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Editorial 6 MIN READ

State conformity to federal tax changes, the lag problem

Why the state income-tax base sometimes drifts from the federal one for years, and what pass-through owners should know before filing

The Editors
Staff, Incorporator.org
6 min read Updated
Contents 5 sections
  1. Three ways a state can conform
  2. Where the friction actually shows up
  3. What this means for a pass-through owner
  4. The year this gets interesting
  5. Sources

wo taxpayers with identical federal returns can owe different state tax on the same dollar of income, and the reason is almost never policy. It is a calendar problem. Forty-one states levy a broad-based income tax, and they disagree about how, and how quickly, their taxable-income definition tracks the Internal Revenue Code.

This matters right now because Congress is actively drafting a tax bill, state legislatures are adjourning, and the owners of LLCs, partnerships, and S corporations are the ones who will wear the difference on a Schedule K-1 next April.

Three ways a state can conform

A state's corporate or individual income tax typically starts from a federal number — federal taxable income for corporations, federal adjusted gross income or federal taxable income for individuals — and then adds and subtracts its way to a state-specific base. The question is which version of the Code the state is pointing at when it does that.

Rolling conformity. The state statute references "the Internal Revenue Code" or "the Internal Revenue Code as in effect," full stop. Whatever Congress enacts is adopted automatically, subject to any provisions the state has specifically decoupled from. About twenty states and the District of Columbia sit in this bucket. The Tax Foundation's most recent survey lists Alabama, Alaska, Colorado, Connecticut, Delaware, Illinois, Kansas, Louisiana, Maryland, Massachusetts, Missouri, Montana, Nebraska, New Mexico, New York, North Dakota, Oklahoma, Rhode Island, Tennessee, and Utah, plus D.C.

Fixed-date (static) conformity. The statute references the Code "as amended through" a specific date. Any federal change after that date does not take effect for state purposes until the legislature passes a bill updating the date. Roughly twenty states use this model, including Arizona, Florida, Georgia, Hawaii, Idaho, Indiana, Iowa, Kentucky, Maine, Michigan, Minnesota, New Hampshire, North Carolina, Ohio, Oregon, South Carolina, Vermont, Virginia, West Virginia, and Wisconsin. The conformity dates are never the same. Virginia, for instance, advanced from the Code as amended through December 31, 2015 to December 31, 2016 only in February this year — via emergency legislation, House Bill 1521, signed by Governor McAuliffe on February 3 and documented in Virginia Tax Bulletin 17-1. Minnesota, as of this writing, still points at the Code as amended through December 16, 2016, which is why its conformity debate will run deep into the summer.

Selective conformity. A handful of states (Arkansas, California, Mississippi) do not wholesale-adopt the Code at all. They incorporate individual federal provisions by section, on their own schedule. California's selective conformity is the best-known example; its general conformity date for incorporated IRC sections is January 1, 2015, which means California practitioners spend a meaningful part of their year explaining why a federal change from 2016 does not apply in Sacramento.

Where the friction actually shows up

Conformity looks abstract until you follow a specific deduction through it. Three make the pattern clear.

Section 179 expensing. The federal immediate-expensing cap is $510,000 for 2017, with the phase-out beginning at $2,030,000, per Rev. Proc. 2016-55. The Tax Foundation's most recent state-by-state count finds twelve states plus D.C. sitting below the federal limit. Arizona is at $120,000; Arkansas, California, Hawaii, Indiana, Kentucky, Maryland, New Hampshire, New Jersey, and D.C. are at $25,000; Florida is at $128,000; Georgia is at $250,000; and Minnesota is at $196,000. A single-member LLC in New Jersey that buys $200,000 of qualifying equipment writes the whole thing off federally and $25,000 of it for New Jersey, with the rest depreciated under regular MACRS. The difference is real money that hits the owner's 1040 twice, once correctly and once according to the state's add-back.

Bonus depreciation under § 168(k). Federal bonus depreciation is scheduled at 50% for 2017 under the PATH Act of 2015. A long list of states have decoupled, sometimes for over a decade. Virginia has disallowed bonus depreciation in full since the 2001-era enactment and continues to do so under Tax Bulletin 17-1. Maine has required an add-back for bonus depreciation since tax year 2002. Pennsylvania, Maryland, North Carolina, and New Jersey all maintain their own variants of the add-back, each with its own recapture-schedule arithmetic.

The § 199 domestic-production deduction. Enacted in 2004 and phased up to 9%, it drops "qualified production activities income" for federal purposes. Twenty-one states and the District of Columbia have decoupled from it, by the Center on Budget and Policy Priorities' 2013 count — Texas does not conform, Pennsylvania conforms only on the corporate side and not under its personal income tax, and several states require an explicit add-back on the state return. A manufacturing S-corp with shareholders in multiple states routinely takes the § 199 deduction on Form 1120-S, sees it flow through to the shareholders' federal returns, and then has to reverse it for several of the states where those shareholders live.

What this means for a pass-through owner

The practical consequence is that the state K-1 is not a scaled version of the federal K-1. It is a separate calculation, and the gap is widest in exactly the cases owners care most about — the year a new piece of equipment is bought, the year a building is placed in service, the year a section 199 deduction is claimed. A well-run CPA practice already maintains separate state depreciation schedules for the decoupled provisions; a less-well-run one discovers them during an audit letter.

The lag also operates asymmetrically. In a year when Congress expands a federal benefit, fixed-date states default to not granting it, and the state base is broader than the federal base until the legislature catches up. In a year when Congress narrows a benefit, fixed-date states can end up temporarily more generous than the federal baseline. Either direction creates an owner-level surprise — income the state taxes that the federal government doesn't, or vice versa.

The year this gets interesting

The House Republican "Blueprint" released last June, the Administration's one-page outline released in April, and the ongoing Ways and Means drafting all point at a large base-and-rate rewrite moving sometime in the next twelve to eighteen months. If any substantial version passes, rolling-conformity states will absorb its entire base-change by default and scramble to decouple from the parts they can't afford. Fixed-date states will face the reverse problem: their legislatures, most of which meet briefly, will need to pass a conformity-update bill before filing season, or every state return that year will require a long list of add-backs and subtractions keyed to the prior-year Code. Minnesota's spring debate is a preview; Virginia's February emergency bill is another.

For anyone forming or restructuring an entity this quarter, the takeaway is narrow. The state of formation almost never determines your state conformity treatment; your state of residence (for individuals) and your apportionment factors (for the entity) do. Delaware is a rolling-conformity state, but forming in Delaware does nothing for an owner in Minnesota or Virginia whose K-1 income is apportioned home. Picking a state for formation on conformity grounds is a category error. Picking a CPA who maintains separate state depreciation schedules is not.

If Congress does move a bill this fall, the first question to ask your preparer in December is not "what does it do federally," but "what has my state done about it yet." In more than half the country, the answer in December will be "nothing, check back in March."

Sources

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