Federal Tax Law Changes Drive Surge in State Tax Revenue

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By Aaron Nicodemus

Some high-tax states experienced end-of-the-year tax revenue surges due to taxpayer behavior after the recent federal tax changes and the results of a long-awaited federal tax rule change on overseas hedge fund profits.

State revenue agents said taxpayers seeking to maximize their 2017 deductions by prepaying their state income taxes was a major driver behind the increased revenue. A provision of the 2017 federal tax act ( Pub. L. No. 115-97) caps deductions for state and local taxes at $10,000. The deduction previously was unlimited.

Some taxpayers chose to prepay state taxes owed in 2018 by Dec. 31, 2017, to claim deductions before the cap went into effect. However, the federal law prohibited pre-payment in 2017 for 2018 state and local income taxes. And in a December 2017 release ( IR-2017-210), the Internal Revenue Service said that property taxes must be assessed and paid before 2018 in order to claim the deduction.

States with large hedge fund industries, like Connecticut, also attributed the revenue surge to one-time payments required under Section 457A of the Internal Revenue Code, a federal law enacted in October 2008 requiring hedge fund managers to bring overseas profits back into the U.S. by the end of 2017.

But while tax revenue swelled in Connecticut and New York, officials urged caution. A spokesman for Kevin Sullivan, commissioner of the Connecticut Department of Revenue Services, told Bloomberg Tax the state considers these unexpected funds to be “one-time” revenue.

New York officials shared that sentiment.

“This is not a windfall. We expect that these unanticipated December receipts are timing related and will be offset by a corresponding decline in personal income tax receipts for 2018,” wrote Robert Mujica, director of the New York State Division of the Budget.

Hedge Fund Rule Deadline

Bruce McGuire, founder and president of the Connecticut Hedge Fund Association, said both the state and the hedge fund industry knew there would be a large windfall for the state budget this year.

“I expect that many hedge fund managers have been strategizing with their tax advisors about this for quite some time,” he told Bloomberg Tax in an email. He doesn’t believe there was a rush to comply at the end of 2017.

“What I think is clear, is that while the state of CT knew that this money was coming, they did not have a truly effective means of quantifying the amount that would be coming in,” he said.

Year-End Revenue Swells

Connecticut Gov. Dannel Malloy (D) announced Jan. 8 that personal income tax revenue is estimated to exceed administration projections by over $900,000 in December 2017 and January 2018.

“An unexpectedly large amount of the tax revenues are attributable to one-time payments” from the new federal rules for overseas hedge fund profits, according to the news release announcing the figures. The other reason, officials said, was taxpayers prepaying their state taxes due in 2018 by Dec. 31, 2017.

While the unexpected revenue is welcome, Connecticut won’t be using the money to wipe out its current deficit, estimated at $224 million.

That’s because the state budget, passed four months late on Oct. 31, 2017, contained a “volatility cap” provision that “requires that any revenue from estimated and final income tax payments in excess of $3.15 billion be diverted to the budget reserve fund. This means that only $10 million of any increased collections can offset any budget deficit in FY 2018, while the rest will be transferred into the rainy day fund under this new law,” according to the release.

Connecticut officials said they won’t know exactly how much revenue was generated by the hedge fund rule change until April.

Revenue Spikes Elsewhere

Revenue numbers have also gone up in other states. While none would quantify whether the hedge fund rule change was a factor, all said that taxpayers prepaying their 2018 taxes was a factor.

  •  In California, December revenue collections came in at $16 billion, 32 percent more than forecasts, according to the state Legislative Analyst’s Office.
  •  In Massachusetts, the state pulled in $527 million (21.2 percent) over its monthly benchmark in December 2017, according to Department of Revenue Commissioner Christopher Harding, crediting prepayments of 2018 taxes as the main reason. “This year’s inflow of such payments was very significant from historical standards,” Harding said.
  •  New Jersey’s Department of the Treasury reported that $3.29 billion was collected in December 2017 for all taxes, an increase of $461 million over December 2016.
  •  Illinois, New York, and Pennsylvania all reported dramatic year-end revenue increases and cited taxpayers prepaying their 2018 taxes, but haven’t released the numbers.

With assistance from Michael J. Bologna in Chicago and Leslie A. Pappas in Philadelphia (Bloomberg Tax); and Romy Varghese in San Francisco and Martin Z. Braun in New York (Bloomberg)

To contact the reporter on this story: Aaron Nicodemus in Boston at anicodemus@bloomberglaw.com

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

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