GOP Tax Plans a Plus, Minus for Conforming States: A Primer (Corrected)

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By Che Odom

Certain provisions of the House and Senate tax plans would put more money in state coffers without states raising rates—but other components could hurt local budgets.

That distinction will be important to many cash-strapped states going into legislative sessions in 2018.

Both the House bill (H.R. 1) and the Senate-amended bill call for a broadening of the tax base by eliminating deductions and exemptions to pay for lower tax rates. Generally, a broadening of the base means states would see more tax revenue without changing rates if they conform to the Internal Revenue Code. However, major provisions in the House and Senate plans—such as limiting the state and local tax deduction, allowing full and immediate expensing of certain business costs, changing partnership taxes, and implementing international tax reform—could mean a net plus or minus for states.

The two chambers will meet in conference to address differences between the tax plans in the coming weeks. Republican leaders want to send a final bill to President Donald Trump by Christmas.

While details remain in flux, states are on the lookout for select provisions likely to appear in the final bill that could increase or diminish their revenue streams. Below, Bloomberg Tax highlights key proposals and their potential impact on states.

SALT Deduction

Paring down the federal deduction for taxes paid to state and local governments has become a significant source of contention, largely because it’s one of the biggest “pay-fors” in both bills and wealthier states see the repeal as unfair to their taxpayers.

Current law allows for the deduction of sales, income, and property taxes paid at the state and local level (SALT deduction). The House and Senate proposals don’t completely eliminate the deduction, preserving a property tax write-off up to $10,000. However, Republican lawmakers are discussing a potential compromise that would allow taxpayers to deduct state income tax, House Ways and Means Chairman Kevin Brady (R-Texas) said Dec. 6. And Senate Majority Leader Mitch McConnell (R-Ky.) said Dec. 6 that he’s open to tweaking final tax legislation to allow a deduction of state income taxes.

Though limits on the deduction wouldn’t directly hurt states, they could have an indirect impact with taxpayers growing intolerant of high state and local taxes that may not be deducted in a federal filing.

“Currently states disallow the state and local deduction so there is unlikely to be a revenue impact,” Joseph Bishop-Henchman, executive vice president of the conservative-leaning Tax Foundation, said in a Dec. 4 blog posting. “Many taxpayers who currently take SALT will instead take the standard deduction, potentially adding to the state tax base.”

Individual Deduction, Exemption

Similar to the SALT deduction, the House and Senate bills also align by roughly doubling the standard deduction and eliminating the personal exemption. “If states conform, this is a revenue loss and a revenue boost,” and states should analyze to see the net impact, Bishop-Henchman said.

According to the Pew Charitable Trusts, 12 states link to the federal standard deduction and eight states link to federal personal exemption amounts.

Congressional revisions to these provisions “would leave the states that link to those provisions with a difficult choice: either adopt the federal changes and manage the resulting revenue effects” or decouple from them and make taxpayers adjust to new state provisions,” according to Nov. 28 Pew analysis. The analysis forecasted potential revenue declines associated with raising the standard deduction and revenue increases from eliminating the personal exemption.

But the chambers differ on the estate tax. The House bill would repeal the estate tax over time, while the Senate would double the exemption.

“Under the House bill, states with an estate tax will have to choose between constructing their own or repealing,” Bishop-Henchman said. “Under the Senate bill, conforming states will see revenue loss” from the increased deduction.

Immediate Expensing

The Senate and House bills further call for temporary full expensing of certain business assets. In a Dec. 4 blog posting, attorneys from McDermott Will & Emery said that this proposal “would have a dramatic reduction in taxable income for many capital intensive companies.”

This would mean a revenue reduction for states on such assets, so many states may decide not to conform.

“Given the potential magnitude of the impact of this benefit on state tax revenues, it is likely state legislatures will respond with additional decoupling or modifications,” according to the McDermott Will & Emery posting. “If and when they do so, it will result in additional complexity by giving rise to differences in adjustments to basis for state and federal purposes and book-to-tax differences for financial reporting purposes.”

And the approach states took to bonus depreciation may provide a hint on how they’ll respond to full, immediate expensing.

“Two-thirds of states do not conform to the 50 percent bonus depreciation,” Karl Frieden, vice president and general counsel of the Council On State Taxation, said Nov. 18 at a meeting in Miami Beach of the National Conference of State Legislators.

Net Interest Deduction

Both bills seek to address the net interest deduction, linking it to the immediate expensing. The goal, according to Frieden, is to take away “favoritism of debt.”

States that conform to the cap on the net interest deduction would generally have a huge revenue gain, Frieden said, because it limits the deduction—though small businesses would be treated differently.

States could opt out of the full expensing to avoid a revenue loss and opt into the net interest deduction to, again, increase revenue. However, Congress sees the two as going hand-in-hand, Frieden said. “States will have to deal with this from a political, economic, and fairness perspective,” he added.

In addition, the House and Senate would cap net operating loss carryforward at 90 percent and 80 percent respectively. “Most states conform to this, or close to it,” Bishop-Henchman said. “Choosing to conform will probably increase revenue overall,” although net operating losses can vary greatly year by year.

Private-Activity Bonds

While the Senate would preserve the exemption on private-activity bonds, the House would repeal it—which could lead up to a 50 percent reduction in certain public-works projects and the loss of tens of thousands of low-income housing units, developers and state affordable-housing advocates have said.

Eliminating the exemption on bonds used for construction, transportation, and water infrastructure projects in which a private entity either owns, manages, or leases the project would earn the federal government about $38.9 billion over the next decade, according to a Nov. 11 Joint Committee on Taxation report estimating the revenue effects of the House bill.

The Council of Independent State Housing Associations said Dec. 4 in a statement emailed to Bloomberg Tax that loss of the exemption would present a challenge to state and local governments attempting to raise funds to build various types of infrastructure, especially housing for low-income residents.

Passthrough Entities

The House and Senate differ over their proposed treatment of passthrough entities, such as partnerships, S corporations, LLCs and certain trusts—and it’s not clear how the two chambers will reconcile their differences on the issue.

“I really don’t know what conference is going to come up with on passthroughs,” Bishop-Henchman told Bloomberg Tax. “The provisions are very different.”

The House approach involves rate reductions, which wouldn’t affect states. However, the Senate version involves a deduction. States that pick up federal deductions through conformity would see less revenue from passthrough entities, which make up 60 percent of all business income in the country, Frieden said.

International Tax Reform

Should the U.S. switch from a worldwide tax system to a territorial system with some base erosion, states may face several apportionment and constitutional issues, Frieden said.

The House and Senate bills provide immediate “deemed repatriation” of existing foreign earnings held abroad, but would apply reduced federal tax rates to such earnings. States may see a “one-time boost in revenue,” Bishop-Henchman said.

Congress would create a new category under Subpart F of the IRC, which eliminates deferral of U.S. tax on some foreign income by taxing certain persons on their pro rata share of such income earned by their controlled foreign corporations.

Foreign Commerce Clause

However, states are limited when it comes to taxing foreign earnings by the foreign commerce clause and the U.S. Supreme Court’s 1992 ruling in Kraft General Foods Inc. v. Iowa Department of Revenue and Finance.

The case involved an Iowa statute requiring the taxpayer to report taxable income based on an IRC provision that excluded foreign dividends from a deduction. Iowa’s conformity to the code meant that it also taxed foreign dividends, but not those received from domestic companies.

Most states allow a full or partial deduction for Subpart F income, but companies should stay alert to changes in state laws, which could come years after changes at the federal level, Frieden said.

“The states do not have a worldwide tax system. States did have it at one point with worldwide combined reporting, which the Supreme Court said was ‘OK,’” Frieden said. “For political and practical reasons, the states backed off. The states have either a water’s edge combined reporting or separate entity.”

(Corrected description of passthrough provisions in Senate, House bills)

With assistance from Erik Wasson, Sahil Kapur (Bloomberg); Laura Davison and Kaustuv Basu (Bloomberg Tax)

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

To contact the editor responsible for this story: Cheryl Saenz at csaenz@bloombergtax.com

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