The federal tax reform bill, H.R. 1, formerly known as the Tax Cuts and Jobs Act, created a new individual income tax deduction codified as section 199A. The deduction is equal to 20 percent of qualified business income received from a sole proprietorship, partnership, limited liability company, S corporation, cooperative, real estate investment trust, or publicly traded partnership. Structurally, the deduction is a below-the-line item that directly adjusts federal taxable income under section 63(b), and is not taken until after the computation of adjusted gross income under section 62(a). At the federal level, this approach has minimal impact other than allowing individuals who do not itemize to claim the deduction; however, from a state and local tax perspective, the subtle difference between a reduction to adjusted gross income and a reduction to taxable income can result in a substantial difference.
Although the computational relationship between federal and state individual income tax is often described as conformity, many states do not actually directly adopt the provisions of the IRC. Instead, the most common approach is for a state to adopt a starting point for the state tax computation that is tied to a line item on the federal return, and then require state-specific modifications. Of key importance to the application of the section 199A deduction at the state level, most states, including New York and California, use federal adjusted gross income as their starting point. In these states, individual taxpayers would not benefit from the section 199A deduction absent a change in the law at the state level either conforming specifically to the deduction or creating a similar state-level deduction tied to the federal code. As of the date of this article, no state has proposed the requisite legislative changes.
Businesses can consider a number of steps now in analyzing state section 199A impact:
- Review the starting point for the states in which you file to determine whether it is an adjusted gross income or taxable income state. To the extent that you live in, or file as a nonresident in, an adjusted gross income state, be prepared to utilize a tax base without the 20 percent section 199A deduction in computing estimated and final tax.
- When considering the application of the credit for income tax paid to another state in your state of residence, remember that no credit is granted for tax on income that was not also taxed by your home state. Accordingly, if you file as a non-resident in an adjusted gross income state that does not allow the deduction and is a resident of a taxable income state that does allow the deduction, be aware that your home state may not grant you a credit for the tax paid to the nonresident state on the section 199A deductible amount.
- Stay up to date on the issue as 2018 state legislative sessions progress. Some adjusted gross income states may pass legislation to allow the deduction before the end of the calendar year. Alternatively, the small number of states that start from taxable income may pass legislation requiring an additional modification for the amount of the deduction.
Taxpayers with questions should reach out to their tax advisors with questions.
As state legislatures begin to analyze and respond to federal tax reform, stay up to date with the latest reform developments from RSM’s Tax Reform Resource Center.