The sweeping overhaul of the federal tax system included a host of provisions that will require New York to decide whether to decouple its tax code, amend it, or allow the federal changes to take effect as-is.
The limit on federal deductibility of state and local taxes has generated significant attention in New York because it could cost state taxpayers some $14 billion. However, the 2017 federal tax act ( Pub. L. No. 115-97) has raised dozens of conformity issues, including several personal income tax provisions and several business tax provisions, according to a recent report from the state Department of Taxation and Finance.
If the state does nothing, personal income tax revenue would increase by an estimated $1.5 billion as a result of the federal law, according to the report. Business tax revenue would rise by $52.5 million to $112.5 million.
E.J. McMahon, research director at the Empire Center for Public Policy, a conservative-leaning think tank, said the tax conformity issues raised by the federal law would be the primary focus of New York tax policy in most years. Instead, the state and local tax deduction (SALT deduction) issue—and the related proposals to shift the state’s reliance away from the personal income tax—has drawn the lion’s share of attention, he said.
“All the governor’s talk about exploring alternative tax systems has basically distracted and diverted attention from the far more important and immediate issue of conformance,” McMahon told Bloomberg Tax Jan. 19.
Using a Sherlock Holmes analogy, he said tax conformity is “the dog that wasn’t barking.”
Gov. Andrew M. Cuomo (D) is expected to propose measures for handling the conformity issues and the SALT issues when he releases 30-day amendments to his proposed budget, Morris Peters, a spokesman for the Division of the Budget, told Bloomberg Tax.
The 30-day amendments normally give a governor the chance to clean up budget language and make relatively small changes to the proposed budget. This year, however, the 30 days has given the state additional time to analyze the impact of the federal tax law, which President Donald Trump signed Dec. 22, 2017, less than a month before Cuomo released his FY 2019 budget.
“We’re looking at all of it,” Peters said in a Jan. 19 email. “Rather than attempting to haphazardly address every impact of the bill on New York in less than a month, we appropriately chose to analyze the bill thoroughly and solicit feedback from outside experts.”
The state Senate unanimously approved a bill ( S. 6974) Jan. 23 that would resolve the conformity issues by simply coupling the state tax code to the federal code prior to enactment of the new federal law. The measure, which faces an uncertain future in the state Assembly, was put on a fast track for approval.
A second bill ( S. 6951), which is in committee, would create a state tax credit equal to any increase in tax liability resulting from the federal law.
Single Filers Hit
The biggest hit to state taxpayers involves elimination of the federal personal exemption and how that will impact the state’s standard deduction for single filers.
The state Tax Department estimates that 5.2 million taxpayers will see their tax liability increase by $840 million if the state doesn’t make any changes.
New York law only allows single filers to take the standard deduction, which is $8,000, if they aren’t married, nor the head of a household, nor “an individual whose federal exemption amount is zero,” the Tax Department report said.
“Absent a state statutory change, single taxpayers will be required to claim the lower deduction intended for dependent filers, $3,100 in 2018,” the report said.
However, several state business tax provisions raise conformity issues for New York.
For example, the new federal law’s deemed repatriation provisions for deferred foreign income may provide the state with a $60 million revenue increase from the interest expense attribution related to deferred foreign income, according to the Tax Department report.
The law requires U.S. shareholders owning at least 10 percent of a foreign subsidiary to include as Subpart F income the shareholder’s pro rata share of accumulated foreign-subsidiary earnings and profits, the report said. The shareholder is allowed a separate dividends-received deduction under tax code Section 965(c) for a portion of the foreign earnings and profits.
The companion deduction, however, “has caused uncertainty and poses a separate fiscal risk to the state,” the report said. Generally, New York taxpayers must add back dividends-received deductions taken at the federal level, but it remains unclear “whether this new deduction can be characterized as a dividend,” according to the report.
New York taxpayers stand to receive a double benefit if it isn’t a dividend, the report said. The income reported through Subpart F would be exempt from state tax, but the deduction “would have already been removed from the starting point at the federal level,” giving New York taxpayers both a deduction and an exemption.
The report recommended state legislation to require a new statutory income add-back for the Section 965(c) deduction to block “an inappropriate windfall” to taxpayers, “provide the greatest clarity to taxpayers,” and offer “the most secure approach to resolving this ambiguity.” The amount of the state’s potential exposure from the deduction can’t be quantified at this point, according to the report.
The deferred foreign income should be exempt from New York tax because the state generally excludes Subpart F income, Kara M. Kraman, a New York-based attorney with Morrison & Foerster LLP, told Bloomberg Tax Jan. 22. But “unless the companion deduction is somehow characterized as a dividend received, or New York amends its law, taxpayers could receive an unintended windfall in the form of an exemption and a deduction for part of that exempted income,” she said in an email.
Alysse McLoughlin, a New York-based partner with McDermott Will & Emery LLP, agreed with the department’s analysis of the repatriation transition provisions. She said it’s clear under New York tax law that the entire one-time inclusion of certain accumulated earnings and profits from foreign subsidiaries should be deducted from the apportionable business income tax base as exempt controlled foreign corporation (CFC) income.
But uncertainty remains over whether taxpayers must add back the repatriation transition deduction for state tax, she told Bloomberg Tax in a Jan. 21 email.
“Thus, for example, if a taxpayer includes $100 and deducts $70 under the repatriation provisions, resulting in a total inclusion in federal taxable income of $30, New York will exclude the $100 of income but very possibly cannot require the add-back of the $70 deduction, resulting in $70 less in the taxpayer’s business income tax base,” McLoughlin said.
The uncertainty around the companion Section 965(c) deduction and the accompanying potential revenue loss from the double benefit suggests that the state Legislature “will need to take a close look” at those factors “in evaluating the extent to which the state will decouple from the federal tax reform bill,” R. Gregory Roberts, a New York-based partner at Reed Smith LLP, told Bloomberg Tax Jan. 22.
An area ripe for guidance, from either the state tax agency or the Legislature, is how to reduce the amount of Section 965(a) deferred income qualifying as exempt CFC income for state tax purposes by the amount of interest expenses attributable to that income, Roberts said in an email.
The unique nature of Section 965(a), which requires companies to include accumulated foreign earnings back to 1986, creates “some uncertainty in the statute as to how interest expenses should be attributed to the amounts included,” he said.
“Taxpayers should carefully review and consider this point, including how interest expenses were historically attributed to subsidiary capital in the pre-corporate tax reform era,” he said.
The department’s $60 million estimate of potential revenue from interest expense attribution may be inflated and should be re-examined, McLoughlin said.
“Even though the amount of the exempt CFC income may be substantially increased due to the repatriation transition provisions, the value of the assets generating that income has not changed, and there should not be a material increase in the expense attribution from those assets,” she said. “Guidance should be issued by the department to recognize this fact.”
The Tax Department report notably didn’t address the impact of the Section 965 deemed repatriation tax on taxpayers making the possible 40 percent expense safe harbor election, or the federal law’s potential effect on certain credit and incentive programs found in the New York corporate franchise tax, according to Douglas J. Upton, a New York-based associate at Mayer Brown LLP.
“We think the 40 percent expense safe harbor election is particularly notable because, although the election is revocable, some taxpayers may be caught off guard by not realizing the potential interplay of the safe harbor election and the increase to their Subpart F income through the new Section 965 provisions,” he told Bloomberg tax in a Jan. 22 email. “We look forward to additional guidance as everyone has further opportunity to digest the new federal tax provisions.”
The federal law’s requirement for current-year inclusion of global intangible low-taxed income (GILTI) by U.S. shareholders of CFCs will yield revenue for New York, but the amount would be reduced by the law’s allowance of flow-through deductions under tax code Section 250 for a portion of the GILTI and also foreign-derived intangible income (FDII), according to the Tax Department report.
$30M Revenue Bump?
The combined impact of the income inclusion and flow-through deductions would produce an estimated $30 million in revenue, the report said. But the state could capture a greater GILTI share by legislative action to decouple from the Section 250 deductions.
“If the state is looking for additional revenue, decoupling from the Section 250 deduction for GILTI and FDII is something the legislature may seriously consider, particularly since the income qualifying for the FDII regime historically has been included in the tax base and, based on the Section 250 deduction, only a portion of that income will now be included,” Roberts said.
McLoughlin said it’s also possible under New York law that “all or part of the GILTI inclusion could be excluded from the tax base,” depending on whether it’s treated as a dividend.
It doesn’t appear that New York, under current state law, will experience as significant a revenue increase as some states as a result of the new international tax provisions, Kraman said. But the Tax Department report presented the option of making certain dividends from CFCs taxable that haven’t been before, she said.
No such changes have been proposed, Kraman said, but the possibility “is worth keeping an eye out for in the future.”
Interest Expense Deduction Limit
The Tax Department report also found that the federal tax law’s limitation on deductions for business interest expenses could yield an estimated $45 million in revenue. But Peter L. Faber, a partner at McDermott Will & Emery, said that New York shouldn’t go along with the deduction limitation because it’s linked to changes in expensing that have no bearing on New York tax.
The changes introduced 100 percent temporary expensing for business assets into a federal “bonus depreciation” provision from which New York decoupled in 2003, the report said.
The interest deduction limitation is meant to avoid giving companies a double tax benefit from deducting the cost of property purchased with borrowed funds and also deducting the interest on the loan, according to Faber.
New York can decouple from the expensing provision without special legislation, Faber told Bloomberg Tax in a Jan. 21 email. If New York won’t adopt the federal expensing provision, “it should also not adopt the interest deduction limitation,” he said.
Personal Income Tax
Meanwhile, the federal law may also impact numerous provisions governing personal income taxes. The significant increase in the federal standard deduction, for instance, will require New York to make some key decisions.
Under current state law, taxpayers who take the federal standard deduction must also take the state standard deduction, which is far smaller. The state could simply eliminate the requirement, or it could raise the state standard deduction.
If the state doesn’t make any changes, it will reap a windfall of about $44 million because fewer New York taxpayers are expected to itemize and will be forced to take the state standard deduction, according to the report. The Tax Department estimates that raising the state’s standard deduction from $16,050 to $16,550 for joint filers and from $8,000 to $8,250 would cost the state $100 million.
Kraman said one thing that the Tax Department report didn’t address is the impact of the 20 percent deduction for qualified business income from pass-through entities.
At first glance, it would seem that the 20 percent deduction should have no impact on an individual taxpayer’s New York State taxable income, “since New York starts with federal gross adjusted income, which does not include the deduction,” she said.
Under the wording of New York’s itemized deductions statute, however, the 20 percent deduction may still be allowed for individuals who itemize, unless the state enacts remedial legislation, according to Kraman. “This is because although the 20 percent deduction is not an itemized deduction for federal purposes, under the existing statute, it may be treated as one for New York purposes.”
Changes in federal itemized deductions also raise conformity issues because New York uses the federal code as the base for state itemized deductions.
One big-ticket item is the $10,000 federal cap on state and local tax deductions. The federal cap will not only cost New York taxpayers an additional $14 billion in federal taxes, but it will also cost them $400 million in state taxes if the state doesn’t decouple or approve one of Cuomo’s proposed workarounds, according to the Tax Department report.
In addition, elimination of all federal miscellaneous deductions currently subject to the 2 percent floor will have a significant impact on state taxpayers, unless the state decouples or makes changes in the state code. Almost 1 million taxpayers took miscellaneous deductions in 2015 totaling $11.5 billion, according to the Tax Department report. Taxpayers would pay an additional $281 million in state taxes, without any changes, it said.
Elimination of the 3 percent limit on federal itemized deductions, on the other hand, will raise the base amount for New York itemized deductions. State revenue would decrease by $36 million, according to the report.
Fred Slater, a sole practitioner in the New York City accounting firm MS040 LLC, predicted the state wouldn’t decouple on the issue of miscellaneous deductions.
“The state audits people to death over nothing,” Slater, a frequent critic of the state Tax Department, told Bloomberg Tax Jan. 19. “They don’t want to give it to anybody,” he said, referring to the miscellaneous deductions. “They want everybody to have a standard deduction.”
Jonas Shaende, senior budget and policy analyst at the Fiscal Policy Institute, a left-leaning think tank, said the state’s goal should be to maintain the progressivity of the tax code, as it decides if and where to decouple or make changes.
For example, the federal expansion of the child tax credit makes the credit less progressive and the state should probably decouple from it, he told Bloomberg Tax Jan. 22.
Cuomo did include provisions in his budget to decouple the Empire State Child Credit from the federal credit, saying the federal change would cost the state $500 million in revenue if it was allowed to pass through to the state.
Daniel M. Dixon, of counsel at Morgan, Lewis & Bockius LLP, said decoupling from the federal code will “add a level of complexity” for taxpayers, particularly for individuals and small business.
“Taxes are difficult enough and already complex enough,” he told Bloomberg Tax Jan. 22.