State Conformity to Federal Tax Law Should Be Careful, Tailored

Ben Franklin once wrote to an associate from his time in Paris that “in this world nothing is certain except death and taxes.” Given the goings-on at the state level in response to the $3.4 trillion tax-and-spending law enacted in July, one might wonder whether Franklin today would exclude state taxes from his declaration of certainty.

The issue of conformity—the process by which states decide if and when to adhere to changes in the Internal Revenue Code—can cause complexities for taxpayers and their advisers, and may lead to some unintended consequences. We’re already seeing this play out in several states since the new law’s enactment.

State policymakers should consider delaying conformity or enacting transition rules to provide tax relief and reduce administrative burdens for taxpayers.

Conformity Considerations

Conformity generally is seen as a desirable attribute for state tax purposes because it makes tax compliance simpler when federal and state tax rules intersect. There are three types of conformity approaches that states take—rolling, static, and selective.

Rolling conformity happens when states automatically update and conform to the federal tax code as it’s amended in real time by virtue of their statutory language.

Static conformity pegs the state’s conformity to the tax code as of a certain date, which can lead to some confusion for multistate taxpayers, who must refer back to versions of the tax code as of the conformity date (which varies among the static conformity states) to calculate taxable income in these states.

Finally, selective conformity states don’t conform to the tax code broadly. Instead, they choose which provisions to which they wish to conform. Regardless of a state’s approach to conformity, it’s always free to decouple from specific tax code provisions.

New Complications

The new tax law raises several distinct challenges. State tax liabilities likely will decrease in lockstep with federal tax liabilities, which can affect financial statements, cash taxes, and create modeling complexities (though decoupling may mitigate these effects in some states).

For financial statement purposes, deferred tax assets may not currently have a valuation allowance against them due to projections of future taxable income or state tax that would allow the business to use the DTAs fully before expiration.

A reduction in future taxable income may create an inability to ever use these DTAs such as net operating losses, which may result in a valuation allowance being placed against these DTAs—even against indefinitely-lived deferred tax assets.

Tax departments probably have been asked to consider the cash tax impact of the fiscal package. The new law could affect taxpayers’ ability to ever use non-refundable, non-transferable tax credits with limited carryforwards.

The law will create myriad administrative complexities. Multistate, multi-entity taxpayers must model and consider the effect of these provisions in multiple states with differing conformity provisions that have decoupled from different sections of the law.

Best Practices

There are two best practices to consider given the federal changes under the new law.

Wait and see. The new law is somewhat unique in that it contains provisions that dealt with reduced federal transfers to states as part of its “pay for.” Coupled with guidance that will need to be released by the IRS to help interpret key provisions of the law, states could take a cautious approach to conforming to federal tax code changes.

Measured approaches where conformity is updated annually but lags the tax code by a year or so could allow state governments to consider more carefully the impact of federal legislation before state tax policy decisions are made.

Such an approach also could reduce the potential for states to reverse tax policy decisions made under the pressure of rolling conformity statutes, which would provide taxpayers with a more certain sense of a state’s ultimate tax policy.

For example, Maryland and Virginia delay rolling conformity if the fiscal impact to the state reaches certain thresholds, with Virginia carving out an exception for extenders in its most recent appropriations bill.

Create transition rules. States that make significant tax changes often create transition rules to offer some relief to taxpayers affected by such changes.

For instance, North Carolina switched to market-based sourcing for services for sales factor apportionment purposes beginning in tax year 2020. However, the North Carolina General Assembly permitted taxpayers to make a one-time election in 2020 to continue using the old percentage of income-producing activities methodology until such time as any unused net operating losses were used or expired.

State legislatures could consider transition rules, either by phasing in changes to state tax because of federal changes or by offering statutory relief mechanisms to taxpayers who may be adversely affected by the changes. Such transition rules help taxpayers manage their financial statement reporting along with their cash tax projections.

Tennessee took such a step by enacting House Bill 635 in May. It allows taxpayers to add back to income any federal tax deductions that were allowed in computing Tennessee taxable income and any subtraction modifications, It has a caveat that such adjustments couldn’t reduce a taxpayer’s taxable income below the level that would have been computed if such provisions hadn’t been in place. By doing so, the state sought to allow taxpayers to create a higher tax liability against which they could apply credits.

Like any federal tax law change, the new fiscal package has trickle-down state tax impacts. These changes may call for a measured response by the states to provide greater predictability for taxpayers.

The fiscal effects of the law are significant and complex enough as they are. How states choose to conform to the second major federal tax code shake-up in less than a decade could either ease burdens for corporate taxpayers or lead them into some unwelcome states of confusion.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law, Bloomberg Tax, and Bloomberg Government, or its owners.

Author Information

Lance Jacobs is managing director of Forvis Mazars’ Washington National Tax Office.

Matt Gentile is a principal with Forvis Mazars’ state and local tax practice.

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