Back to basics: The effects of federal tax changes on state law
How states respond to federal tax law changes depends on several factors
Anytime federal tax laws change, taxpayers should evaluate how those changes will affect their tax situation. Most recently, many provisions of the 2017 Tax Cuts and Jobs Act (TCJA) will affect 2018 tax returns. But the impact of the largest overhaul of the U.S. tax system since the Tax Reform Act of 1986 doesn’t end there. The effects on state tax laws are often overlooked when major tax changes occur, and every state does things a little differently. This article looks at the three different methods of conformity, how federal tax changes affect state revenue, and gives examples of what certain states use as starting points.
Lawmakers evaluate many considerations when deciding whether to implement tax legislation
When lawmakers draft tax legislation they take multiple factors into account. For example, lawmakers might look at the state’s revenue situation to determine if the tax base needs to be broadened or not. If lawmakers broaden the tax base, the amount of taxable income subject to state taxation increases which, in turn, increases revenues absent rate decreases. There are also broad policy points that lawmakers consider when drafting legislation because tax legislation can be a valuable tool to effectuate lawmakers’ policy goals. For example, a lawmaker might seek funding for a state-run program and use tax legislation to generate it. Finally, there are efficiency concerns at play, including to what extent states want to take advantage of federal guidance and administration of tax forms by adopting federal changes. For example, states that conform to a federal change must also conform to the federal interpretations or regulations that coincide with the federal law. Furthermore, those states can simply carry a number from the federal return to the base state return instead of producing another state-specific tax form.
The following discussion elaborates on how these considerations are put into play.
Three types of conformity: rolling, static, and selective
States often react to federal changes by passing conformity legislation which determine the effect federal changes will have on state income tax returns. When determining how the TCJA or any new federal tax law affects a state’s tax code, it’s necessary to understand the method of conformity each state subscribes to. There are three methods of conformity states can choose from: rolling, static and selective.
Rolling conformity means states automatically adopt changes to the IRC
States that choose rolling conformity automatically comply with the most recent version of the Internal Revenue Code (IRC), unless the state specifically acts not to adopt the most current version of the IRC or a specific provision. Rolling conformity requires the least amount of effort for legislatures and state income tax administrators because they don’t have to pass any new law to conform to federal changes. In these states, legislators rely heavily on federal policy preferences because they are automatically adopting on federal laws and regulations. As a result, rolling conformity can result in passive adoption of federal policy preferences, which may not match the state population’s policy preferences since there is no debate or legislative activity prior to enactment. Colorado is one state that uses rolling conformity which means they conform to the most current version of the IRC, including the higher standard deduction and the suspension of personal and dependent exemptions.
Static conformity adopts the IRC as of a specific date
States that choose static conformity only conform to the IRC as of a specific date. For example, Minnesota conforms to the IRC as amended through December 16, 2016. This means any changes after that date do not apply to Idaho with regards to state returns. This type of conformity often results in less certainty because taxpayers must wait to see whether the state will pass legislation to adopt changes to the federal tax code that were enacted after the state’s specific date of conformity or merely continue using the IRC under the previous conformity date. Once taxpayers know whether the state legislature is going to change the conformity date there is greater certainty because they will know which version of the code to look to for guidance.
Selective conformity adopts only specifically stated federal provisions
The final option states can choose from is selective conformity which is a mixture between rolling and static conformity. States that choose selective conformity pick and choose certain sections of the IRC to adopt. For example, Mississippi has no set conformity date. It has adopted certain provisions of the TCJA, such as the changes to Section 179 (bonus depreciation) and Section 1031 (like-kind exchanges), but it does not conform to the TCJA’s treatment of net operating losses (NOLs).
While the type of conformity determines whether a state will automatically adopt new federal tax laws or require a new state law to adopt those changes, each state must decide how much of the code to adopt using that method (i.e. through federal AGI, taxable income, or merely selective). Rolling conformity states and static conformity states generally use the federal definitions of adjusted gross income or taxable income as a starting point for state taxable income. Selective conformity states generally don’t use federal adjusted gross income or federal taxable income as a starting point. Starting points are discussed in greater detail below.
States decide how to conform to tax reform depending on state revenue bases
When a state legislature is determining whether to conform to federal changes, it must consider political preferences and revenue requirements and how those federal changes affect the state’s income tax base. The state’s income tax base (i.e. income subject to state taxation) is typically a major source of its revenue. Whenever the income tax base is changed the state could potentially collect more or less in revenues absent a change in tax rates. Thus, when a federal change occurs the state must evaluate how that change will affect its income tax base before deciding whether to conform. State legislatures can choose to conform to or decouple from any federal tax law subject only to limitations in the state’s constitution. There are two types of changes a federal law can make to a state’s income tax base: broadening and narrowing.
Income tax base broadening results in more taxpayer income subject to tax
A base broadening change occurs when the income tax base increases due to the elimination of certain tax deductions or exclusions, the result of which is a greater portion of taxpayers’ income is subject to tax than prior to the change. For example, if a state that conforms to the value of federal personal exemptions when calculating state income tax adopts the TCJA suspension of personal exemptions, a base broadening change occurs. Any taxpayers who previously claimed personal exemptions would have higher taxable income, barring any other changes. This means states that adopt that change may see revenues increase based on that change. As a result, many states that are suffering from a revenue shortage or hoping to expand state programs may choose to conform to these provisions to increase revenue.
Revenue base narrowing results in less taxpayer income subject to tax
A base narrowing change, which is the inverse of a base broadening change, results in a lesser portion of taxpayers’ income being subject to tax. For example, the increased federal standard deduction decreases the amount of income subject to tax, ignoring any other changes. Thus, states that conform to a base narrowing provision like the increased federal standard deduction but not to base broadening provisions can expect a decrease in state income tax revenue. As a result, states with a revenue surplus or with a policy preference for decreases in state funded programs may choose to conform to these provisions since increased revenues may not be their focus. For example, when a state conforms to the TCJA’s new qualified business income deduction (QBID), small business owners who qualify for QBID on their federal return would also be entitled to a new deduction on their state return. This would lower their taxable income and decrease state income tax revenues. Therefore, states look at their current codes and determine what effects conformity will have on their income tax bases when deciding whether to conform.
Starting point for state returns make a difference
Where a state chooses to “start” the return is another component of state taxation that can be a factor in how a federal change will affect the state. The starting point for a state’s return is the amount of taxpayer income that they “start” or begin to adjust for state differences in calculating deductions, credits, and tax. This amount typically incorporates the taxpayer’s earned and unearned income that is subject to taxation. Each state can have its own additions and subtractions from income and they vary, but there are three main starting points states use: adjusted gross income (AGI), taxable income (TI), and state specific definitions of income.
For example, states that use AGI as their starting point use Line 7 from the federal Form 1040 as the first line for income on the state tax return. The states that use this method don’t automatically take into account the federal standard deduction, personal exemptions (that were available in prior years), or the new QBID in determining the starting point for income subject to state tax, although many AGI states do choose to conform to the number of personal exemptions allowed on a federal return. In other states, TI is the starting point, so taxpayers carry the amount on Line 10 from the federal Form 1040 to their state return. This method incorporates the standard deduction, personal exemptions (or lack thereof in 2018) and the QBID, thus incorporating more federal provisions into its starting point. Finally, selective conformity states, determine their own definition of income. The reference to AGI or TI as a starting point is a separate decision from the method of conformity, such as rolling, static, or selective.
These three starting points can result in considerable differences in state’s income tax revenue. But, again, a state can always choose to adopt a provision that isn’t typically accounted for on the state’s return or decouple from specific federal provisions.
Understanding how states conform to the IRC, how their revenue bases are affected, and their starting point are important when trying to evaluate how federal changes, such as those in the TCJA, impact taxpayers. Remember, every state is different, so taxpayers should consult their state’s law and a tax advisor before making any tax planning decisions.