United States

Why federal tax reform may affect your state tax exposure

May 05, 2017
From the Tax Governance Institute

Is the Blueprint on a collision course with political reality?

By Larry Cusack, Principal in Charge, State and Local Tax Services, KPMG LLP

Read more Tracking Tax Reform blog posts

Lost amid all the noise about federal tax reform is the significant impact it could have on state income tax systems and, ultimately, on you and your company. True, the road to tax reform is far from clear. And predicting its impact on state corporate taxes is even more uncertain. But there are steps you can take now so your company is well-positioned to act—not just react—if and when federal and state tax reform happens.

The federal-state tax connection: Nearly every state that imposes a corporate income tax conforms in some manner to the federal Internal Revenue Code. For example, most states generally start computing state corporate taxable income using federal taxable income as the base.

So the House Blueprint, which may move the federal system in the direction of a consumption-based tax—through provisions such as expensing, denying net interest expense deductions, and implementing a border adjustable tax—would have a major effect on state corporate taxes. That’s because it would modify the federal taxable income base.

If federal tax reform is enacted with those provisions, each state would have to decide whether to follow suit or retain its existing system. However, if tax reform relies more on rate reductions with some base broadening, there would be less of a direct impact on state tax structures.

In either case, the significant tax rate reductions in the President’s proposal and in the Blueprint will undoubtedly shine a spotlight on state tax systems, exerting pressure on them to lower their effective tax rates as well. How states respond likely will depend on a number of factors, including the political culture and tax philosophy of a state’s legislative and executive branches. Other factors include the following:

  • States tend to pick and choose which federal provisions to follow. For example, states often do not adopt federal deductions that decrease federal taxable income, such as bonus depreciation, because they may reduce state revenues.
  • Nearly every state is required to maintain a balanced budget. It’s estimated that more than 30 states are experiencing budget shortfalls. Others may experiencing uncertain fiscal conditions. This may make it less likely that they would adopt significant tax structure changes with uncertain outcomes.
  • Timing of federal tax reform will be a major challenge. Depending on when Congress passes tax reform and when it becomes effective, many state legislatures will have difficulty responding effectively and in a timely manner.

What to do now: There are a number of steps companies can take now to prepare for dealing with and managing the state-level impact of federal tax reform:

  • Assess your tax posture in the states where you have the most exposure. Determine where the liability appears greatest and what’s driving it. What are the key characteristics of the tax systems in those states? How could potential federal reform affect the state’s tax base and your state tax liability? Have you modeled the impact of these changes on your tax position?
  • Monitor what key state officials are saying. What’s their position on the impact of federal reform at the state level? What’s the likelihood that they’ll model the federal changes at the state level?
  • Explore the overall state fiscal outlook. What is the financial outlook of the key states in which you do business? What are their prospects for achieving a balanced budget if they do, or do not, make changes to their tax system?
  • Gauge the impact of federal changes on the valuation of deferred state tax assets and liabilities.

To update an old metaphor: If Washington sneezes, most states will likely get a cold. We’d strongly suggest that corporate taxpayers start exploring now what remedies they might be needing in the medicine cabinet if and when federal tax reform is enacted.

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This article represents the views of the author only, and does not necessarily represent the views or professional advice of KPMG LLP.

The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser.