Federal Law Prompts States to Weigh Own Tax Policy Overhauls

Daily Tax Report: State provides authoritative coverage of state and local tax developments across the 50 U.S. states and the District of Columbia, tracking legislative and regulatory updates,...

By Che Odom

California. Maryland. New Jersey. New York. Pennsylvania. These states are joining number of others in proposing policy changes to bypass federal tax law changes that eliminate many deductions and alter the way businesses are treated.

New York may move away from taxing the income of wage earners in favor of payroll taxes. California might allow taxpayers to make certain charitable contributions and take the full amount as a credit against their state tax liability.

Maryland could restore personal exemptions on state tax returns, and a Pennsylvania lawmaker aims to reverse a state revenue official’s position on the expensing of large equipment purchases.

In general, states want to prevent taxpayers from paying more as a result of federal base broadening, but some of their ideas for doing so carry a host of potential problems, tax experts told Bloomberg Tax.

At the same time, states want to protect revenue for public services.

“Right now, states are inevitably evaluating the budgetary impact of federal tax reform and will soon be making decisions based on the expected revenue loss or gain,” said Valerie Dickerson, a partner at Deloitte Tax LLP who leads the firm’s Washington National Tax-Multistate practice.

Payroll Taxes

Acting on a request from Gov. Andrew Cuomo (D), the New York Department of Taxation and Finance on Jan. 17 released a report laying out possible options the state might take to bring relief to state taxpayers who may lose money to a new limit on the federal deductibility of state and local taxes.

The limit is part of the new federal tax act ( Pub. L. No. 115-97) signed by President Donald Trump on Dec. 22. Taxpayers who itemize deductions on the federal return can deduct state sales, individual income, and property taxes up to $10,000 beginning this year. The deduction previously was unlimited.

Several states, including New York, California, and New Jersey, have begun to explore how to do an end run of new tax law provisions through converted charitable gifts or an employer-based payroll tax system. Cuomo has been among the most outspoken critics of the new tax law and even suggested he will sue over the deduction cap.

Among the options suggested by New York tax officials is a progressive employer compensation expense tax—or payroll tax—coupled with elimination of the personal income tax on wages. Another option also calls for a payroll tax plus wage credits to employees.

“Superficially, it sounds great,” Christopher Doyle, a partner and state and local tax practice leader at Hodgson Russ LLP, said of replacing income tax with payroll tax.

Instead of withholding and remitting tax to the state on behalf of the worker, the burden simply shifts to the employer, which becomes the taxpayer, Doyle said.

Likely Unpopular

The change from a tax on wage earners to employers may mean workers would actually be paid lower salaries to cover the employers’ new tax bill, though actual employee take-home pay would remain the same, Doyle said.

“I imagine it will not go over well, even if you educate people,” he said.

In the simplest terms (and using rough numbers), an employer-side payroll tax would work like this: an employee who previously earned a salary of $100,000 per year, but netted about $80,000 after the employer deducted taxes on their behalf, would now earn a salary of $80,000 with the employer just paying the $20,000 in taxes they otherwise would have deducted from the employee. The net effect to the employee would be the same, but the employee wouldn’t be subject to the new state-and-local taxes deduction cap. And because employer payroll taxes are still deductible in full, the company wouldn’t be affected by the new tax law.

However, the problem may not end there. Lower salaries may mean lower contributions to individual retirement accounts, 401(k) retirement plans, and Social Security, Doyle said. Pensions, which are often calculated based on earnings in an individual’s last years of employment, also could be slightly reduced, he added.

In addition, businesses could find calculating tax payments for nonresident employees difficult to do until the end of the year, he said.

Charitable Contributions

Cuomo, in his proposed budget for fiscal year 2019, called for creating two charitable funds through which New Yorkers could pay for the state’s education and health care needs. The contributions, which would be federally deductible, would be eligible for a state tax credit.

In the same vein, California may decide to allow residents to make a donation to the state to satisfy their income tax liabilities and claim the charitable contribution as a credit to reduce their federal tax bill. New Jersey and Maryland lawmakers are considering similar plans.

However, Treasury Secretary Steven Mnuchin, during a Jan. 12 talk in Washington, threatened to target tax audits at residents of states that allow deductions for charitable donations to state charities that provide funding for public services.

States might not adopt such a system if they’re not sure it will hold up to Internal Revenue Service scrutiny, said Jared Walczak, a senior policy analyst at the Tax Foundation.

“The IRS operates on the concept of substance over form,” he said. “What a state or local government calls it or how they frame it matters much less than what it actually is.”

The charitable donation approach has its fans. Eight law professors wrote a paper posted Jan. 11 on the Social Science Research Network, a website that shares academic papers, arguing that states may expand their use of charitable tax credits in this manner.

Given that charitable donations are fully deductible, while state and local taxes are now capped at the $10,00 threshold, “it may be possible for states to provide their residents a means of preserving the effects of a state/local tax deduction, at least in part, by granting a charitable tax credit for federally deductible gifts, including gifts to the state or one of its political subdivisions,” the paper said.

Taxable Income Defined

Minnesota is widely expected to zero in on a facet of its tax code that is shared by only a few states: the state uses taxable income as a baseline for calculating state income taxes.

Therefore, the state could modify its law in response to federal adjustments to the definition of federal taxable income.

The federal taxable-income changes are likely to reduce the amount Minnesota taxpayers send to the federal government and boost the amount paid to the state.

Minnesota’s legislative session doesn’t begin until Feb. 20, but most tax policy groups believe lawmakers will pursue revenue-neutral reforms that avoid a revenue windfall for the state. The Minnesota Center for Fiscal Excellence has said lawmakers will likely remedy the tax imbalance by using adjusted gross income as a base for calculating state income taxes.

Federal Tax Deduction

Another state issue stemming from the tax law is expected to play out in Iowa. During the Condition of the State address Jan. 9, Gov. Kim Reynolds (R) said she is preparing a tax overhaul that would end federal tax deductibility and provide tax relief to middle-class taxpayers and small businesses.

Unless addressed, federal deductibility would essentially raise state income taxes on most Iowans, she said.

Reynolds didn’t offer a specific framework for revamping the state tax code after erasing federal deductibility, but pointed to a strategy that significantly reduces rates, modernizes the tax code, and provides other forms of relief for middle-class families, farmers, and small businesses.

Attacking Property Taxes

While New York, Maryland, California, and New Jersey look for creative ways to mitigate the cap on the federal SALT deduction, Illinois Gov. Bruce Rauner (R) is using it as an opportunity to curb escalating local property taxes, as well as a recent income tax increase engineered by Democrats.

In a series of Twitter posts and a talk radio interview Jan. 3, Rauner said he would devote much of the year to restructuring the state’s tax system. The new federal limit on the SALT deduction could be “punishing” for Illinois taxpayers, adding urgency to his demands for reform.

Though Rauner is Republican, Illinois is one of the predominantly Democrat-leaning states where lawmakers have been most outspoken about the 2017 tax law and opposing the new deduction cap. Though estimates of the revenue impact from the new tax law are still preliminary and inconsistent, many reports have said the deduction cap will hit high-tax states like California, Illinois, New Jersey, and New York the most.

Specifically, the Nelson A. Rockefeller Institute of Government said in an Oct. 5 report that eliminating the federal deduction for taxes paid to state and local governments would hurt states that give more to the federal government than they get back in federal spending.

Connecticut taxpayers would be hardest hit, the report said, followed by those in New Jersey, New York, Massachusetts, Illinois, and California.

Reactions by State

So far, states have reacted to the federal tax changes in widely differing ways. And many not at all. Almost all state officials, however, have said they are looking for ways to lower the tax burden of residents who might otherwise have to make higher payments merely because the state conforms to parts of the federal code.

A general rundown of state responses follows, including whether the state has a system of rolling conformity to the Internal Revenue Code and the definition of taxable income. “Rolling” means states automatically conforms to the latest version of the IRC and definition of federal taxable income; “static” IRC conformity means states calculate state taxable income as of a certain date; and “none” identifies states with no defined IRC conformity system, meaning that they take a selective approach to federal conformity.

  • Alabama (rolling) — Could allow more taxpayers to take the minimum standard deduction on state income taxes
  • Alaska (no income taxes) — Not much talk of taking action in response to federal changes
  • Arizona (static) — Impact of federal changes are, as in most states, under review by state revenue officials, but no talk yet of responding with specific legislation
  • Arkansas (none) — Regulators considering lower utility rates after federal changes lead to tax savings for utilities
  • California (static) — Could allow taxpayers to make charitable contributions, then take the full amount as a credit against state tax liability
  • Colorado (rolling) — Governor said “there’s not much” state can do to mitigate effects of cap on state and local deduction
  • Connecticut (rolling) — No legislation offered, but some talking of replacing income tax with payroll tax, finding ways to mitigate cap on state and local deductions
  • District of Columbia (rolling) — Council member proposed measure calling for report on how D.C. might decouple from federal tax law
  • Delaware (rolling) — No serious talk of a legislative response to federal changes
  • Florida (static; no income taxes) — Regulators asked to adjust power-utility rates
  • Georgia (static) — No serious talk of a legislative response to federal changes
  • Hawaii (static) — No serious talk of a legislative response to federal changes
  • Idaho (static) — Senate bill lowering rates may be introduced as a result of increased revenue expected from conformity to federal code
  • Illinois (rolling) — Governor plans to use limit on state-local tax deduction as a political tool to push for lower property rates
  • Indiana (static) — Various tax bills already introduced this session, but none address federal changes
  • Iowa (static) — Lawmakers may look to lower rates as a result of increased revenue resulting from conformity to federal changes
  • Kansas (rolling) — No serious talk of a legislative response to federal changes
  • Kentucky (static) — No serious talk of a legislative response to federal changes
  • Louisiana (rolling) — No serious talk of a legislative response to federal changes
  • Maine (static) — Regulators looking to lower utility rates as a result of increased revenue from federal changes
  • Maryland (rolling) — May allow taxpayers to receive a tax credit for donations made to state-run charity to benefit public schools, may restore personal exemptions on state tax returns
  • Massachusetts (static) — Officials discussing a way to mitigate higher tax burdens on individuals, but no legislation has been proposed
  • Michigan (static) — GOP leaders to reduce income taxes while conforming to federal code, proposing to increase state personal income tax deduction to $4,800 by 2021
  • Minnesota (static) — Expected to redefine federal taxable income, possibly adopt adjusted gross income as baseline
  • Mississippi (none) — No serious talk of a legislative response to federal changes
  • Missouri (rolling) — Legislation already introduced would decouple the Missouri standard deduction from the federal standard deduction, but bill’s sponsor may scrap that provision
  • Montana (rolling) — No serious talk of a legislative response to federal changes and legislature not in session this year
  • Nebraska (rolling) — Sen. Jim Smith (R) plans a bill to address the personal income-tax side to prevent the state from “receiving a windfall”
  • Nevada (no income taxes) — Regulators considering rate decreases for utility industry customers
  • New Hampshire (static; no tax on earned income, but interest and dividends are taxed) — No serious talk of a legislative response to federal changes
  • New Jersey (none) — New governor working on plan to convert property taxes into charitable gifts
  • New Mexico (rolling) — No serious talk of legislative response to federal changes
  • New York (rolling) — Officials considering charitable contribution alternative, replacing income tax with employer levy
  • North Carolina (static) — Regulators considering lower rates for utility companies’ customers; companies should see more revenue from tax changes
  • North Dakota (rolling) — Revenue officials saying federal changes to have a negligible impact on state revenue from federal changes
  • Ohio (static) — No legislation yet offered
  • Oklahoma (rolling) — Regulators considering lower utility rates after federal changes
  • Oregon (static) — Lawmakers considering ways to maintain revenue for local services, but no details as of yet
  • Pennsylvania (none) — Lawmaker considering bill to address full expensing after state revenue officials require businesses to add back any deduction
  • Rhode Island (rolling) — No legislation yet offered
  • South Carolina (static) — State may look at ways to address deduction for pass-through entities
  • South Dakota (no income taxes) — No serious talk of a legislative response to federal changes
  • Tennessee (rolling; no tax on earned income, but interest and dividends are taxed) — No serious talk of a legislative response to federal changes
  • Texas (static; no income taxes) — Not expected to respond in a significant way
  • Utah (rolling) — No talk of taking action to mitigate impacts of federal changes
  • Vermont (static) — May give tax relief to group of taxpayers impacted by federal changes
  • Virginia (static) — Regulators considering lower utility rates after companies benefit from federal changes
  • Washington (no income taxes) — No legislation proposed
  • West Virginia (static) — No significant response expected
  • Wisconsin (static) — No significant response expected
  • Wyoming (no income taxes) — No significant response expected

With assistance from Tripp Baltz in Denver, Michael J. Bologna in Chicago, Christopher Brown in St. Louis, Leslie A. Pappas in Philadelphia, and Gerald B. Silverman in New York.

To contact the reporter on this story: Che Odom in Washington at codom@bloombergtax.com

To contact the editor responsible for this story: Ryan C. Tuck at rtuck@bloombergtax.com

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