Federal Tax Reform Could Have Big Effect on States

While the outlook is unclear, sitting back and waiting to see how things unfold is not a winning strategy.
Larry CusackFebruary 28, 2017

One of the outcomes of the November election is that the near-term prospects for comprehensive federal tax reform increased considerably. Yet while most of the attention has been focused on the federal tax impacts of reform, it is well worth noting that, if enacted, any federal reform will have significant effects on states and their income tax structures. As a result, tax and finance leaders at companies should focus now on the potential impact at the state level and the effect on a company’s state tax position of the current proposals.

Why Federal Reform Matters to States

Nearly every state that imposes a corporate income tax conforms in some way to the federal internal revenue code.  In large part, states begin the computation of state corporate taxable income with federal taxable income. Therefore, they allow many federal deductions for state tax purposes.

However, states do not  generally conform to various federal tax credits, such as those given for using alternative energy sources. Thus, while changes to the federal tax base may well have an impact on state taxes, changes to federal credits and federal rates are unlikely to have a direct impact on state taxes.

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Besides the nature of the federal reform changes, there are several other considerations that will influence whether and how federal changes might likely affect state taxes and whether the federal changes will be adopted by the states. These include:

  • States tend to “pick and choose” the provisions to which they conform. States will often decouple from federal deductions that decrease federal taxable income, such as bonus depreciation and the domestic production activities deduction, because of the impact on state revenues.
  • Nearly every state is required to maintain a balanced budget (that is, they’re restricted in borrowing for operating purposes). Further, many states are expected to experience budget shortfalls, meaning that expected revenues are coming in short of expected expenditures in the current fiscal year. Together, these realities could make states somewhat risk averse in regard to adopting changes with uncertain outcomes.
  • Various features of state tax systems (for instance, combined reporting and the degree to which states bring foreign sourced income into the state’s tax base) will cause certain federal tax reform proposals under consideration (for example, the disallowance of the interest expense disallowance, and the establishment of a territorial tax system) to have different effects across states. Further, the impact in a given state will depend on the degree to which it currently conforms to the federal tax.
  • A major challenge to states will be the timing of federal tax reform. If the federal government actually passes tax reform, when will it become effective? It seems quite likely that if federal reform is passed in 2017, it will be after most state legislatures have adjourned. If so, that means the opportunity for states to respond until 2018 will be limited.

How Companies Can Prepare

The net result of all these factors? The outlook for state corporate taxes will be highly uncertain for the next few years. There will be uncertainty as to whether federal reform will be passed, what it might contain, how it will affect the states, whether they will choose to adopt the federal model, and when the states might decide how they will respond to a potential reform. While the outlook is unclear, sitting back and waiting to see how things unfold is not a winning strategy.

There are a number of steps a company can take to prepare itself for dealing with and managing the state-level effects of federal tax reform. Some questions to be asked and situations to be analyzed are:

  • What is our tax posture across our most significant states? Where is our liability the greatest, and what is driving that liability? What are the key characteristics of the tax systems in those states?
  • How will the key aspects of potential federal reforms be likely to affect the tax base and our liability in these key states? Have we modeled the impact of these changes on our tax position?
  • What are key officials in these states saying about the impact of federal reform at the state level and the likelihood that they will or will not model the federal changes at the state level?
  • What is the overall fiscal outlook for the next two to four years in our key states?
  • How might federal changes impact the valuation of deferred state tax assets and liabilities?
  • Are there steps we can take now that might mitigate any undesirable outcomes from the federal reform at the state level, or conversely, enhance desirable outcomes?

The Big Question

The question that should be top of mind for CFOs and chief tax officers is: Are tax-rate reductions similar to those proposed at the federal level to be expected at the state level, given the various linkages between state and federal taxes? There is, of course, no one answer to that question.

How states respond to a potentially broader tax base likely will depend on a number of factors unique to each state, including the fiscal condition of the state; the degree to which the state tax base is actually broadened given the different linkages between the state and federal taxes and the potential for states to decouple from certain federal provisions; the distributional impact of any potential rate changes in light of the broader tax base; and the political culture and tax philosophy of the state.

Even though the crystal ball is far from clear, the time to analyze and prepare for managing the impact of federal reform at the state tax level is now. Waiting until things unfold will mean you reacting to events, not managing outcomes.

Larry Cusack is the national practice leader for state and local tax at KPMG.

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