The Conference Report to H.R. 1, the “Tax Cuts and Jobs Act” (the “Act”), which was agreed to by House and Senate conferees on December 15, 2017, passed the Senate on December 19, 2017, and passed the House on December 20, 2017. The Act enacts the most sweeping federal tax reform since 1986. President Trump signed the bill into law on December 22, 2017. This Alert discusses particular problematic state and local tax issues that could be presented for individuals, including S corporation shareholders and individual partners/members of other pass-through entities (“PTEs”), as a result of two new international tax provisions in the Act.
For personal income tax purposes, most states will begin the calculation of state taxable income with an individual’s federal adjusted gross income as determined under the Internal Revenue Code (the “IRC”). A handful of states calculate an individual’s state taxable income starting with their federal taxable income. To this starting point, states will provide various addition and subtraction modifications to ultimately arrive at state taxable income. However, the IRC may mean different things for different states and taxpayers.
For example, a state may adopt “rolling” conformity, which means it will adopt a definition of federal adjusted gross income (as well as addition and subtraction modifications) on the basis of the IRC “as amended.” Such states could automatically conform to the federal tax reform changes contained in the Act unless they enact legislation to expressly decouple from the particular aspects of the Act (most of which will be effective for taxable years beginning after December 31, 2017). Other states conform to the IRC on a “fixed date” basis. For example, if a state’s definition of federal adjusted gross income (as well as addition and subtraction modifications) is to the IRC “in effect on” or “as amended through” December 31, 2016, that state will not conform to any of the federal tax reform changes in the Act unless or until the state updates its conformity date or enacts specific legislation adopting a federal change. Other states only adopt or conform to specific IRC sections on a rolling or fixed date conformity basis.
Whether any change in the Act will have an impact on a state personal income taxpayer will initially be determined on the basis in which the states, where the taxpayer is a resident and/or earns income and has a personal income tax return filing obligation, conform to the IRC.
Deemed Repatriation Transition Tax
The Deemed Repatriation Transaction Tax (the “DRTT”) enacted by the Act presents an immediate 2017 state tax issue for individuals, shareholders of S corporations, and individual owners of other pass-through entities (e.g., partnerships or LLCs taxed as partnerships) that are 10 percent or more shareholders in foreign corporations with deferred foreign earnings.
In brief, under the new IRC § 965(a), a “deferred foreign income corporation” (DFIC) is deemed to repatriate all of its post-1986 accumulated foreign earnings and profits (E&P) to a “U.S. shareholder.” A “U.S. shareholder” is defined in IRC § 951(b) and is generally a U.S. person that owns 10 percent or more, by vote or value, of the voting stock of a foreign corporation, taking into account the ownership attribution rules of IRC § 958. A “U.S. person” includes an individual, S corporation, partnership, or limited liability company (LLC). Therefore, an individual, S corporation or other pass-through entity (PTE) that owns 10 percent or more, by vote or value, of the voting stock of a foreign corporation will be a U.S. shareholder for purposes of the DRTT of new IRC § 965.
The U.S. shareholder first determines its pro rate share of the DFIC’s post-1986 accumulated foreign E&P. This “inclusion amount” is treated as an increase to Subpart F income and is included in federal gross income of the shareholder under IRC § 951. Next, to arrive at the effective 15.5 percent or eight percent tax rates, the shareholder is allowed a deduction under new IRC § 965(c) based on a calculation referenced to the shareholder’s aggregate foreign cash position equal to an amount that results in an effective tax rate of 15.5 percent on foreign E&P held in cash or cash equivalents and/or eight percent on foreign E&P held in other property. Lastly, the shareholder may elect to pay the transition tax currently or in eight annual installments under new IRC § 965(h).
The “inclusion year” for the deemed repatriation “inclusion amount” that is included in a U.S. shareholder’s Subpart F income is the last taxable year of a DFIC that begins before January 1, 2018. As a result, for most U.S. shareholders, the inclusion year for the deemed repatriation is 2017 (although a U.S. shareholder could have an inclusion in more than one taxable year). Thus, a state’s method of conformity (“rolling,” “fixed-date,” or other) takes on added significance for determining whether, as an initial matter, the deemed repatriation could be included in a state’s personal income tax adjusted gross income starting point for an individual’s 2017 state taxable year.
Treatment of Subpart F Income for State Personal Income Tax Purposes
While a number, but certainly not all, of states will wholly or partially exclude federal Subpart F income from a C corporation’s state taxable income, these exclusions or deductions often do not apply to individuals for personal income tax purposes. As a result, individuals in that capacity or that are shareholders in S corporations or partners/members of a PTE that are U.S. shareholders with respect to a DFIC that has a 2017 IRC § 965 DRTT “inclusion amount” could also realize a significant state personal income tax impact from the DRTT. Therefore, because few states exclude Subpart F income for personal income tax purposes, it is important for such individuals to determine whether states in which they will be filing personal income tax returns are “rolling” IRC conformity states or “fixed-date” IRC conformity states.
In addition to whether an IRC § 965(a) “inclusion amount” is included in an individual’s state taxable income, an individual will need to determine whether a state will recognized the IRC § 965(c) “participation exemption” deduction.
Further, the federal tax impact of the DRTT for shareholders of S corporations is eased by allowing an election under IRC § 965(i) to defer payment of such shareholder’s net tax liability arising under IRC § 965(a) until a “triggering event” occurs. A “triggering event” is defined to include (a) the S corporation ceases to be an S corporation; (b) a liquidation, dissolution, or sale of substantially all of an S corporation’s assets; or (c) a transfer of any share of stock by the shareholder. Once a triggering event occurs, the S corporation shareholder may also elect to pay his or her federal net tax liability in eight annual installments. While an individual in that capacity or partner/LLC member does not have the same “triggering event” deferral election, the individual may still elect to pay the DRTT liability in eight annual installments.
While these deferral elections help ease the federal tax impact of the DRTT, they may not apply at the state level. Rather than being a deferral from inclusion in federal gross income, the election defers the payment of a federal tax liability. As such, the election does not impact a state’s inclusion of the DRTT “inclusion amount” in an individual’s federal adjusted gross income state starting point. It is an election to defer payment of the increase in a U.S. shareholder’s federal tax liability as a result of the DRTT, not an increase in a U.S. shareholder’s state tax liability. Therefore, absent affirmative state action by legislation, or administrative guidance at a minimum, it is questionable that the IRC § 965(h) election to pay the DRTT in installments or the IRC § 965(i) triggering event election for S corporation shareholders will apply at the state level.
Individuals that receive flow-through of an IRC § 965(a) “inclusion amount” of Subpart F income from S corporations or other PTEs and that file personal income tax returns with states that are “rolling” IRC conformity states could also have a state personal income tax liability as a result of the DRTT, but without any corresponding state tax payment deferral election(s).
Global Intangible Low-Taxed Income
The Act also imposes another special tax on global intangible low-taxed income (GILTI). The Act amends Subpart F of the IRC to include a new IRC § 951A to add the GILTI tax. Generally, the tax is at a 10.5 percent rate on a U.S. shareholder’s share of a CFC’s GILTI and, while similar to Subpart F income and treated as such for certain purposes, GILTI is not included in federal gross income under IRC § 951 nor included in the definition of “subpart F income” under IRC § 952. The amount of GILTI and corresponding federal tax is a complicated calculation, but generally impacts U.S. shareholders of CFC’s that have a heavy concentration of intangible assets compared to fixed/tangible assets (or high income relative to low depreciable assets). Like the DRTT, GILTI is included in the U.S. shareholder’s federal gross income under new IRC § 951A, and then a new deduction is provided under new IRC § 250 in an amount under a calculation that arrives at the 10.5 percent effective rate of tax on the GILTI. Unlike the DRTT, the GILTI tax is effective for taxable years beginning after December 31, 2017.
However, the same problem that will confront individuals, including shareholders of S corporations and partners/members of other PTEs, for federal income tax purposes with respect to GILTI will also confront them for state personal income tax purposes. The GILTI deduction under IRC § 250 is contained in Part VIII, Subchapter B of the IRC, “Special Deductions for Corporations.” New IRC § 250(a)(1) clearly provides that the deduction is applicable to “a domestic corporation for any taxable year.” The Conference Agreement to the TCJA explains that, because the GILTI deduction is a “special deduction” under Part VIII, Subchapter B, it is available only to C corporations. “An S corporation’s taxable income is computed in the same manner as an individual (sec. 1363(b)) so that deductions allowable only to corporations, such as FDII and GILTI, do not apply.” As a result, an individual or S corporation (or other PTE) that is a U.S. shareholder of a CFC with GILTI will have an IRC § 951A income inclusion, but no corresponding IRC § 250 deduction for federal and state tax purposes.
For the same reasons that a state is likely to include the DRTT “inclusion amount” in an individual’s federal adjusted gross income starting point, GILTI is also likely to enter into an individual’s state adjusted gross income starting point, but without offsetting deduction. Similar state IRC conformity evaluations applicable to the DRTT will need to be applied by taxpayers that are individuals, including shareholders of S corporations or partners/members of other PTEs, and subject to the provisions of the new federal GILTI tax.
• Obviously, the federal tax reform changes enacted by the “Tax Cuts and Jobs Act” will impact all federal taxpayers immediately. However, taxpayers should also account for the impact of the federal changes on their state personal income taxes, especially state tax treatment of S corporations and PTEs.
• Despite the differences in how rolling conformity, fixed date conformity, and other states conform or decouple from the IRC, it is expected that state legislatures, most of which will be convening new legislation sessions starting in January 2018, will have an active legislative season as states address their conformity to or decoupling from the myriad federal tax reform changes.
• Individuals, S corporation shareholders, and individual partners/members of other PTEs must evaluate the state tax impact of the new federal DRTT and GILTI provisions.