing a tax bill far larger than its federal counterpart.

Why not decouple? In July, Bloomberg BNA’s Rachel Martin noted in her blog post “Corporate Close up: Federal Tax Reform Proposals Make States Look in the Mirror,” that states could react to federal reductions in corporate income tax rates by decoupling from the IRC. Now that federal tax rate reductions are no longer a mere possibility, but an impending reality, states that prefer not to adopt certain provisions of the Tax Cuts and Jobs Act (that have rolling or static conformity to the IRC), may choose to modify or decouple from undesirable provisions. However, modifying or decoupling could introduce unnecessary complexity into state tax calculations. Some suggest that “chaos” would result if states decoupled completely or delayed IRC conformity in pursuit of retaining their current corporate income taxes. Among the administrative challenges states would face in pushing back against federal corporate income reform is the risk of not having a unified starting point for corporate income taxation. The possibility of two different tax regimes with different tax bases, structures and philosophies is a very real one.

So what is a state left to do? This will become clearer as the Tax Cuts and Jobs Act moves through the legislative process. Now that H.R. 1 has made it past the Ways and Means Committee, it is set to be considered by the House Committee on Rules on Nov. 15. Considering the narrow margins needed to pass the bill (with the GOP controlling 239 seats in the house and 52 seats in the Senate) the bill may even reach the president’s desk by the year's end.

Continue the discussion on Bloomberg BNA’s State Tax Group on LinkedIn:  What states do you think will retain their conformity statutes in the wake of upcoming federal tax reform?

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[1] The House Committee amended H.R. 1 to include a greater tax cut for smaller pass-through entities around the same time as the Senate Committee released its version of the bill.

[2] Policy highlights released by the Senate Committee on Finance can be found here.

[3] The estimated revenue effects included in this article apply to the House’s proposal. To see the Joint Committee on Taxation’s estimated revenue effects of the Senate’s proposal, click here.

[4] For more on IRC conformity, click here.