The Stealth Increase in State Income Taxes under the Tax Cuts and Jobs Act of 2017

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Tax Policy

Commentators and legislators are hotly debating whether the elimination of exclusions and deductions in the recently released federal tax reform legislation will have a significant impact on individual taxpayers at the federal level. In this article, West Virginia University College of Law Professor Elaine Waterhouse Wilson discusses how the proposed federal changes may result in an increase in individual taxes at the state level.

Elaine Waterhouse Wilson

By Elaine Waterhouse Wilson

Elaine Waterhouse Wilson is a Professor of Law at the West Virginia University College of Law, Morgantown, West Virginia.

On November 2, 2017, the House Ways and Means Committee released its long awaited draft federal tax legislation (the Tax Cuts and Jobs Act of 2107 or “TCJA”). While there has been significant discussion of various aspects of the bill in the media, one impact of the proposed legislation has flown under the radar: the potential for a stealth increase in state income taxes.

Above the Line Deductions Eliminated

The TCJA eliminates a number of “above-the-line” deductions – those deductions that are taken into account for purposes of calculating adjusted gross income (“AGI”). For example, the TCJA repeals the following:

  •   Certain trade or business deductions of employees under IRC § 162 (repealed by TCJA § 1312)
  •   The alimony deduction under IRC § 215 (repealed by TCJA § 1309(a))
  •   The moving expense deduction under IRC § 217 (repealed by TCJA § 1310)
  •   Archer MSAs under IRC § 220 (repealed by TCJA § 1311)
  •   The student loan interest deduction under IRC § 221 (repealed by TCJA § 1204(a)(1))
  •   Certain qualified tuition expenses under IRC § 222 (repealed by TCJA § 1204(a)(1))

(list not exhaustive), all of which are currently taken into account for purposes of calculating federal AGI (see IRC §§ 62(a)(2), (10), (15), (16), (17), and (18) (2017), respectively.)

Excluded Items Now Included

In addition, certain items that the Code excluded from gross income entirely will now be included in gross income, and therefore, in AGI, including:

  •   Some housing allowances under IRC § 119 ( see TCJA § 1401)
  •   Some capital gain on the sale of a principal residence under IRC § 121 ( see TCJA § 1402)
  •   Employee achievement awards under § 74(c) ( see TCJA § 1403)
  •   Dependent care assistance programs under § 129 ( see TCJA § 1404)
  •   Qualified moving expenses under § 132(a)(6) ( see TCJA § 1405)
  •   Adoption assistance programs under § 137 ( see TCJA § 1406)

Proponents of the TCJA argue that many of the individuals who will lose these exclusions and above the line deductions will benefit from lower rates and the higher standard deduction. Accordingly, on the federal level, the loss of these exclusions and deductions may have little or no net negative tax impact. It will, of course, ultimately depend on the circumstances of each individual taxpayer to determine whether the loss of these exclusions and deductions is offset by other changes in the tax law for federal income tax purposes.

One thing is certain, however: the loss of these exclusions and deductions will increase the federal AGI of affected individuals. As a result, any tax attribute that is triggered off of AGI will be affected as a result. Obviously, this includes, on the federal level, the 2% floor for itemized deductions ( seeIRC § 67(a) (2017)) and the charitable deduction ( seeIRC § 170(b) (2017)).

Impact on State Taxes

Less obvious is the impact that the loss of these federal exclusions and deductions have on state income taxes. The majority of states with a state level income tax start with federal AGI as their base for calculating state income tax. For example, here in West Virginia, the state income tax starts with federal AGI as its tax base. (W.Va. Code § 11-21-12(a) (2017); see also W.Va. Form IT-140, line 1). In any state that keys its state income tax off of federal AGI, a taxpayer's state level taxable income should rise. ( see Federation of Tax Administrators, State Personal Income Taxes: Federal Starting Points (February 2017), https://www.taxadmin.org/assets/docs/Research/Rates/stg_pts.pdf (full list as of January 1, 2017)).

From federal AGI, a state may choose to add back in the federal itemized deductions or provide its own standard deduction, but of course, it is not required to do so. Again, using West Virginia as an example, the state modifies federal AGI by adding in state and local bond interest that is federally tax-exempt, and subtracts certain active military duty pay. (W.Va. Code §§11-21-12(b) and (c) (2017); see also W.Va. Form IT-140, Schedule M). None of the items in the TCJA that offset the economic impact of the loss of the federal exclusions and deductions, such as the lower rates, the heightened child credit, or higher standard deduction, will necessarily be available to offset the increase in gross income at the state level.

For some states, this may be a welcome way to raise state tax revenue without actually having to pass tax increase legislation. Other states may choose to add back in the lost exclusions and deductions for purposes of calculating the state income tax base. In either event, tax professionals should take into account the potential for (the potentially no-longer tax deductible) a state level income tax increase when evaluating the impact of the proposed federal legislation on individual clients.

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