But wait, there’s more! Although public attention to date has focused on the drastically reduced deduction for state and local taxes (SALT), the recent federal Tax Cuts and Jobs Act (TCJA), like a Russian matryoshka doll, contains layers within layers of significant impacts upon state tax systems. To make sure that New Jersey’s tax system remains competitive, our policymakers need to assess those impacts and craft appropriate amendments to the state’s tax laws. Here’re some suggestions for getting started.
The TCJA made amendments to both personal and business income taxes. This brings both good and bad news for New Jersey’s tax laws.
First, the good. Thanks to the fact that New Jersey’s gross income tax does not use federal adjusted gross income as its computational base, most of the federal personal income tax changes will not impact the calculation of New Jersey tax. This offers an unusual opportunity to argue that New Jersey’s lack of conformity with federal law – generally considered a drag on efficiency and ease of tax administration — is a plus for both the state and its taxpayers.
That said, a fine-tooth-comb review of the federal personal income tax changes is warranted to identify small but potentially significant pitfalls and/or opportunities. For example, the TCJA changes the tax treatment of alimony, in this instance bringing New Jersey out of a rare instance of alignment with federal law. Under prior law, both the feds and New Jersey treated alimony payments as taxable income to the recipient and deductible by the payor. Beginning in 2019, the TCJA shifts the burden of tax to the payor, which lines up with the treatment of child-support payments. To reduce confusion, New Jersey may wish to consider aligning its law to the new federal approach. Caveat emptor: Such a change might raise a small amount of revenue to the extent that payors of alimony are in higher tax brackets that recipients.
Now the bad news. The TCJA’s corporate-tax changes present a host of complex issues for New Jersey’s corporation business tax (CBT). The CBT is in “selective conformity” with federal law, meaning that it incorporates or references some but not all important federal tax provisions and concepts, with the result that some of the federal changes will “flow through” and impact the CBT (and CBT taxpayers). Understanding and responding to these impacts will require a systematic review of every federal change.
The view from 80,000 feet
At the 80,000-foot level, the TCJA’s provisions that impact state corporate tax laws in New Jersey and elsewhere fall into three major categories: restructuring of international taxation, limitations on deductions and exclusions, and amendments to tax accounting rules.
First, the TCJA switches the U.S. international corporate tax regime from a “worldwide” system that taxes all of a corporate taxpayer’s income, no matter where it is earned (although generally only upon repatriation to the United States), to a “territorial” system that only taxes profits earned in, or in connection with, the United States. As part of this switch, the new law imposes a one-time tax on a mandatory “deemed” repatriation of untaxed foreign earnings. To soften the blow, the new law creates a complicated dividends-received deduction that reduces the one-time tax’s effective tax rate to a level well below the standard corporate rate.
The impact of this change on the CBT may seem straightforward initially because the computation of taxable income under the CBT — “entire net income” — starts with Line 28 of the federal corporate tax return (“taxable income before net operating loss deduction and special deductions”). Everything else being equal, any increase in federal taxable income will flow through to the CBT. Consequently, New Jersey might reasonably anticipate a temporary and arguably fair increase in revenue from its share of taxable repatriations of foreign earnings under the new law.
But not all is equal, and the details will prove devilish. For example, as noted, Line 28 is federal taxable income before net operating loss deductions (NOLs) and “special deductions,” which are mainly deductions for dividends received from subsidiaries and affiliates. In other words, the CBT applies to entire net income after taking into account deductions for NOLs and dividends received as well as other adjustments. Naturally, New Jersey’s rules with respect to deductions for NOLs and dividends received differ from their federal counterparts. Whether New Jersey law will classify the special dividends-received deduction for deemed repatriations a “special deduction” is unclear. If not, taxpayers may technically qualify for an extra deduction and realize an associated windfall. The state would be obliged to respond.
In addition, New Jersey insists that each corporate taxpayer file separately, even if it files as part of a consolidated group at the federal level. This further complicates the deductibility of NOLs and dividends received. It is unclear whether or how the Murphy administration’s plan to adopt mandatory combined reporting (as consolidated filing is known at the state level) will impact this issue.
Just to make matters even more complicated, New Jersey’s policymakers must keep in mind that, per the U.S. Constitution, any special treatment of deemed repatriations may not discriminate against foreign commerce. (1)
Sorry to say, the treatment of deemed repatriations is just the tip of the iceberg. The TCJA contains many other international tax provisions that will have direct or indirect impacts on state revenue systems.
Second, to offset some of the revenue loss from lowering the corporate tax rate from 35 to 21 percent, the TCJA eliminates or curbs certain corporate tax exclusions and deductions (such as for interest expense). In most instances, thanks to the linkage to Line 28 noted above, these changes will flow through to the CBT, increasing entire net income and thus potentially driving a modest revenue increase for the state. But is that good policy? Other states in similar circumstances will likely choose to avoid unintended tax increases by “decoupling” from some federal provisions. In evaluating its options, New Jersey would do well to consider its relative competitive position.
Finally, the TCJA changes certain tax-accounting rules. The impact will again depend upon the extent to which New Jersey’s rules align with their federal counterparts. In some cases, a lack of conformity will protect (rather than enhance) the state’s revenue base. For example, because New Jersey decoupled from federal bonus depreciation as of January 1, 2002, the JCTA’s new 100 percent depreciation deduction for the first year in which qualifying business property is placed in service (“100% expensing”) will not flow through to the CBT. Although business would be delighted, it is hard to imagine our policymakers pursuing a recoupling to federal law in the current fiscal climate.
Indeed, there will be instances in which it makes sense to consider further decoupling. For example, the TCJA increases the required period for deducting qualified research and development expenses. Under current law, the lower annual deductions will flow through to the CBT and generate a slight unintended increase in state revenue. The state should therefore consider decoupling. Alas, current state rules that require an “add-back” of otherwise deductible expenses related to claiming New Jersey’s Research and Development Tax Credit will make the analysis quite complicated.
As my persistent use of vague generalities suggests, this is really complicated and specialized stuff well beyond my professional paygrade. I can do little more here than raise awareness of the issues. Nonetheless, I hope it’s clear by now that our policymakers need to act to make sure that New Jersey’s tax system is protected while remaining competitive. This will require careful expert analysis. Happily, New Jersey boasts experts, both in and outside government, who are willing and able to help.
1. See Kraft Gen. Foods v. Iowa Dep’t of Revenue & Finance (90-1918), 505 U.S. 71 (1992)
The author wishes to thank the following for their technical assistance in preparing this column: Michael Bryan, CPA; Roger Cohen, Ph.D.; John Kelly, CPA, MBA, MAFM; and Jaime Reichardt, Esq.