The TCJA Five Years Later: State Tax Issues

Within the first of a three-episode sequence, Steven Wlodychak, previously with EY, discusses the creation of the SALT cap deduction by the Tax Cuts and Jobs Act and the way states addressed it and different adjustments.

This transcript has been edited for size and readability.

David D. Stewart: Welcome to the podcast. I am David Stewart, editor in chief of Tax Notes Right this moment Worldwide. This week: TCJA at 5, state version.

We’re approaching the fifth anniversary of the passage of the Tax Cuts and Jobs Act, which implies that, sure, we have been speaking in regards to the world intangible low-taxed earnings, foreign-derived intangible earnings, and the state and native tax cap for half a decade. To mark the event, we’ll spend three episodes taking a more in-depth take a look at how the TCJA has affected taxes on the state, federal, and worldwide ranges.

This week’s episode, the primary in our sequence, takes a more in-depth take a look at the TCJA’s relationship with state taxes. Right here to speak extra about that is Tax Notes senior authorized reporter Andrea Muse.

Andrea, welcome again to the podcast.

Andrea Muse: Thanks, Dave. Glad to be again.

David D. Stewart: To start out off, may you give us a quick overview of what impact the TCJA had on state taxes?

Andrea Muse: Since most states conform to the Inner Income Code, any federal tax change will influence states except they decouple from the availability. For the TCJA, there are a number of limitations on the provisions that impacted states, however what most likely acquired probably the most consideration is the $10,000 cap on the state and native tax deduction, which solely not directly impacted states as a result of it is a limitation on the federal deduction, however resulted in states enacting workarounds just like the passthrough entity tax.

David D. Stewart: All proper. I perceive you latterly talked to somebody about this. May you inform us about your visitor?

Andrea Muse: Sure, I talked with Steve Wlodychak. He is a Tax Notes State columnist and retired principal with EY. He is written extensively in regards to the state and native tax remedy of passthrough entities, together with the enactment of passthrough entity taxes as workarounds for the TCJA. He is additionally a frequent speaker on state and native tax developments.

David D. Stewart: All proper, let’s go to that interview.

Andrea Muse: Hey, Steve. Welcome to the podcast.

Steven Wlodychak: Thanks, Andrea. Good to speak with you once more.

Andrea Muse: Sure. We’re speaking in regards to the TCJA’s five-year anniversary developing and also you’re an skilled in how the states have reacted to the TCJA. We needed to speak with you about that.

I suppose the very first thing to start out with could be, what did the TCJA do on the federal degree and why that mattered to the states?

Steven Wlodychak: Nicely, probably the most important factor the TCJA did was drop the federal company price from 35 p.c, which was among the many highest on the earth on the time, to 21 p.c. To place that in context, that is a 40 p.c price discount. That was a considerable part of the TCJA.

One other factor that it did that was crucial from the state perspective was it offered passthrough enterprise homeowners, companions, and S company shareholders with a particular 20 p.c price for commerce or enterprise earnings. That was on high of all the opposite tax cuts that it offered.

In alternate what Congress did was they doubled the usual deduction from $12,000 to $24,000 for people married submitting collectively, and offered for rapid expensing of analysis and improvement and considerably modified the taxation of overseas earnings. For these of you who overlook, there was a brand new base erosion and antiabuse tax that was generated in IRC part 59A.

Then they created this new factor known as world intangible low-taxed earnings or GILTI, part 951A primarily, after which one thing known as foreign-derived intangible earnings.

On high of all that, they offered particular remedy, or lowered federal tax price for particular overseas dividend earnings, a one-year-only deal, below IRC 965.

Now what had been the trade-offs? The trade-offs had been, in alternate for the speed discount, additionally they lowered deductions. For instance, probably the most important from the state and native perspective I suppose could be the state and native tax deduction was restricted to $10,000 yearly for anyone submitting married submitting collectively. Then likewise, all these worldwide provisions had been supposed to generate taxable earnings on earnings abroad and convey it into the U.S. tax system instantly.

Now, why had been these TCJA adjustments vital for state tax functions? That comes right down to the conformity difficulty as a result of most state earnings tax legal guidelines depend upon the IRC for figuring out their tax base. As adjustments occur to the IRC, states need to resolve for earnings tax functions, is that this one thing that they are going to conform to or not conform to? Relying on how the state earnings tax legal guidelines conform to the IRC, they got here into play.

However these had been, Andrea, the foremost adjustments that occurred below the TCJA.

Andrea Muse: For the conformity for states, as you mentioned, it is determined by the state, however you do have some states that mechanically conform after which others that need to both move laws or actively conform to provisions.

Steven Wlodychak: One of the crucial important elements of state earnings taxation is the truth that they depend on the IRC as the bottom for figuring out state taxable earnings. I imply, that was a comfort that was created over 100 years in the past when the states first began implementing their company earnings taxes. Everyone mentioned, “Why make it arduous on taxpayers? Let’s simply tie to the Inner Income Code because it exists.” So you do not have to compute your base every time.

However Andrea, as you level out, each single state does it in a different way. Some both mechanically conform, often known as rolling conformity states. A bunch of different states are what they name static conformity states, the place they repair the IRC at a particular date, and but there are even nonetheless others like Mississippi and Arkansas, which choose and select sections that they are going to conform to and that they do not.

A very powerful half about that is these states that conform to the IRC and the TCJA points typically noticed income will increase.

They go, “Nicely, why did that occur?” That occurred as a result of a considerable part of the trade-offs that had been finished below the TCJA included important base adjustments. In different phrases, decreasing deductions typically meant that if the states did not do something, in the event that they did simply nothing however conform, they might see elevated tax revenues.

I keep in mind when this primary got here out again in 2017-2018, my colleague Andrew Phillips, a accomplice at Ernst & Younger, and I undertook a bit of thought experiment. That was merely: “If the states did nothing and conformed to the TCJA, what would the influence on the state company earnings tax base be? Simply the company earnings tax.”

Andrew’s rather a lot higher than I’m on the math and modeling, and he concluded that we got here up with an general 12 p.c enhance in state company earnings tax base. In case you saved the state tax charges the identical, one would anticipate a 12 p.c enhance in company tax revenues.

It is ironic that trying again, we weren’t too far off. Even while you do take into accounts what was taking place with respect to COVID-19 and all that.

One different attention-grabbing impact that occurred that I do not assume Andrew and I projected was firms began to speed up earnings early within the enactment of the TCJA believing that this company price discount could not final ceaselessly. They accelerated earnings into these earlier years, which resulted in even larger taxable earnings and much more company tax revenues for the states as a result of once more, you did not see the states scale back their company tax charges by 40 p.c just like the federal authorities did. So it was solely pure that we might see that tax base enhance on the state degree and tax revenues growing on the state degree.

Andrea Muse: As you had been saying for states, evidently was a internet constructive so far as revenues go, however had been there some issues? I do know as you are speaking the TCJA limits the state and native tax deduction, and whereas that is not a direct influence to states, I am positive that states had issues about that. How did they react?

Steven Wlodychak: I feel it is attention-grabbing that when you concentrate on it, this limitation on the state and native tax deduction to $10,000, single and married submitting collectively, $5,000 for married submitting individually, did not straight have an effect on state taxes, proper?

It wasn’t a direct influence on the state taxes, however clearly what occurred is people obtained fairly upset as a result of they noticed it as a rise, if you’ll, on their state tax liabilities. This was significantly true with what one would name to be the high-tax states. There was an actual political clamoring for some adjustments to the SALT deduction in order that the voters in these states who had been most affected would not be adversely affected by that.

The attention-grabbing factor is the SALT cap was one thing that was a goal early on by some legislators to try to remove the SALT cap. Nevertheless it did not occur. It is not as if Congress did not attempt. In case you return proper after President Biden was elected, his signature plan was this Construct Again Higher Act. As a part of that deal, lots of the Northeast congressmen threatened, “No SALT, no deal.” Mainly what they had been saying is that they weren’t going to assist the president’s legislative initiatives except the SALT cap was repealed.

For instance, final summer season we noticed the Home move an modification growing the cap to $80,000. We additionally noticed the Senate move its personal modification limiting the SALT cap solely to the taxpayers with earnings greater than $500,000. In case you take a look at these numbers, even the Congressional Finances Workplace identified that that might solely have an effect on taxpayers within the high 1 p.c of American taxpayers. The present limits most likely quantity to the highest 99 p.c. However in each circumstances, the CBO mentioned 99 p.c of non-public earnings tax payers would’ve benefited from the change.

As everyone knows, Senator Joe Manchin from West Virginia opposed the Construct Again Higher Act. It fell aside final yr and people amendments ended up falling down by the wayside. This summer season we noticed parts of the Construct Again Higher Act enacted because the Inflation Discount Act. However curiously, once more, saying that “no SALT, no act,” effectively, that did not occur. They ended up reenacting or simply not altering the SALT deduction.

Many of the adjustments that they made had been the institution of the brand new e-book earnings tax, federal tax on inventory buybacks, and budgeting gadgets to the IRS. However no person actually touched the SALT cap, and because it did not make the final invoice, I suppose the query right here is, “Is that this ever going to occur earlier than it expires on the finish of 2025?” And with the final election, in the truth that now now we have a divided authorities, I do not assume it appears very doubtless that we’ll see any additional adjustments within the TCJA SALT cap.

Andrea Muse: I do know there have been some states that went by the judiciary and filed litigation to ask the courts to search out that the cap was unconstitutional and that appeared to fail. I consider that the litigation has been concluded unsuccessfully.

Steven Wlodychak: Yeah, that was the very very first thing that the states did. We noticed New York, joined by New Jersey, Connecticut, Maryland, sue the federal authorities, the Trump administration, and problem the constitutionality of the SALT cap. The southern district of New York, the district courtroom there, in a really considerate opinion, rejected that notion, saying that there wasn’t any constitutional requirement that there be a deduction for state and native taxes. This ended up going as much as the courtroom of appeals, which affirmed, and finally the U.S. Supreme Courtroom refused to listen to the attraction from that courtroom.

I feel that the litigation angle is closed at this level, however then the states began doing a bunch of different issues. We noticed a bunch of states provide you with what are known as the SALT deduction cap workarounds, and the primary of that was creating what had been known as state-sponsored charities.

Underneath these proposals, which we noticed enacted in Maryland and Connecticut and New York, primarily what would occur is the state or native governments would sponsor a charity, and below that charity, the taxpayers may make a contribution to the charity after which get a credit score for his or her tax liabilities for the quantity that was paid. These charities would say, present funding for public training and healthcare. And keep in mind, there have been no limitations imposed on charitable deductions, simply on the SALT cap.

However the IRS shortly responded, and in June 2019 adopted laws that severely restricted the power to make use of this kind of workaround and successfully closed that technique. What they mainly mentioned was, “You possibly can’t do it except the property that is contributed is 15 p.c or lower than the honest market worth.” That basically was no profit. So that actually hasn’t gotten very talked-about.

One other proposal we noticed was making an attempt to shift the tax from particular person workers to employers. Now keep in mind, particular person workers, if that they had withholding on their tax legal responsibility, that might be their private tax legal responsibility topic to the $10,000 SALT cap.

New York got here up with an attention-grabbing enactment. They known as it the New York Employer’s Compensation Expense Tax (ECET) and the way this is able to work was it will be elected by the employer. Keep in mind, the election’s not by the staff however by the employer. Then what would occur is the employer would have a tax levied at a price of 5 p.c on the wages paid to the staff in extra of $40,000 every. Now the eligible workers may then declare a credit score in opposition to their private earnings tax for the share of the ECET paid by the employer.

Keep in mind, arguably what you are doing is shifting the tax from the worker, who’s topic to the SALT deduction, to the employer, who would simply deal with it as an peculiar commerce or enterprise expense, which may nonetheless be deductible. Paradoxically, New York’s the one state that enacted such a provision.

I took a take a look at a few of the finances data from New York and apparently in the event you check out the overall quantity of earnings tax that was collected in New York, this factor quantities to lower than 0.1 p.c of the $54 million collected in 2021. They solely collected $3.2 million below that tax. So it actually hasn’t gotten very talked-about, and I have never seen every other states enact that.

However then that brings us to what was most likely the most important response, which is the SALT PTE taxes, passthrough entity taxes. The way in which this is able to work is actually as a substitute of imposing the tax on the distributive share of earnings that was acquired by the shareholders or the passthrough entity homeowners, the companions who would pay it on the particular person degree, as a substitute this is able to be a direct tax on the passthrough entity itself.

It is attention-grabbing. Connecticut was the very first state to enact this in 2018, nearly instantly after the TCJA was enacted. After Connecticut did this and after the IRS acquiesced, extra states have enacted one in every of these since then. It is attention-grabbing to see how that is going to evolve. I suppose now we have 29 states which have this sort of a passthrough entity tax.

Andrea Muse: Was it stunning how briskly the states moved, significantly given the truth that the IRS hadn’t issued any steerage till almost three years later?

Steven Wlodychak: I wasn’t very shocked at it as a result of if you concentrate on the enactment of the passthrough entity taxes, it is no price to the states. The states acknowledged and the proponents of those taxes identified that there could be no internet loss, in reality, probably a income enhance, to the states by enacting these passthrough entity taxes.The one chance right here is the truth that perhaps the IRS would deny the deduction, however there’d be no internet loss to the state. So it did not actually shock me that they had been enacted so shortly.

I feel what actually shocked me was the issuance of Discover 2020-75, and the IRS primarily acquiesced to this proposal, however as it’s, that is already enacted and these provisions are going to be round till the TCJA provisions expire. As a result of keep in mind, they expire in December 2025. I suppose I actually wasn’t very shocked that there could be such fast acceptance of the passthrough entity tax as one thing each state ought to have.

Andrea Muse: With the fast acceptance with the states, and as you mentioned that cap is meant to run out in December of 2025, would you anticipate to see extra steerage from the IRS on this difficulty?

Steven Wlodychak: I feel the reply is not any. I feel what now we have is all we will get.

In case you take a look at the IRS, they’ve so many tasks, however they’ve restricted assets, proper? Similar to every other enterprise. It is not as if the IRS has hundreds of thousands of individuals. I feel there’s solely like 80,000 folks in your complete IRS and solely a small portion are devoted to guidelines and laws.

We have been ready on guidelines, for instance, on part 385 provisions, for nearly 20 years. When you concentrate on it, the IRS solely has restricted assets and you’ve got a provision that is going to run out after December 31, 2025, and you have already got members of Congress which were threatening to repeal or change the availability.

In case you had been the IRS, would you spend the assets to try to develop laws past what you may have already? I simply do not assume it will occur. However that creates an excessive amount of uncertainty with respect to how these provisions will work and the way they might be utilized. I feel that provides a bit of little bit of uncertainty for taxpayers.

Andrea Muse: Going to different provisions within the TCJA that impacted states, significantly the worldwide provisions, what did you see with states reacting to these provisions?

Steven Wlodychak: Once we first noticed the worldwide provisions, I feel a whole lot of the states checked out this and mentioned, “Nicely, we deal with worldwide provisions in a different way.” And also you go, “Nicely, why is that?” Nicely, traditionally, the federal authorities subjected dividends from overseas subsidiaries to tax solely when the earnings was acquired. The thought being, “Look, we’re a worldwide tax system in the US. We’ve got offsetting earnings for actions abroad, however you primarily simply tax the entities which are right here in the US, and you allow the entities elsewhere alone.”

Then you definitely had subpart F provisions and all that. However from the state perspective, it’s important to keep in mind that the states had been restricted otherwise than that. The U.S. Supreme Courtroom mentioned that below the overseas commerce clause, the states couldn’t deal with dividends acquired from overseas firms in a different way than they do the dividends which are acquired from home corporations. That is below the overseas commerce clause. That was in a case known as Kraft Meals v. Iowa Division of Income again in 1992.

In that sense, the states had to check out these GILTI provisions and the worldwide provisions and resolve, “Gee, is that this one thing that we are able to really incorporate right here, or are we going to run into constitutional issues?”

One other attention-grabbing issue is that states like California already had worldwide mixed reporting. Once they checked out this, I feel they shortly acknowledged we actually do not want any of those provisions which speed up earnings into the federal return as a result of we already topic that present earnings of unitary overseas subsidiaries in our state tax base.

Theoretically, they did not want any of the TCJA’s worldwide tax provisions. Once you put these all collectively, a whole lot of the states, I feel, rightly acknowledged that none of them actually utilized to them. Most states have decoupled from all these provisions, I feel appropriately, primarily based upon the constitutional limitations, in addition to the truth that their system is designed very in a different way than the federal authorities, and in essence, already had a particular regime for taxing worldwide earnings.

Andrea Muse: Some other provisions the place states look carefully at both decoupling or conforming?

Steven Wlodychak: One provision specifically was part 199A. Keep in mind, this was the availability that offered a profit to small companies and passthrough entities by primarily giving them a 20 p.c federal price reduce for commerce or enterprise earnings of passthrough entities like partnerships as firms and LLCs.

The states I feel correctly acknowledged they did not want to adapt to this provision. Why? This provision was actually created for federal functions to supply some parity between C firms and passthrough entities who say, “You gave a 40 p.c price reduce to companies organized as C firms, however what about us?” That is why the 199A provision got here in.

However from the state perspective, did the states scale back their tax charges as dramatically because the federal authorities? The reply is not any. Consequently, most states decoupled and there wasn’t actually this disparity as a result of there wasn’t this disparity between the company and private earnings tax charges.

The one exception I feel was actually type of attention-grabbing to me was the state of Iowa expressly coupled to 199A, despite the fact that they did not have a company price discount. I feel that is actually attributable to the legislative energy of small companies in that state.

However general, most states did not conform to 199A. That is created, I feel, some problems for taxpayers as a result of it is a discount within the tax base. It is not a price discount, however a 20 p.c discount in tax base that will get to the identical place. However a whole lot of states needed to have a provision that gives for the addback or the elimination of the 199A discount for federal functions. That is one aspect.

The opposite one, which is far more problematic, is part 163(j), and that is the one which imposes a limitation on the quantity of curiosity that enterprise taxpayers can take in opposition to their taxable earnings. That is been mainly a nightmare for taxpayers to calculate on the state degree.

The explanation for that is 163(j) is a limitation within the quantity of the curiosity deduction that was initially arrange as 30 p.c of adjusted taxable earnings and the corporate’s enterprise curiosity earnings. That will be the limitation annually. That was adjusted to 50 p.c by the CARES Act in response to the onset of the COVID-19 pandemic again in 2020.

However the important thing characteristic right here is that this adjusted tax politically is actually the identical as EBITDA, earnings earlier than curiosity, taxes, depreciation, amortization, by 2021. However within the authentic TCJA, they moved to remove the depreciation and amortization computation within the ATI, making it far more restricted.

The one factor that is actually attention-grabbing from a federal perspective is they are going to compute this limitation primarily based on a consolidated foundation of the corporate. That provides a extremely attention-grabbing query from the state perspective. If a state’s going to adapt to this, how are you speculated to do it for state functions?

Most states haven’t got consolidated reporting. Most of them nonetheless are separate-return reporting. A number of states have enacted one thing known as mixed reporting, which is totally different than the federal consolidated group reporting. Consequently, in the event you’re computing 163(j) limitation and following these provisions for federal functions, what are you speculated to do for state functions, whether or not you may need separate reporting and there is no separate computation of 163(j), otherwise you’re submitting a mixed report that does not have the identical members of the mixed reporting group, which occurs ceaselessly?

On high of that, there is a provision to permit so that you can carry over this 163 limitation quantity into later years. The issue there may be what occurs while you’re computing all these things? I problem the truth that I do not assume there is a tremendous laptop on the earth that might observe 50 iterations. That is an extremely difficult difficulty.

I feel that is turned out to be a little bit of an issue for lots of companies, each these C firms in addition to passthrough entities, as a result of the state guidelines are so difficult and it is actually tough to determine how these provisions are supposed to use.

Andrea Muse: And so the reply there, I feel you are saying, could be the states ought to simply decouple from that provision.

Steven Wlodychak: I had been an advocate from the very starting with 163(j) that the states ought to have decoupled it from the start. The explanation for that is without doubt one of the massive issues that this was meant to deal with was the truth that you had deductions for curiosity that had been paid to associated companies. Nicely, that downside was eradicated by mixed reporting for state functions.

On high of that, many states, even the separate-return states, have enacted their very own addback guidelines. Consequently, the states, in my opinion, had been at all times means forward of the federal authorities on curiosity limitations, and had been doing it for the fitting causes. There actually was no want for this.

However while you began placing all these problems on the 163(j) calculations and all these tough choices on how do you apply it to separate returns and mixed returns, my thought was merely add again the constraints for state functions and be finished with it, somewhat than making an attempt to create all these problems going ahead with carryovers and the computation of the 163(j) limitation and what occurs when you may have variations in apportionment. I simply thought it was going to be an enormous headache for the states.

We’d’ve been higher off simply including an addback as an merchandise for state functions, which many states did.

Andrea Muse: Nicely, as we mentioned, it is a five-year anniversary of the TCJA, and as you talked about there, a few of the provisions just like the SALT cap disappear on the finish of 2025. What do you anticipate to see sooner or later and perhaps what points ought to folks look out for?

Steven Wlodychak: Nicely, an important factor to bear in mind is the TCJA was enacted by the reconciliation course of. In different phrases, the GOP didn’t have the votes within the Senate to undergo the common adoption course of for these tax provisions. Consequently, below the pay-for necessities of reconciliation, the TCJA provisions are designed to self-destruct inside a 10-year timeframe.

For instance, the SALT cap’s going to vanish for taxable years starting after December 31, 2025, except Congress does one thing. Additionally the company tax price’s going to leap from 21 p.c again as much as the progressive price that flattens out at 35 p.c simply because it existed earlier than then. That is going to make some very tough choices come into play after the following presidential election in 2024. The large query’s going to be who’s answerable for Congress and who’s going to be the president at the moment. It is type of arduous to undertaking what is going on to occur in that timeframe.

However the one factor that I do know that is not going to occur is, as I discussed, I do not assume there’s going to be any adjustments within the TCJA throughout the subsequent two years due to the divided Congress.

So what may we see occur and what to search for? I feel the states are going to need to resolve what they are going to do with the TCJA provisions. Are they going to remain tied to it? I’d assume that might be the simple factor for taxpayers, however that is going to require an evaluation on a state-by-state overview.

The opposite factor that I feel goes to be attention-grabbing is the state PTE taxes. I feel a whole lot of the states are going to search out out that they are making some huge cash off these state PTE taxes, and they are going to need to preserve them as a everlasting a part of their tax plans. The true query for native taxpayers, is that what they need?

Fortuitously, quite a few states, like California, for instance, and Colorado, expressly say that their passthrough entity tax expires if the TCJA is now not going to be in impact. We’ll see how these all work out, however there is no doubt that the following two years, we’re not going to see a whole lot of federal tax reform that might have an effect on the state company and private earnings taxes.

However there’s going to need to be planning for what is going on to occur when the TCJA provisions expire. That is going to be a tough query to ask in 2024 and past.

Andrea Muse: Thanks for being on the podcast, Steve.

Steven Wlodychak: Nicely, Andrea, thanks for inviting me. This has been an actual pleasure and thanks for having the chance to speak with you.