The proposed federal regulations for the new passthrough entity deduction created by the Tax Cuts and Jobs Act (P.L. 115-97) will have a limited impact on most states but will be important in the few that conform to the deduction.
Zal Kumar of Mayer Brown told Tax Notes that for the most part, the IRC section 199A deduction avoids state tax implications “because it’s neither a deduction from [adjusted gross income] nor a deduction of the passthrough entity that conducts the business; most state or local tax personal income taxes start with AGI, and most state or local business taxes would only include deductions reported by the entity.”
But Kumar said sole proprietors and trusts eligible to claim the federal deduction may also be able to claim the deduction at the state level because of the way Schedule C income feeds into AGI and the way that income is defined for trusts, adding that New York law suggests this possibility.
Bruce Ely of Bradley Arant Boult Cummings LLP said state tax practitioners must initially determine whether a particular state levying an income tax has automatically conformed with the new 20 percent deduction or if the state legislature must affirmatively act “either by updating their date reference to the Internal Revenue Code, or in some cases, such as Alabama and Mississippi, passing a bill specifically incorporating section 199A.” Practitioners then need to determine if the state was obligated to or will voluntarily choose to follow the Treasury regulations, Ely said. If they follow the regulations, he said, then “state revenue officials must figure out how to juxtapose the proposed regulations’ related party rules onto the state’s existing rules.”
Ely said the proposed regulations, issued August 8, have “generally favorable aggregation rules,” allowing a taxpayer to maximize the deduction by aggregating “income from commonly owned business entities, trades or businesses within one entity, or perhaps businesses owned individually.” But he questioned whether states would use the federal rules or apply their own aggregation rules if they’re conducting an independent audit for compliance with the state deduction.
While the proposed regulations do not initially appear to have a significant direct impact on state and local tax, Kumar said, “states may look closely at the aggregation rules in considering the operations and tax positions taken by related entities doing business within their states.” He added that New York City, as an example, could “take a keen interest in aggregation for purposes of its unincorporated business tax.”
Conversely, Ely said, the proposed regulations also have antiabuse rules that attempt to prevent the separation of commonly owned business entities containing nonqualifying business activities, such as “spinning off the office building owned by a law firm or accounting firm into a separate entity in order to qualify the rental income from the spun-off business for the 199A deduction.”
“These rules are inherently subjective, and I doubt that a state [department of revenue] will seek guidance from the IRS in the middle of an audit of a group of taxpayers that’s claimed the 199A deduction on their state income tax returns,” Ely stated, adding that there’s also the question of whether states will abide by the results of an IRS audit of the taxpayer’s section 199A deduction.
At the Georgetown University Law Center’s 2018 Advanced State and Local Tax Institute on May 30, J. Anthony Coughlan, senior tax counsel for the Senate Finance Committee’s Republican staff, said a governor’s office had expressed concern about the revenue impact on states using AGI as the starting point for calculating taxable income for their personal income taxes if the new deduction was allowed in calculating AGI. The TCJA’s conference committee decided that the deduction should instead reduce taxable income, he said.
According to the Federation of Tax Administrators, as of July 1 six states use federal taxable income as their starting point — Colorado, Idaho, Minnesota, North Dakota, Oregon, and South Carolina.
“Since most states don’t incorporate section 199A into their personal income tax laws, it’s not likely that the proposed regulations offered by the Treasury Department will have a great impact on passthrough entities and their owners,” Steve Wlodychak of EY told Tax Notes.
But Wlodychak said taxpayers should be vigilant in monitoring state conformity developments in this area. “We already know one state (Iowa) which has legislatively conformed to section 199A and thus, in that state, understanding the proposed regulations will be critical to business owners and their tax advisers in determining the correct application of the new deduction for Iowa state tax purposes,” he added.
Iowa in May incorporated the section 199A deduction into its personal income tax law in a comprehensive tax measure that lowered individual and corporate income tax rates. Under S.F. 2417, Iowans can take 25 percent of their federal deduction for tax years beginning on or after January 1, 2019. Phased in, Iowans can take 75 percent of their federal deduction for tax years beginning on or after January 1, 2022.
In contrast, Oregon enacted S.B. 1528 in April to decouple the state from the section 199A deduction. Because Oregon bases its income tax calculation on federal taxable income, the state would have automatically conformed to the federal deduction without the bill and cost the state up to $1.3 billion in revenue over the next six years.
New Jersey lawmakers recently passed legislation (A. 4262) decoupling from the deduction, and Hawaii’s governor signed legislation (S.B. 2821) in June rendering the deduction inoperative for state tax purposes.