The TCJA Five Years Later: State Tax Issues

In the first of a three-episode series, Steven Wlodychak, formerly with EY, discusses the creation of the SALT cap deduction by the Tax Cuts and Jobs Act and how states addressed it and other changes.

 For additional coverage, read these articles in Tax Notes:

• Consistent Guidance on SALT Cap Workarounds Needed, Panel Says
• California Governor Signs SALT Cap Workaround Fix
• Pennsylvania Bill Would Create SALT Cap Workaround
• ‘No SALT, No Deal’ Becomes No More

Follow us on Twitter:

• David Stewart: @TaxStew
• Tax Notes: @TaxNotes

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Credits
Host: David D. Stewart
Executive Producers: Jasper B. Smith, Paige Jones
Showrunner and Audio Engineer: Jordan Parrish
Guest Relations: Alexis Hart

Transcript

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David D. Stewart: Welcome to the podcast. I'm David Stewart, editor in chief of Tax Notes Today International. This week: TCJA at 5, state edition.

We're approaching the fifth anniversary of the passage of the Tax Cuts and Jobs Act, which means that, yes, we've been talking about the global intangible low-taxed income, foreign-derived intangible income, and the state and local tax cap for half a decade. To mark the occasion, we'll spend three episodes taking a closer look at how the TCJA has affected taxes on the state, federal, and international levels.

This week's episode, the first in our series, takes a closer look at the TCJA's relationship with state taxes. Here to talk more about this is Tax Notes senior legal reporter Andrea Muse.

Andrea, welcome back to the podcast.

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

David D. Stewart: To start off, could you give us a brief overview of what effect the TCJA had on state taxes?

Andrea Muse: Since most states conform to the Internal Revenue Code, any federal tax change will impact states unless they decouple from the provision. For the TCJA, there are several limitations on the provisions that impacted states, but what probably received the most attention is the $10,000 cap on the state and local tax deduction, which only indirectly impacted states because it's a limitation on the federal deduction, but resulted in states enacting workarounds like the passthrough entity tax.

David D. Stewart: All right. I understand you recently talked to someone about this. Could you tell us about your guest?

Andrea Muse: Yes, I talked with Steve Wlodychak. He's a Tax Notes State columnist and retired principal with EY. He's written extensively about the state and local tax treatment of passthrough entities, including the enactment of passthrough entity taxes as workarounds for the TCJA. He's also a frequent speaker on state and local tax developments.

David D. Stewart: All right, let's go to that interview.

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

Steven Wlodychak: Thanks, Andrea. Good to chat with you again.

Andrea Muse: Yes. We're talking about the TCJA's five-year anniversary coming up and you're an expert in how the states have reacted to the TCJA. We wanted to talk with you about that.

I guess the first thing to start with would be, what did the TCJA do at the federal level and why that mattered to the states?

Steven Wlodychak: Well, the most significant thing the TCJA did was drop the federal corporate rate from 35 percent, which was among the highest in the world at the time, to 21 percent. To put that in context, that's a 40 percent rate reduction. That was a substantial component of the TCJA.

Another thing that it did that was very important from the state perspective was it provided passthrough business owners, partners, and S corporation shareholders with a special 20 percent rate for trade or business income. That was on top of all the other tax cuts that it provided.

In exchange what Congress did was they doubled the standard deduction from $12,000 to $24,000 for individuals married filing jointly, and provided for immediate expensing of research and development and substantially changed the taxation of foreign income. For those of you who forget, there was a new base erosion and antiabuse tax that was generated in IRC section 59A.

Then they created this new thing called global intangible low-taxed income or GILTI, section 951A essentially, and then something called foreign-derived intangible income.

On top of all that, they provided special treatment, or reduced federal tax rate for special foreign dividend income, a one-year-only deal, under IRC 965.

Now what were the trade-offs? The trade-offs were, in exchange for the rate reduction, they also reduced deductions. For example, the most significant from the state and local perspective I guess would be the state and local tax deduction was limited to $10,000 annually for anybody filing married filing jointly. Then likewise, all these international provisions were intended to generate taxable income on income overseas and bring it into the U.S. tax system right away.

Now, why were these TCJA changes important for state tax purposes? That comes down to the conformity issue because most state income tax laws rely upon the IRC for determining their tax base. As changes happen to the IRC, states have to decide for income tax purposes, is this something that they're going to conform to or not conform to? Depending on how the state income tax laws conform to the IRC, they came into play.

But those were, Andrea, the major changes that happened under the TCJA.

Andrea Muse: For the conformity for states, as you said, it depends on the state, but you do have some states that automatically conform and then others that have to either pass legislation or actively conform to provisions.

Steven Wlodychak: One of the most significant components of state income taxation is the fact that they rely on the IRC as the base for determining state taxable income. I mean, that was a convenience that was created over 100 years ago when the states first started implementing their corporate income taxes. Everybody said, "Why make it hard on taxpayers? Let's just tie to the Internal Revenue Code as it exists." So you don't have to compute your base each time.

But Andrea, as you point out, every single state does it differently. Some either automatically conform, known as rolling conformity states. A bunch of other states are what they call static conformity states, where they fix the IRC at a specific date, and yet there are even still others like Mississippi and Arkansas, which pick and choose sections that they're going to conform to and that they don't.

The most important part about this is those states that conform to the IRC and the TCJA issues generally saw revenue increases.

They go, "Well, why did that happen?" That happened because a substantial component of the trade-offs that were done under the TCJA included significant base changes. In other words, reducing deductions generally meant that if the states didn't do anything, if they did just nothing but conform, they would see increased tax revenues.

I remember when this first came out back in 2017-2018, my colleague Andrew Phillips, a partner at Ernst & Young, and I undertook a little thought experiment. That was simply: "If the states did nothing and conformed to the TCJA, what would the impact on the state corporate income tax base be? Just the corporate income tax."

Andrew's a lot better than I am at the math and modeling, and he concluded that we came up with an overall 12 percent increase in state corporate income tax base. If you kept the state tax rates the same, one would expect a 12 percent increase in corporate tax revenues.

It's ironic that looking back, we weren't too far off. Even when you do take into consideration what was happening with respect to COVID-19 and all that.

One other interesting effect that happened that I don't think Andrew and I projected was corporations started to accelerate income early in the enactment of the TCJA believing that this corporate rate reduction couldn't last forever. They accelerated income into these earlier years, which resulted in even higher taxable income and even more corporate tax revenues for the states because again, you didn't see the states reduce their corporate tax rates by 40 percent like the federal government did. So it was only natural that we'd see that tax base increase at the state level and tax revenues increasing at the state level.

Andrea Muse: As you were saying for states, it seems that was a net positive as far as revenues go, but were there some concerns? I know as you're talking the TCJA limits the state and local tax deduction, and while that's not a direct impact to states, I'm sure that states had concerns about that. How did they react?

Steven Wlodychak: I think it's interesting that when you think about it, this limitation on the state and local tax deduction to $10,000, single and married filing jointly, $5,000 for married filing separately, didn't directly affect state taxes, right?

It wasn't a direct impact on the state taxes, but obviously what happened is individuals got pretty upset because they saw it as an increase, if you will, on their state tax liabilities. This was particularly true with what one would call to be the high-tax states. There was a real political clamoring for some changes to the SALT deduction so that the voters in those states who were most affected wouldn't be adversely affected by that.

The interesting thing is the SALT cap was something that was a target early on by some legislators to try and eliminate the SALT cap. But it didn't happen. It's not as if Congress didn't try. If you go back right after President Biden was elected, his signature plan was this Build Back Better Act. As part of that deal, many of the Northeast congressmen threatened, "No SALT, no deal." Basically what they were saying is they weren't going to support the president's legislative initiatives unless the SALT cap was repealed.

For example, last summer we saw the House pass an amendment increasing the cap to $80,000. We also saw the Senate pass its own amendment limiting the SALT cap only to the taxpayers with income more than $500,000. If you look at those numbers, even the Congressional Budget Office pointed out that that would only affect taxpayers in the top 1 percent of American taxpayers. The current limits probably amount to the top 99 percent. But in both cases, the CBO said 99 percent of personal income tax payers would've benefited from the change.

As we all know, Senator Joe Manchin from West Virginia opposed the Build Back Better Act. It fell apart last year and those amendments ended up falling down by the wayside. This summer we saw portions of the Build Back Better Act enacted as the Inflation Reduction Act. But interestingly, again, saying that "no SALT, no act," well, that didn't happen. They ended up reenacting or just not changing the SALT deduction.

Most of the changes that they made were the establishment of the new book income tax, federal tax on stock buybacks, and budgeting items to the IRS. But nobody really touched the SALT cap, and since it didn't make the last bill, I guess the question here is, "Is this ever going to happen before it expires at the end of 2025?" And with the last election, in the fact that now we have a divided government, I don't think it seems very likely that we'll see any further changes in the TCJA SALT cap.

Andrea Muse: I know there were some states that went through the judiciary and filed litigation to ask the courts to find that the cap was unconstitutional and that seemed to fail. I believe that the litigation has been concluded unsuccessfully.

Steven Wlodychak: Yeah, that was the very first thing that the states did. We saw New York, joined by New Jersey, Connecticut, Maryland, sue the federal government, the Trump administration, and challenge the constitutionality of the SALT cap. The southern district of New York, the district court there, in a very thoughtful opinion, rejected that notion, saying that there wasn't any constitutional requirement that there be a deduction for state and local taxes. This ended up going up to the court of appeals, which affirmed, and ultimately the U.S. Supreme Court refused to hear the appeal from that court.

I think that the litigation angle is closed at this point, but then the states started doing a bunch of other things. We saw a bunch of states come up with what are called the SALT deduction cap workarounds, and the first of that was creating what were called state-sponsored charities.

Under these proposals, which we saw enacted in Maryland and Connecticut and New York, essentially what would happen is the state or local governments would sponsor a charity, and under that charity, the taxpayers could make contributions to the charity and then get a credit for their tax liabilities for the amount that was paid. These charities would say, provide funding for public education and healthcare. And remember, there were no limitations imposed on charitable deductions, just on the SALT cap.

But the IRS quickly responded, and in June 2019 adopted regulations that severely restricted the ability to use this type of workaround and effectively closed that strategy. What they basically said was, "You can't do it unless the property that's contributed is 15 percent or less than the fair market value." That really was no benefit. So that really hasn't gotten very popular.

Another proposal we saw was trying to shift the tax from individual employees to employers. Now remember, individual employees, if they had withholding on their tax liability, that would be their personal tax liability subject to the $10,000 SALT cap.

New York came up with an interesting enactment. They called it the New York Employer's Compensation Expense Tax (ECET) and how this would work was it would be elected by the employer. Remember, the election's not by the employees but by the employer. Then what would happen is the employer would have a tax levied at a rate of 5 percent on the wages paid to the employees in excess of $40,000 each. Now the eligible employees could then claim a credit against their personal income tax for the share of the ECET paid by the employer.

Remember, arguably what you're doing is shifting the tax from the employee, who's subject to the SALT deduction, to the employer, who would just treat it as an ordinary trade or business expense, which could still be deductible. Ironically, New York's the only state that enacted such a provision.

I took a look at some of the budget information from New York and apparently if you take a look at the total amount of income tax that was collected in New York, this thing amounts to less than 0.1 percent of the $54 million collected in 2021. They only collected $3.2 million under that tax. So it really hasn't gotten very popular, and I haven't seen any other states enact that.

But then that brings us to what was probably the biggest response, which is the SALT PTE taxes, passthrough entity taxes. The way this would work is essentially instead of imposing the tax on the distributive share of income that was received by the shareholders or the passthrough entity owners, the partners who would pay it at the individual level, instead this would be a direct tax on the passthrough entity itself.

It's interesting. Connecticut was the very first state to enact this in 2018, almost immediately after the TCJA was enacted. After Connecticut did this and after the IRS acquiesced, more states have enacted one of these since then. It's interesting to see how that's going to evolve. I guess we have 29 states that have this kind of a passthrough entity tax.

Andrea Muse: Was it surprising how fast the states moved, particularly given the fact that the IRS hadn't issued any guidance until nearly three years later?

Steven Wlodychak: I wasn't very surprised at it because if you think about the enactment of the passthrough entity taxes, it's no cost to the states. The states recognized and the proponents of these taxes pointed out that there would be no net loss, in fact, possibly a revenue increase, to the states by enacting these passthrough entity taxes.The only possibility here is the fact that maybe the IRS would deny the deduction, but there'd be no net loss to the state. So it didn't really surprise me that they were enacted so quickly.

I think what really surprised me was the issuance of Notice 2020-75, and the IRS essentially acquiesced to this proposal, but as it is, this is already enacted and these provisions are going to be around until the TCJA provisions expire. Because remember, they expire in December 2025. I guess I really wasn't very surprised that there would be such rapid acceptance of the passthrough entity tax as something every state should have.

Andrea Muse: With the rapid acceptance with the states, and as you said that cap is supposed to expire in December of 2025, would you expect to see more guidance from the IRS on this issue?

Steven Wlodychak: I think the answer is no. I think what we have is all we're going to get.

If you look at the IRS, they have so many responsibilities, but they have limited resources, right? Just like any other business. It's not as if the IRS has millions of people. I think there's only like 80,000 people in the entire IRS and only a small portion are dedicated to rules and regulations.

We've been waiting on rules, for example, on section 385 provisions, for almost 20 years. When you think about it, the IRS only has limited resources and you have a provision that's going to expire after December 31, 2025, and you already have members of Congress that have been threatening to repeal or change the provision.

If you were the IRS, would you spend the resources to try and develop regulations beyond what you have already? I just don't think it's going to happen. But that creates a great deal of uncertainty with respect to how these provisions will work and how they would be applied. I think that adds a little bit of uncertainty for taxpayers.

Andrea Muse: Going to other provisions in the TCJA that impacted states, particularly the international provisions, what did you see with states reacting to those provisions?

Steven Wlodychak: When we first saw the international provisions, I think a lot of the states looked at this and said, "Well, we treat international provisions differently." And you go, "Well, why is that?" Well, historically, the federal government subjected dividends from foreign subsidiaries to tax only when the income was received. The thought being, "Look, we are a worldwide tax system in the United States. We have offsetting income for activities overseas, but you essentially just tax the entities that are here in the United States, and you leave the entities elsewhere alone."

Then you had subpart F provisions and all that. But from the state perspective, you have to remember that the states were limited in a different way than that. The U.S. Supreme Court said that under the foreign commerce clause, the states could not treat dividends received from foreign corporations differently than they do the dividends that are received from domestic companies. That's under the foreign commerce clause. That was in a case called Kraft Foods v. Iowa Department of Revenue back in 1992.

In that sense, the states had to take a look at these GILTI provisions and the international provisions and decide, "Gee, is this something that we can actually incorporate here, or are we going to run into constitutional concerns?"

Another interesting factor is that states like California already had worldwide combined reporting. When they looked at this, I think they quickly recognized we really don't need any of these provisions which accelerate income into the federal return because we already subject that current income of unitary foreign subsidiaries in our state tax base.

Theoretically, they didn't need any of the TCJA's international tax provisions. When you put these all together, a lot of the states, I think, rightly recognized that none of them really applied to them. Most states have decoupled from all those provisions, I think correctly, based upon the constitutional limitations, as well as the fact that their system is designed very differently than the federal government, and in essence, already had a special regime for taxing international income.

Andrea Muse: Any other provisions where states look closely at either decoupling or conforming?

Steven Wlodychak: One provision in particular was section 199A. Remember, this was the provision that provided a benefit to small businesses and passthrough entities by essentially giving them a 20 percent federal rate cut for trade or business income of passthrough entities like partnerships as corporations and LLCs.

The states I think properly recognized they didn't need to conform to this provision. Why? This provision was really created for federal purposes to provide some parity between C corporations and passthrough entities who say, "You gave a 40 percent rate cut to businesses organized as C corporations, but what about us?" That's why the 199A provision came in.

But from the state perspective, did the states reduce their tax rates as dramatically as the federal government? The answer is no. Consequently, most states decoupled and there wasn't really this disparity because there wasn't this disparity between the corporate and personal income tax rates.

The one exception I think was really kind of interesting to me was the state of Iowa expressly coupled to 199A, even though they didn't have a corporate rate reduction. I think that's really attributable to the legislative power of small businesses in that state.

But overall, most states didn't conform to 199A. That's created, I think, some complications for taxpayers because it's a reduction in the tax base. It isn't a rate reduction, but a 20 percent reduction in tax base that gets to the same place. But a lot of states had to have a provision that provides for the addback or the elimination of the 199A reduction for federal purposes. That's one element.

The other one, which is much more problematic, is section 163(j), and that's the one that imposes a limitation on the amount of interest that business taxpayers can take against their taxable income. That's been basically a nightmare for taxpayers to calculate at the state level.

The reason for this is 163(j) is a limitation in the amount of the interest deduction that was originally set up as 30 percent of adjusted taxable income and the company's business interest income. That would be the limitation each year. That was adjusted to 50 percent by the CARES Act in response to the onset of the COVID-19 pandemic back in 2020.

But the key feature here is that this adjusted tax politically is essentially the same as EBITDA, earnings before interest, taxes, depreciation, amortization, through 2021. But in the original TCJA, they moved to eliminate the depreciation and amortization computation in the ATI, making it much more restricted.

The one thing that's really interesting from a federal perspective is they're going to compute this limitation based on a consolidated basis of the company. That adds a really interesting question from the state perspective. If a state's going to conform to this, how are you supposed to do it for state purposes?

Most states don't have consolidated reporting. Most of them still are separate-return reporting. A lot of states have enacted something called combined reporting, which is different than the federal consolidated group reporting. Consequently, if you're computing 163(j) limitation and following those provisions for federal purposes, what are you supposed to do for state purposes, whether you might have separate reporting and there's no separate computation of 163(j), or you're filing a combined report that doesn't have the same members of the combined reporting group, which happens frequently?

On top of that, there's a provision to allow for you to carry over this 163 limitation amount into later years. The problem there is what happens when you're computing all this stuff? I challenge the fact that I don't think there's a super computer in the world that could follow 50 iterations. This is an incredibly complicated issue.

I think that's turned out to be a bit of a problem for a lot of businesses, both those C corporations as well as passthrough entities, because the state rules are so complicated and it's really difficult to figure out how those provisions are supposed to apply.

Andrea Muse: And so the answer there, I think you're saying, would be the states should just decouple from that provision.

Steven Wlodychak: I had been an advocate from the very beginning with 163(j) that the states should have decoupled it from the beginning. The reason for that is one of the big problems that this was meant to address was the fact that you had deductions for interest that were paid to related businesses. Well, that problem was eliminated through combined reporting for state purposes.

On top of that, many states, even the separate-return states, have enacted their own addback rules. Consequently, the states, in my view, were always way ahead of the federal government on interest limitations, and were doing it for the right reasons. There really was no need for this.

But when you started putting all these complications on the 163(j) calculations and all these difficult decisions on how do you apply it to separate returns and combined returns, my thought was simply add back the limitations for state purposes and be done with it, rather than trying to create all these complications going forward with carryovers and the computation of the 163(j) limitation and what happens when you have differences in apportionment. I just thought it was going to be a big headache for the states.

We would've been better off just adding an addback as an item for state purposes, which many states did.

Andrea Muse: Well, as we said, it's a five-year anniversary of the TCJA, and as you mentioned there, some of the provisions like the SALT cap disappear at the end of 2025. What do you expect to see in the future and maybe what issues should people look out for?

Steven Wlodychak: Well, the most important thing to keep in mind is the TCJA was enacted through the reconciliation process. In other words, the GOP did not have the votes in the Senate to go through the regular adoption process for these tax provisions. Consequently, under the pay-for requirements of reconciliation, the TCJA provisions are designed to self-destruct within a 10-year time frame.

For example, the SALT cap's going to disappear for taxable years beginning after December 31, 2025, unless Congress does something. Also the corporate tax rate's going to jump from 21 percent back up to the progressive rate that flattens out at 35 percent just as it existed before then. That's going to make some very difficult decisions come into play after the next presidential election in 2024. The big question's going to be who's in control of Congress and who's going to be the president at that time. It's kind of hard to project what's going to happen in that time frame.

But the one thing that I do know that's not going to happen is, as I mentioned, I don't think there's going to be any changes in the TCJA during the next two years because of the divided Congress.

So what could we see happen and what to look for? I think the states are going to have to decide what they're going to do with the TCJA provisions. Are they going to stay tied to it? I would think that would be the easy thing for taxpayers, but that's going to require an analysis on a state-by-state review.

The other thing that I think is going to be interesting is the state PTE taxes. I think a lot of the states are going to find out that they're making a lot of money off these state PTE taxes, and they're going to want to keep them as a permanent part of their tax plans. The real question for local taxpayers, is that what they want?

Fortunately, a number of states, like California, for example, and Colorado, expressly say that their passthrough entity tax expires if the TCJA is no longer going to be in effect. We'll see how those all work out, but there's no doubt that the next two years, we're not going to see a lot of federal tax reform that would affect the state corporate and personal income taxes.

But there's going to have to be planning for what's going to happen when the TCJA provisions expire. That's going to be a difficult question to ask in 2024 and beyond.

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

Steven Wlodychak: Well, Andrea, thanks for inviting me. This has been a real pleasure and thanks for having the opportunity to chat with you.

David D. Stewart: And now, coming attractions. Each week we highlight new and interesting commentary in our magazines. Joining me now is Acquisitions and Engagement Editor in Chief Paige Jones. Paige, what will you have for us?

Paige Jones: Thanks, Dave. In Tax Notes Federal, Marie Sapirie reviews the Greenhouse Gases, Regulated Emissions, and Energy Use in Technologies model for taxpayers who want to qualify for the new clean hydrogen credit. Mitchell Kane argues that the dispute over perpetual conservation easements just got worse.

In Tax Notes State, Jeffrey Friedman and Cyavash Ahmadi examine New York's False Claims Act tax meltdown. Robert Willens reviews a California tax case in which a new resident received a "free" basis step-up.

In Tax Notes International, Michelle Markham examines the global standing of the OECD's new bilateral advance pricing arrangement manual. Michael McDonald shares his observations on whether the arm's-length principle or formulary apportionment provides the best means of allocating income between associated enterprises.

In Featured Analysis, Nana Ama Sarfo reviews upcoming priority actions for the OECD Global Forum on transparency and exchange of information for tax purposes.

And finally, on the Opinions page, Robert Goulder and Joe Thorndike break down the 2022 Congressional midterm election results and their potential effects on tax policy.

David D. Stewart: That's it for this week. You can follow me online @TaxStew, that's S-T-E-W, and be sure to follow @TaxNotes for all things tax. If you have any comments, questions, or suggestions for a future episode, you can email us at podcast@taxanalysts.org. And as always, if you like what we're doing here, please leave a rating or review wherever you download this podcast. We'll be back next week with another episode of Tax Notes Talk.