Why federal tax reform matters to Colorado

One of the outcomes of last November’s election is that the near-term prospects for comprehensive federal tax reform increased considerably.

While most of the attention has been focused on federal tax impacts of reform, it is worth noting that, if enacted, any federal reform will have significant impacts on states and their income tax structures.

As a result, tax and finance leaders at companies should proceed with some dispatch in analyzing the potential impacts at the state level and the effect on a company’s state tax position of the current proposals.

Nearly every state that imposes a corporate income tax conforms to the federal internal revenue code. In large part, states begin the computation of state corporate taxable income with federal taxable income and, therefore, allow – for state tax purposes – many federal deductions. States do not generally conform to federal tax credits, such as those for alternative energy sources. In short, changes to the federal tax base may well have an impact on state taxes, but changes to federal credits and federal rates are unlikely to have a direct impact on state taxes.

Several other considerations will influence whether and how federal changes are likely to affect state taxes and whether they will be adopted by the states. These include:

• States tend to “pick and choose” the provisions to which they conform. States will often decouple from federal deductions that decrease federal taxable income, such as bonus depreciation and the Domestic Production Activities Deduction, because of the impact on state revenues.
• Nearly every state is required to maintain a balanced budget (i.e., they are restricted in borrowing for operating purposes). Also, fiscal observers estimate that more than 30 states are currently experiencing budget shortfalls, meaning expected revenues are less than expected expenditures in the current fiscal year. Together, these realities could make states somewhat risk averse in adopting changes with uncertain outcomes.
• Various features of state tax systems (e.g., combined reporting and the degree to which states bring foreign source income into the base) will cause certain provisions under consideration (e.g., interest expense disallowance, territorial tax system) to have a differential effect across states. In addition, the impact in a given state will depend on the degree to which it currently conforms to the federal tax.
• A major challenge to states will be timing, meaning when Congress will pass reform (if they do) and when will it become effective? It seems quite likely that if federal reform is enacted in 2017, it will be after most legislatures have adjourned so the opportunity for states to respond until 2018 will be limited.

The net result of all these factors?

The outlook for state corporate taxes will be highly uncertain for the next few years. There will be doubt as to whether federal reform will be passed; what it might contain; how it will affect the states; whether they will choose to adopt the federal model; and when the states might make determinations of how they will respond to a potential reform.

While the outlook is unclear, sitting back and waiting to see how things unfold is not a winning strategy.