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INSIGHT: 2020 Vision for State and Local Tax

December 27, 2019, Bloomberg Tax: Daily Tax Report

The 2017 tax law and the 2018 Wayfair decision continue to reverberate through state and local taxes. In this state and local tax Outlook, Leighanne Scott of Caplin & Drysdale highlights what are expected to be the top five initiatives in 2020.

It is that time once again—the time where tax professionals peer into the proverbial crystal ball to predict future developments in the coming year. Admittedly, the SALT crystal ball has been working overtime since 2017 with the advent of the TCJA and the seminal 2018 Wayfair decision. With such significant developments in the past, is it safe to assume one can expect a quiet 2020 for SALT? From my SALT view, the answer is a resounding “no.” Unlike any other time in recent tax memory, SALT is at the forefront of a national dialogue on tax policy. In the highlights that follow, expected developments for 2020 reflect the increasingly important topic SALT has become at a national and local level.

Top 5 SALT Initiatives for 2020

1. State Tax Deduction Limitation
2. Residency Audits
3. GILTI Apportionment Factor Inclusion
4. Wayfair Enforcement
5. Economic Nexus for Income Tax

State Tax Deduction Limitation

The limitation on the deduction for state taxes has the attention of taxpayers and state legislators alike and will continue to do so in 2020. As we know, the Tax Cuts and Jobs Act (TCJA) significantly restricted the ability of individuals to deduct state taxes paid within their federal income tax return. For residents of jurisdictions with high tax rates and correspondingly high property values, the state tax deduction cap is of such concern that local lawmakers are continuing to pursue relief measures, almost two years after adoption of the TCJA, that will pass scrutiny by Treasury and the Internal Revenue Service.

Identifying a solution that is both permissible for federal purposes and responsive to concerns posed by residents of high tax jurisdictions has proven to be a substantive challenge for state legislators. Specific efforts to mitigate the impact of the state tax cap have ranged in viability and complexity alike. They include, but are not limited to, legislative action to increase and/or repeal the cap, judicial action, in lieu of taxes, and introduction of pass-through entity (PTE) tax regimes.

On Dec. 19, the House approved the Restoring Tax Fairness for States and Localities Act (H.R. 5377), a bill that seeks to repeal the SALT deduction limitation for 2020 and 2021 while also retroactively increasing the limitation for 2019 to $20,000 for persons filing a joint return. H.R. 5377 also carries a top marginal income tax rate increase to 39.6% as an offset to lost revenue from the cap’s repeal. Passage in the Democratic majority House was expected, as leaders in large democratic states have argued that their residents have been severely impacted by the cap. As the bill moves to the Senate, though, it is unlikely to be approved by the Republican majority. Both the Senate and the White House have indicated little support for the measure. Thus, we can expect to see the legislative dialogue continue into 2020.

While lawmakers seek compromise on the SALT deduction limitation, we should continue to see judicial developments related to the limitation in 2020 as well. The first major legal challenge to the cap was brought by a collective of states including New York, Connecticut, Maryland, and New Jersey in July 2018. Within the suit, the states claimed that Congress did not have the authority to limit the state tax deduction and in doing so, was attempting to force the states to make responsive policy changes. On Sept. 30, 2019, a federal judge dismissed the suit finding no basis that Congress had exceeded its authority or that the state and local deduction limitation was unconstitutionally coercive. Following the dismissal, the states joined in a now-pending appeal to the U.S. Court of Appeals for the Second Circuit.

With expeditious resolution unlikely at the legislative or judicial level, is the state deduction cap simply a new normal? It is admittedly difficult to provide an unequivocal yes, but one solution may come in the form of elective PTE taxes. As surveyed in Bruce Ely and Kelvin Lawrence’s, A More Viable SALT Cap Workaround? Pass-Through Entity-Level Taxes, certain states have chosen to pursue PTE level taxes as a way to limit the impact of the state tax cap. Rhode Island, Louisiana, Oklahoma, and Wisconsin have all passed measures to adopt elective PTE taxes which generally permit a credit or exclusion to the individual owners of the entities for taxes paid. Connecticut also provides for a PTE tax, but it has a notable difference in that it is not elective. To date, Treasury has not opined on PTE taxation as an indirect method by which the state tax cap is lifted.

Of the proposed responses to the state tax deduction cap, the elective taxation of PTEs is predicted to expand to more states in 2020. The taxation of PTE’s at the entity level is not novel to the TCJA response. In fact, it is a longstanding regime in state and local tax. Specifically, the District of Columbia and New York City have imposed unincorporated business entity taxes (UBT) since 1947 and 1966, respectively. If there is a compromise to be found, it may rest with elective PTE tax regimes that are consistent with federal law and historical precedent, while being responsive to concerns posed by those impacted by the cap.

Residency Audits

Residency audits of high net worth individuals have been a focus at the state level for a number of years. With the passage of the TCJA and the limitation of the state tax deduction, residents are now increasingly seeking more taxpayer-favorable jurisdiction in which to lay their head…and file their tax returns. The challenge for state taxing authorities is that every departing resident means lost revenue. Participating in a residency audit is typically a long and arduous process for the taxpayer, but bears significant fruit for the state. New York estimates that in recent years, residency audits have resulted in significant revenue generation for the state—in excess of $1 billion dollars.

With high profile residents publically expressing their intent to depart states such as New York and California for low-tax jurisdictions such as Florida, we should expect states to increase their focus on residency audits in 2020.

GILTI Apportionment Factor Inclusion

As we near the end of 2019, most states have answered the primary question of whether and how global intangible low-taxed income (GILTI) is included in the respective jurisdiction’s tax base. What is less than clear, yet carries great significance, is an outstanding question on apportionment representation. To the extent a state has chosen to include GILTI within its tax base, it must also consider factor representation—likely in the form of a corresponding rule whereby GILTI income is includable in the sales factor denominator. Factor inclusion by the states would address the longstanding argument of parity; that is, if an item of income is included in the tax base, the apportionment factor to be applied against that base should also be representative of the income to which it is applied.

On its face, this may appear to be a straightforward fix for a taxing authority—perhaps simply a notice to be issued by the respective state that clarifies GILTI income is to be included in the sales factor denominator. (Barring a special and unique circumstance, the sales factor numerator inclusion for GILTI is zero.) Such a thought is deceptively simple. In addressing apportionment of GILTI, a state is likely going to have to consider issues related to:

  • gross versus net inclusion,
  • section 250 deduction treatment, and
  • application of the sales factor to total income versus stand-alone GILTI income.

In recent months, certain states that tax GILTI such as New Jersey and Nebraska have attempted to address the apportionment factor question. In 2020, we should expect to see additional states address this question—either as an issue of first impression or as a revision to prior administrative positions as application challenges are raised.

Wayfair Enforcement

The Wayfair decision is often referred to as the TCJA of the states and for good reason. It dramatically changed the foundational principles of nexus for sales and use tax by applying economic nexus rules to sales tax for the first time since the 1992 Supreme Court decision in Quill.

In the year following Wayfair, most states have now passed responsive legislation that generally adopts a revenue and/or transaction threshold as a trigger for sales tax nexus. Why then is this a forward looking topic if most states have addressed the issue? The answer lies in audit initiatives. In 2020, we should expect the Wayfair dialogue to shift from nexus to enforcement. Initial reports from the states suggest that voluntary compliance with the Wayfair laws has resulted in a significant increase to state coffers. It follows that states will continue to direct resources toward the audit function to increase collection results. In fact, certain jurisdictions have already begun to audit compliance and this should only increase in the coming months.

Economic Nexus for Income Tax

Historically, the state tax community had often debated the issue of whether Quill—as a sales tax case—could reasonably stand for the premise that physical presence was also a pre-requisite for income tax nexus. While that debate ensued, certain states went forward with adopting rules that replaced a physical presence standard with an economic one. Jurisdictions like Washington adopted gross receipts thresholds for the B&O tax, while other states like California imposed factor presence standards where receipts in excess of a certain amount, (generally $500,000) were enough to establish income tax nexus.

Post-Wayfair, it did not take long for additional states and localities to expand the notion of economic nexus to income tax. States and cities such as Hawaii, Pennsylvania, Philadelphia, Massachusetts, Oregon, San Francisco, and Texas have either passed or proposed legislation to formally adopt economic nexus standards for income tax. We should expect to see additional states in 2020 to follow suit and clarify the standards of nexus for income tax filers.

The Steiners [Hope] to Go to Washington

Outside the thematic initiatives we can expect in 2020, one of the more interesting cases to watch in the continuing line of Commerce Clause decisions is Steiner v. Utah State Tax Commission. The Steiners were residents of Utah and shareholders in an entity taxable as an S corporation. Within their Utah individual income tax return, the Steiners reported credits for state tax paid, while also deducting their share of the S corporation’s foreign sourced income. Because Utah does not provide for a foreign tax credit, the Steiners exclusion of foreign sourced income from Utah taxable income was based on an equitable argument against discrimination. That is, pursuant to the Foreign Commerce Clause, Utah cannot permit a credit for state tax paid while denying the same for foreign taxes.

The Utah State Tax Commission disagreed and the Steiners appealed to the Utah Tax Court where they prevailed. In a well-reasoned decision consistent with Wynne, the Tax Court held that Utah could not discriminate between foreign and domestic credits for tax paid. On appeal to the Utah Supreme Court, the Utah Supreme Court reversed the Tax Court’s decision on the basis that the Foreign Commerce Clause is inapplicable to individuals.

Given the Utah Supreme Court’s decision directly contravenes Wynne, the Steiners intent to file a writ of certiorari with the U.S. Supreme Court is one to watch—in the hopes that the high court will continue to remain consistent—about inconsistency.

Conclusion

2019 saw no lessening of state tax issues, even as time increasingly passed from the adoption of the TCJA and the Wayfair decision. The prediction for 2020 is more of the same—policy debates around the state tax deduction cap, TCJA conformity considerations, nexus expansion, and audits seeking to ensure compliance with each. All make for an exciting year to come in state and local tax.

Reproduced with permission from Copyright 2019 The Bureau of National Affairs, Inc. (800-372-1033) http://www.bna.com/.

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