Conformity and State Income Taxes: Suggestions for a Post-COVID Era
(Posted by David Gamage on behalf of Michael A. Livingston)
To guarantee adequate revenues in the post-COVID era, States need to utilize all possible tools at their disposal. In particular States may wish to evaluate their degree of conformity with Federal tax changes in order to achieve this purpose. Specifically, the States should consider:
1. Adopting either a “static” or “selective” conformity that enables the State to choose the Federal tax changes it is adopting, rather than automatically adopting all such changes. In most cases, this would likely involve accepting revenue-enhancing provisions and rejecting those that reduce revenues
2. Rejecting or postponing conformity to several changes contained in the Coronavirus Aid, Relief, and Economic Security (CARES) Act including changes to the business interest deduction rules (sec. 163), Net Operating Losses (sec. 172), charitable deductions (sec. 170), and several employer-related provisions, most of which are revenue-losers
3. Adopting, if they have not done so already, the revenue-enhancing provisions of the so-called GILTI (Global Intangible Low-Taxed Income) rules, originally continued in the 2017 tax act
The remainder of this post provides background and details regarding the suggestions above.
Background. — Conformity is the State practice of piggybacking on the Federal income tax in designing the State tax base. All States with income taxes practice conformity to some degree, but the degree is important, especially in a period of rapid tax changes. When State revenues are in peril, as they are in the COVID era, the differences become still more significant.
One of the principal issues here is the question of static or dynamic conformity. Let’s say the Federal Government decides that, beginning in 2018, previously depreciable expenditures are now currently expensed, or depreciated on a faster schedule. A State practicing dynamic conformity would automatically enact the same change for 2018 returns. By contrast, a State practicing static conformity might say that it conformed to the Federal system as of 2015, or even 2000, leaving for itself the choice of whether to enact the change above. In this example, the State’s revenues would be correspondingly higher.
Of course, when Congress expands the Federal tax base, the effect is the opposite. Take, for example, the 2017 GILTI rules, which reduce tax evasion by transfer of intangibles to low-tax jurisdictions. A State practicing dynamic conformity would most likely put in place a similar rule with respect to 2018 returns. But a State that preferred static conformity would not: unless it enacted new legislation, it would remain tied to old law, and continue to permit the (now Federally impermissible) tax evasion. In this case, the static rule would reduce revenues.
A third possibility is for a State to practice selective conformity, adopting only those Federal tax changes it wishes to, and ignoring the others. This is implicit in the static method described above, but the State may also choose it explicitly.
Like many things in tax — or life — the playing field for State conformity is somewhat random, reflecting historical circumstance more than a consistent logical pattern. According to a recent Tax Foundation report, some 19 states have adopted static conformity with respect to individual tax provisions, 18 have adopted “rolling” (dynamic) conformity, and only four selective conformity, with a handful of states not fitting perfectly into any single category. Since the 2017 Tax Act broadened the tax base, while reducing tax rates, the rolling or dynamic states (who in theory benefit from base broadening while still setting their own independent tax rates) would in this case come off better than those using a static model. But this conclusion relies on many assumptions, including the effect of the 2017 changes on personal exemptions and the standard deduction (which show up in taxable income but not AGI) and State conformity to changes in Federal business tax provisions. States using selective conformity would have the best deal of all, assuming that they chose to embrace the revenue-enhancing provision but not revenue losers, although this is not always politically possible.
For States seeking new revenues — as many will be in the post-COVID era — it would seem logical to adopt a selective approach looking forward, allowing the State to follow changes that add revenue and avoid those with the opposite effect. There is admittedly a problem here in that it is hard to predict the nature and extent of Federal tax changes. Like States, the Federal Government faces conflicting pressures, needing revenue enhancers to offset the losses resulting from COVID, but at the same time coming under enormous pressure for individual and corporate tax relief. A selective approach would allow a State to hedge its bets, metaphorically speaking, rather than adopting all Federal changes (dynamic conformity) or presumptively rejecting them (static conformity). Of course, this approach assumes that the State Government has sufficient political clout to enact the changes it likes and reject those it doesn’t.
Details. — An immediate conformity problem presents itself in connection with the Federal Coronavirus Aid, Relief, and Economic Security (CARES) Act, enacted this Spring. The most visible example concerns the tax status of Economic Impact (“Stimulus”) Payments (EIP) as well as loans provided under the Paycheck Protection Program (PPP) of the Small Business Administration, which help businesses meet payroll in the COVID crisis. Federal law provides that EIP payments are tax-free and that the cancellation of loans made under the PPP program is likewise exempt from tax. It seems unlikely any State would tax the EIP payments, except perhaps in extraordinary cases. But the PPP rules are a little bit more complex, providing that cancellation of the loans will not be taxable under section 61(a)(12), but somewhat unclear as to the extent that related interest payments will be nondeductible under section 265, which prohibits deductions related to tax-exempt income. (See IRS Notice 2020–32, April 30, 2020). There may accordingly be room for States to take a more assertive position in this area.
The CARES Act also makes other temporary and permanent amendments to the Federal tax laws, including changes to business interest deduction rules (sec. 163), Net Operating Losses (sec. 172), charitable deductions (sec. 170), and several employer-related provisions, most of which are (understandably) of a pro-taxpayer, revenue-reducing variety. These provisions put States in a more difficult position, appearing heartless to taxpayers if they do not conform to the new rules, but further reducing their early shrunken revenues if they don’t. States in need of more revenue may wish to reject some or all of these changes, particularly as they tend to affect primarily wealthier taxpayers, and are likely to be largely invisible to the average voter. Refusing to adopt all of some of these changes would appear to involve fewer political risks than (say) a divergence with respect to the PPP rules.
Additional Reading. — More detailed treatment of conformity and COVID is provided by Adam Thimmesch, “Taking Control of the State Tax Base During The Pandemic,” http://surlysubgroup.com (May 11, 2020) and, with respect to GILTI, by Darien Shanske in several prior posts on this blog. A more comprehensive treatment of the theory and practice of conformity is Ruth Mason, “Delegating Up: State Conformity With The Federal Tax Base,” 62 Duke L.J. 1267 (2013).
