The 2018 CFO State Tax Survey
(Jump to the survey results at bottom of page.)
The preparation of state income tax returns has in recent years evolved into a more complex endeavor. Now, uncertainty over how states will respond to the federal Tax Cuts and Jobs Act (TCJA), as well as fallout from a U.S. Supreme Court decision, could further muddy the state-tax picture.
While many companies stand to benefit from the TCJA, which slashes corporate income tax rates to 21% from 35%, most organizations will likely will end up paying some of that found money to state governments. How much will depend on the degree to which states — which generally conform much of their tax law to the Internal Revenue Code — decide to “decouple” from the TCJA in efforts to grab new tax revenue for their depleted coffers.
Adding to that uncertainty is the fact that the 50-year-old system governing how states collect taxes on revenues of out-of-state vendors — how they determine the “nexus” of such businesses — is set to change radically. The Supreme Court decision in South Dakota v. Wayfair, handed down in late June, will result in new tax-collection responsibilities for internet retailers.
To many corporate finance and tax executives, however, federal tax changes and the nexus issue are just the newest sources of proliferating complexity in the state tax arena.
Ongoing changes in the tax laws of many states make compliance much tougher, these executives say.
Marc Porter, CFO of The Law Company, has been preparing the tax returns of the $100 million construction-and-engineering company, which operates in 38 states, for 15 years. He sees it as a way of gaining a firmer understanding of the company’s finances.
But over the last five or so years, a proliferation of state income tax rules has made the task “a major headache,” he tells CFO. “It takes a lot longer to deal with state income taxes than the federal taxes.”
The red tape is in part due to political pressure on state legislatures to refrain from hiking income tax rates, even though many states are starved for cash. Instead, to pick up incremental revenue, states are forcing corporate taxpayers to make adjustments to the income reported on their federal tax returns.
For example, many states have already decoupled from the bonus depreciation element of federal corporate income taxes, according to a report on the new tax law by KPMG.
Under bonus depreciation rules, corporations can deduct from their taxes a portion of the purchase price of certain equipment and off-the-shelf software. The TJCA increased the previously existing 50% bonus depreciation to 100% for qualified assets placed in service after Sept. 27, 2017, and before Dec. 31, 2022.
It’s not unusual for states to pick and choose the federal tax provisions to which they conform, often choosing to reject those that entail revenue-loss consequences, according to KPMG.
Still, Porter isn’t thrilled that such maneuvers by states threaten to erode the benefits of the federal tax cuts. And he senses the potential for more financial hits at the hands of states.
For example, as owners of an S corporation, shareholders of The Law Company will enjoy, under the TCJA, a 20% tax deduction on qualified business income. (At such entities, profits or losses are passed through to shareholders, who are taxed on them.)
However, Porter observes, that tax break is hardly guaranteed at the state level. “All states have to do is pass a statute that says you have to add back the 20%,” he says. And he suspects some states might do just that.
The inconsistency in state tax laws was worsened by state legislatures scrambling to react to the TCJA, which was enacted on December 22, 2017. With many legislatures starting 2018 sessions on Jan. 15, “time was really short” to incorporate the complexities of the TCJA into state tax law, especially provisions concerning offshore earnings, says Harley Duncan, managing director in the Washington National Tax practice of KPMG.
No matter what impact the TCJA ultimately will have on the accounting for and payment of state taxes, it’s the biggest state tax issue for companies this year, according to Marji Gordon-Brown, a tax counsel at MacAndrews & Forbes, a diversified holding company.
The TCJA mandates that tax-deferred offshore earnings be “deemed repatriated” and taxed at a 15.5% one-time rate if held in the form of cash and cash equivalents.
And, with some companies expected to move large amounts of revenue-generating assets back onshore, their future taxable income could also change markedly. Such changes could make it extremely difficult to forecast corporate income for the purposes of state tax filing.
The states themselves are adding to the confusion by changing their own rules in response to the TCJA. “Every day, we’re hearing about another state opposing a particular provision or enacting a particular piece of legislation” that addresses whether to decouple with provisions of the TCJA, Gordon-Brown says.
“An organization’s calculation today may not be accurate a month from now, when another state enacts a different piece of legislation,” she says, noting that the more states a company operates in, the more complicated its tax preparation becomes.
Several states, for example, have decoupled from a component of the TCJA that allows deductions on foreign expenses, notes Gordon-Brown. In such states, “if you have income that’s excluded from the federal tax, you have to attribute some of your expense to that income on your state return,” she notes.
The mounting discrepancies between federal and state taxation mean that federal and state corporate tax department functions must be much more tightly linked, according to Gordon-Brown.
“If the people who are doing the federal returns and the people who are doing the state returns are not the same people, they need to be increasingly connected and communicative.” she says. “Otherwise things are for sure going to fall through the cracks.”
Before last month, how states collected taxes on sales made by out-of-state online vendors to in-state consumers was a wide-open question. In most states, businesses with a clearly defined physical presence, like property or employees, have long been required to collect sales taxes from their customers.
However, since a 1967 U.S. Supreme Court decision, National Bellas Hess, Inc. v. Department of Revenue of Ill., out-of-state retailers selling products via mail order, for instance, have been excused from that responsibility. Under that decision, use taxes (sales taxes on out-of-state purchases) were still due. But they had to be collected from the in-state customer, not the out-of-state seller. A 1992 Supreme Court ruling, Quill Corp. v. North Dakota, reaffirmed the 1967 judgment.
But because of the vast changes in how business has been conducted since then — especially the changeover to Internet sales — the existing regime of sales tax collection needed a second look, Justice Anthony Kennedy wrote in his concurrence with another Supreme Court opinion in March 2015.
Over the last few years, the matter of whether online out-of-state retailers could be required to collect taxes on purchases by their customers in a given state has hung in the balance. On January 12, the Supreme Court provided some hope that the matter might be settled by agreeing to hear a lower-court decision involving a lawsuit by South Dakota against Wayfair, an e-commerce company that sells home goods.
“Today, states’ inability to effectively collect sales tax from internet sellers imposes crushing harm on state treasuries and brick-and-mortar retailers alike,” South Dakota argued in its attempt to overturn the Quill decision’s physical-presence requirement.
In stated defiance of the past Supreme Court rulings, South Dakota’s legislature passed a law requiring sellers with gross revenue from sales in South Dakota of more than $100,000 within a year, or at least 200 separate transactions in a year, to collect taxes on behalf of the state.
On June, 21 the Supreme Court ruled in of South Dakota. The 5-4 ruling, which applies to thousands of such businesses, allows states to require them to collect and remit state sales taxes for internet transactions. It overturns the court’s 1992 decision in Quill v. North Dakota.
Many other states, perhaps most of them, likely will now adopt a South Dakota-style law of their own, Paul Graney, state and local tax leader for law firm Marcum LLP, told CFO.
Jeffrey LeSage, Americas vice chairman, tax, for KPMG, articulated the ruling’s likely profound effects: It “could turn out to be almost as significant for American businesses as the recent rewrite of the U.S. federal tax code,” he stated. “It’s a decision that reflects the realities of an increasingly digital economy.”
In addition to the questions covered in the accompanying charts (below), respondents were asked about their understanding of how the Tax Cuts and Jobs Act will affect state taxes, how closely states should align their laws with the TCJA, and how confident they were in their tax system’s ability to handle remote sales tax collection if the Wayfair decision required it. (The survey took place before the Wayfair ruling.)
About 38% of tax executives indicated their understanding of the TCJA’s effects on state tax obligations was “unclear” or “completely unclear,” while 32% said they were “clear” or “very clear.” A majority (73%) felt that states should “closely” or “very closely” align their tax laws with the TCJA’s provisions. And, finally, a little more than half of the tax executives were “totally confident” or “confident” that their existing tax systems could adapt to a requirement that they collect sales tax on behalf of states in which they don’t have a physical presence.
David M. Katz is a freelance writer based in New York.
The charts highlight states ranked best and worst on six key measures.
This survey has been conducted biennially since 1996 with the help of KPMG LLP, the audit, tax, and advisory firm, and this year with the additional help of the Tax Executives Institute. The survey aims to capture tax executives’ impressions of the differing tax environments in each state in which they do business. The results presented here represent those impressions, rather than quantitative assessments of actual policies, tax rates, or other criteria.