The 2019-20 Budget: Tax Conformity

The 2019-20 Budget: Tax Conformity GABRIEL PETEK LEGISLATIVE ANALYST MARCH 6, 2019 Summary Recent Federal Tax Changes Created New Differences Between State and Federal Tax Laws. The 2017 federal Tax Cuts and Jobs Act made significant changes to federal tax laws. Generally, the federal tax changes reduced tax rates and broadened the tax base (what is subject to tax). Because the state’s income tax laws closely refer to large portions of federal law, many of those changes created new differences between federal and state taxes. State law currently does not adopt—or conform to—any of the federal changes made in 2017. Governor Proposes Conforming to Portions of the Federal Changes. The Governor proposes conforming to several provisions of the 2017 federal tax law. These include limits on noncorporate business losses, increased flexibility for small business accounting, changes to like-kind exchanges, eliminating net operating loss (NOL) carrybacks, limits on fringe deductions, and other—generally smaller—provisions. (Under the Governor’s updated proposal provided to us March 1, 2019, conforming to these provisions would increase revenue by $1.7 billion in 2019-20. These estimates are very uncertain, however.) The Governor’s proposal for conformity is tied to an expansion of the state Earned Income Tax Credit (EITC). (We view federal tax conformity as a distinct policy issue and discuss the proposed EITC expansion in a separate report.) Evaluate Merits of Conformity on Case-by-Case Basis. While closer conformity between state and federal tax laws provides some benefits, California’s tax laws historically have differed from federal law in various ways. Should the Legislature consider conforming to portions of the recent federal tax law, it will want to consider the merits of conforming to each of the major provisions independently. We lay out the questions to consider for each provision in the figure on page 9. LAO Assessment of Major Provisions. We identify ten major provisions the Legislature could consider for conformity actions (five of these are part of the Governor’s proposal, which total $1.6 billion in estimated revenue in 2019-20). In each case, we discuss which filers may be affected by conforming, the arguments in favor of conforming, and the arguments against. In some cases—like limiting noncorporate business loses and modifying NOLs—we find the arguments in favor of conforming are stronger than those against conforming. In other cases, we find the opposite or we find there are good arguments on both sides. We summarize these findings in the figure on page 11. analysis full gutter 2019-20 BUDGET INTRODUCTION A December 2017 federal law (known as the Tax new federal law to offset the cost of a proposed Cuts and Jobs Act) made many changes to the expansion to the state EITC. This report describes federal personal income tax (PIT) and corporation the major changes to federal tax laws and provides tax (CT). The state has not yet taken action to a framework for assessing potential conformity address those changes—a practice known as actions. (Because we view federal tax conformity as “conformity.” The Governor’s budget proposes a distinct policy issue from an EITC expansion, we conforming state tax laws to some provisions of the analyze that proposal in a separate report.) BACKGROUND Overview of Income Taxation Standard Deduction. Deductions are provisions of tax law that reduce filers’ taxable income. Income taxes are an important source of federal Filers must choose between two different options and state government revenue. In California, PIT for taking deductions—the standard deduction and CT are two of the largest state taxes. The or itemized deductions. About two-thirds of PIT contributes over two thirds—$93.5 billion Californians claimed the standard deduction in in 2017-18—of state General Fund revenue. CT 2017. Partly due to the 2017 federal law, the collections in 2017-18 were $12.3 billion. The rest federal standard deduction is much higher than the of this section describes the basics of income tax state standard deduction. For tax year 2018, the law as they relate to each step that tax filers follow federal standard deduction is $12,000 for single as they prepare their tax returns. filers and $24,000 for married couples filing jointly. Federal Adjusted Gross Income (AGI). When The corresponding state amounts are $4,401 and tax filers prepare their tax returns, they begin by $8,802 respectively. (Prior to 2018, the federal adding up all of their taxable income. For the most standard deduction was $6,350 for single filers and part, the definition of income is the same under $12,700 for married couples filing jointly.) federal and California laws. A filer’s total income Itemized Deductions. As an alternative to is referred to as “adjusted gross income” or AGI. taking the standard deduction, filers may claim one In addition to wage income—which is reported as or more other deductions—known as itemizing. earnings by more than 80 percent of federal tax For example, filers who itemize may take PIT filers—other sources of income include capital deductions for home mortgage interest. Filers gains; business income; interest; dividends; typically choose to itemize their deductions if and distributions from pensions, annuities, and the sum of these deductions is greater than the retirement accounts. About 20 percent of filers standard deduction. have business income and 17 percent of filers PIT Tax Rates. After filers apply deductions, have capital gains income. Capital gains or losses they compare the resulting taxable income to a result from the sale of an asset, such as shares of a schedule. This schedule tells them how much company’s stock or real estate property. tax they owe (called “tax liability”) before they Differences Between State and Federal apply credits (described below). This schedule Definitions of AGI. There are a few differences is based on a structure of marginal tax rates— between the state and federal definitions of AGI. rates that apply incrementally to each additional For instance, California does not tax Social Security dollar of income. Both the federal and state PIT income. On net, these adjustments resulted in use graduated rate structures, meaning that California tax filers’ state AGI being about 2 percent the marginal rate increases as the filer’s income lower than their federal AGI in 2016. 2 LEGISLATIVE ANALYST’S OFFICE analysis full gutter 2019-20 BUDGET increases. Figure 1 shows the Figure 1 state’s marginal rate structure for California Marginal Personal Income Tax Rates tax year 2018. Single Filer, 2018 Credits. A credit reduces a filer’s tax liability directly (as Taxable Income Over: But Less Than: Marginal Tax Rate distinct from deductions, which — $8,545 1.0% reduce the filer’s taxable income). $8,544 20,256 2.0 While some state credits—like 20,255 31,970 4.0 the EITC and low-income housing 31,969 44,378 6.0 credits—are based on or refer 44,377 56,086 8.0 to federal tax laws, others are 56,085 286,493 9.3 286,492 343,789 10.3 different. For instance: 343,788 572,981 11.3 • Federal law provides a credit 572,980 — 12.3 for 30 percent of the cost of qualified residential energy earnings—for up to 20 years. State law also allows savings improvements, such as solar water corporations to “carryback” NOLs—apply them to heaters and geothermal heat pumps. a previous year’s earnings—for up to two years. • State law provides a credit for 15 percent of Overall, NOLs allow corporations to smooth profits the value of fresh fruits or vegetables donated and losses over time. to California food banks. Federal Tax Laws Changed in 2017 Taxes on Business Income. Business income Generally Reduced Tax Rates . . . The 2017 can be earned by individuals or businesses (like federal tax law reduced effective tax rates for many corporations). Most filers with business income filers. (The effective tax rate is the total amount begin by adding up their revenue and then of tax divided by the taxpayer’s gross income.) In deducting their businesses expenses. (In some particular, the law: years, businesses experience a net loss, which we discuss below.) State and federal tax laws • Replaced the previous CT rate structure with a include specific accounting rules to calculate flat 21 percent tax rate. business income and deductions. These rules vary • Reduced PIT rates slightly. somewhat among individuals and different types • Doubled the standard deduction and created of businesses. Federal and state rules also differ. a new 20 percent deduction for business Broadly, any expense that is not directly related to income for individuals. generating income is not deductible. Deductions • Raised the income threshold for the alternative for some types of business expenses—like meals minimum tax and eliminated the corporate with clients—are limited. After these calculations alternative minimum tax. are complete, business owners include this amount in their AGI. Corporate filers apply a flat tax rate— . . . And Broadened Tax Base. In addition to 8.84 percent in California—to this income. the effective rate changes described above, the NOL Deductions Smooth Business Profits 2017 law made other changes that broadened the and Losses Over Time. When business expenses tax base—that is, reduced or eliminated various exceed revenue in a particular year, a corporation credits and deductions. Examples of these changes has a NOL. The value of a NOL is equal to the include eliminating personal exemptions, ending amount by which allowable expenses exceeded many individual and business deductions, and revenue. The corporation can then deduct the imposing new limits on other common deductions. NOL from its taxable income the following year, The law also made significant changes to federal reducing that year’s tax liability. Corporations can taxes for multinational corporations. carryforward NOLs—apply them to a future year’s www.lao.ca.gov 3 analysis full gutter 2019-20 BUDGET Many Changes Are Temporary. Many of the wish to conform to subsequent changes in major changes to federal PIT law are effective federal law, their Legislatures must update the only for tax years 2018 through 2025. Many of “static conformity” date in their tax laws. As we the changes to federal taxes on business income, show in Figure 2, PIT laws in 19 states conform however, are permanent. automatically and 23 must act to conform their PIT laws. (Nine states do not have a PIT.) If a state with States Often Conform to rolling conformity does not want to conform to any Federal Changes, at Least in Part particular provision, their Legislatures must pass laws to specify the difference. States Take Different Conformity Approaches. Recent Conformity Actions. In 2018, most Many states’ income tax laws refer to or otherwise states that levy a state PIT took some legislative incorporate federal tax laws. When federal tax laws action to conform to the federal changes made change, the tax laws of some states automatically in December 2017. While some states adopted conform to the change. (This is sometimes called most of the changes, other states updated their “rolling conformity.”) Other states reference the conformity dates in state law—for example, New federal law as of a particular date. If such states Figure 2 States Approach Personal Income Tax (PIT) Conformity Differently Rolling Conformity Static Conformity or State Definition of Income No PIT Note: New Hampshire and Teneessee do not levy a state PIT on most sources of income, but do tax interest and dividends. 4 LEGISLATIVE ANALYST’S OFFICE analysis full gutter 2019-20 BUDGET York on a rolling basis and Virginia on a static filers pay a proportionally larger share of their basis—but decoupled from many of the major income in state taxes, relative to other filers, than federal changes. Only Arizona, California, and they do in federal taxes. Minnesota have not acted in response to the Some State CT Rules Differ Significantly. federal changes. The state taxes multinational businesses in a Generally, Closer Conformity Facilitates fundamentally different way than the federal Compliance and Enforcement. States conform government. These differences largely apply to to the federal tax code for several reasons. By how corporations file taxes and the rates applied using the federal definition of income as a starting to different types of corporations. Despite these point to calculate state tax liability, states may significant differences, state CT laws conform reduce the compliance burden on tax filers and closely to other federal tax laws regarding how and reduce errors. Additionally, referring to federal tax when corporations account for certain kinds of laws allows state administrators and filers alike to income and expenses for tax purposes. rely on federal regulations, judicial rulings, and tax Other Differences Reflect Different State filer guidance from the Internal Revenue Service. and Federal Priorities. California has historically The federal interpretations generally are more not conformed to certain federal provisions due detailed and extensive than what any individual to differences in policy priorities. This approach state could produce. Furthermore, conformity is sometimes called “selective conformity.” For provides consistency among states’ tax laws. example, California treats employer reimbursements This benefits those filers who pay taxes in multiple for ridesharing and bicycling expenses more states and reduces the effects of tax policy on generously than federal law to provide a stronger taxpayer behavior. Lastly, conformity enhances state incentive for alternative modes of commuting to compliance activities by allowing states to benefit work. Federal tax laws were changed in 1986 to from federal tax filer audits and use federal tax data. increase how quickly businesses could deduct the cost of major new assets to provide a stronger California’s Federal Tax Conformity incentive for business investment and California In this section, we describe key similarities and only partially conformed to those changes in PIT differences between federal income tax laws and law. (California did not conform CT law to these California’s tax laws as they currently stand. changes and provides different incentives for Definition of Income, Many Deductions business investment.) Similar. As noted earlier, the state’s tax laws Last Major Tax Conformity Action in 2015. are based on federal definitions of income. For Following the last major overhaul of the federal instance, the state’s calculation of income begins tax laws in 1986, California passed legislation in with federal AGI. In addition, most state itemized 1987 to selectively conform to federal changes deductions conform to similar federal rules. by changing the specified date of conformity, State PIT More Progressive. California’s affirmatively conforming or partially conforming to PIT historically has differed from federal law in some provisions, and specifically not conforming significant ways. For example, the state provides to certain other federal changes. In addition, this credits to filers and their dependents in place of legislation also reduced state tax rates, increased the federal personal and dependent exemptions the personal exemption credit, and increased the (which are similar to deductions). In addition, the standard deduction. The state Legislature has state taxes income under a more progressive sometimes passed conformity legislation several rate structure and provides significant personal years after changes in federal law. For example, and dependent credits. Consequently, roughly the most recent major tax conformity change 1.5 million Californians earning between $10,000 was Chapter 359 of 2015 (AB 154, Ting), which and $50,000 owe federal taxes but do not owe any changed the specified date of conformity from state tax. In addition, the highest-income California January 1, 2009 to January 1, 2015. www.lao.ca.gov 5 analysis full gutter 2019-20 BUDGET MAJOR INCOME TAX PROVISIONS AFFECTED BY 2017 CHANGES We describe the most significant federal Provisions Affecting Individuals conformity provisions below. We classify these Limits Noncorporate Business Losses. In as “conformity provisions” because California’s some years, the costs of running a business tax laws historically have conformed to these exceed its gross income, resulting in a loss. Filers parts of federal law. Other major changes to generally can deduct business losses from other federal tax laws are entirely new or reference sources of income. (To prevent abuses, there are provisions to which California historically has not limitations on the type of business losses a filer conformed. For instance, given the fundamental may deduct.) The 2017 federal law limits such differences in how California taxes multinational deductions to $250,000 ($500,000 for married corporations, we do not consider those federal couples). Business losses in excess of that amount changes conformity items. (The Franchise Tax become a NOL, which the filer may deduct from Board [FTB], which administers state income tax income the following year. About 700,000 California laws, annually prepares a Summary of Federal PIT filers had a business loss in 2016, but there Income Tax Changes. This annual report provides likely were fewer than 100,000 with other sources full descriptions of all the federal conformity of income in excess of $250,000. items and details all of the technical conformity implications of each federal change.) At the end Suspends Miscellaneous Itemized of this report, we include an appendix that briefly Deductions. Federal PIT law previously allowed filers who itemized their deductions to describes a number of other 2017 federal changes deduct “miscellaneous” expenses, including to which the Legislature could consider conforming. (1) unreimbursed work-related expenses, (2) tax These provisions affect few filers or do not have a preparation fees, and (3) certain other expenses significant fiscal effect. Generally, these provisions related to earning income. Common work-related do not run afoul of existing state tax policy. expenses include protective equipment, training, The Governor proposes conforming to five and transportation. Filers could previously deduct of the major provisions described below. These miscellaneous expenses in excess of 2 percent are (1) limits on noncorporate business losses, of their AGI. The 2017 federal law suspended (2) increased flexibility for small business this deduction until 2026. The change likely will accounting, (3) changes to like-kind exchanges, affect about 2 million California filers—about (4) eliminating NOL carrybacks, and (5) limits 12 percent—who claimed the deduction in previous on fringe benefit deductions. The Governor also years. The change disproportionately affects filers proposes changes to some other—generally with incomes between $75,000 and $200,000, as smaller provisions—which we describe in the lower-income filers are less likely to itemize their appendix. Lastly, the Governor proposes providing deductions and higher-income filers face more tax benefits for investments in “Opportunity Zones.” limits on these deductions. We do not consider Opportunity Zone tax benefits a conformity issue, but describe the implications in Limits Mortgage Interest Deduction. PIT filers generally cannot deduct personal interest the nearby box. (This report reflects the Governor’s payments. Mortgage and home equity loan interest, updated conformity proposal we received March 1. however, are exceptions (within certain limits). The administration estimates its proposal would The 2017 federal changes reduced the amount of raise $1.7 billion in 2019-20—$700 million more mortgage interest PIT filers can deduct. Prior to the than the January proposal. As we discuss later, changes, filers could deduct the interest from up however, these estimates are highly uncertain.) to $1.1 million in combined mortgage and home equity debt. Under the new law, this limit is reduced 6 LEGISLATIVE ANALYST’S OFFICE analysis full gutter 2019-20 BUDGET to $750,000 for new mortgage debt. In addition, (Businesses and corporations are not affected by interest on home equity loans is deductible this limit.) The vast majority of filers who itemized only if the loan proceeds are used for home their deductions in 2016—about 30 percent of all improvements. Nearly one-quarter of tax filers in federal filers in California—claim a deduction for California claim the mortgage interest deduction. state income taxes and local property taxes. Given Tax filers who buy or refinance a home after the increase to the federal standard deduction, December 15, 2017—especially if they live in one we expect that many fewer filers will itemize their of the state’s more expensive real estate markets— deductions in 2018 than in previous years. As will be most affected. A filer with a new mortgage a result, fewer Californians will take the SALT of more than $1 million could see their federal tax deduction on their federal taxes. liability increase by more than $4,000 per year. Suspends Limit on Itemized Deductions. (Roughly 15 percent of California homes sold Federal PIT law previously limited the total amount cost over $1 million. Consequently, this change is of itemized deductions for higher-income tax unlikely to affect most California homebuyers.) filers (those above $261,500 for single filers and Limits State and Local Tax (SALT) Deduction. $313,800 for married filing jointly in 2017). The Federal law allows taxpayers to deduct a broad 2017 federal law suspended the federal limit range of state, local, and foreign taxes. The 2017 on itemized deductions, mostly affecting the federal changes now limit the total amount that deductions for mortgage interest and charitable may be deducted under this provision to $10,000. contributions. (Certain deductions were exempt Opportunity Zones Certain Economically Distressed Areas Identified as Opportunity Zones. The 2017 federal tax changes established Opportunity Zones to increase investment in certain economically distressed areas. States had discretion to identify Opportunity Zones based on federal guidance. Generally, these are areas with relatively low median income and high levels of unemployment. In California, the state Department of Finance—with public input—identified 879 census tracts as Opportunity Zones. Federal Changes Provide Significant Tax Benefits for Investments in Opportunity Zones. To encourage investment in Opportunity Zones, federal law allows filers to defer taxes on capital gains if those profits are invested in Opportunity Zones. In addition, if filers hold on to the investment for multiple years, their tax liability on those capital gains can be reduced. Lastly, filers that maintain their Opportunity Zone investment for at least ten years will not be taxed on the eventual sale of that investment. Administration Proposes Adopting Opportunity Zone Tax Benefits for Specific Investments. In budget summary documents, the administration proposed to allow similar state tax incentives for “green technology” or “affordable housing” investments in Opportunity Zones. The administration has not provided any details regarding this proposal. State Opportunity Zone Tax Benefits Unlikely to Be Effective. Federal tax law typically influences people’s choices more than state tax law because the federal rates are higher. Consequently, creating a state tax benefit for Opportunity Zone investments—on top of the significant federal incentive—likely would not significantly influence decisions about where to invest. Any state tax benefit provided would be a “windfall” to investors because they likely would have made the investment even without the state benefit. Moreover, if the federal tax incentive is insufficient to encourage investment in affordable housing and green technology, a similar state tax benefit likely would not change investors’ choices. www.lao.ca.gov 7 analysis full gutter 2019-20 BUDGET from the limit, including medical expenses and Restricts Like-Kind Exchanges. Tax filers may losses from casualty and theft.) Most tax filers with defer paying PIT and CT on capital gains from incomes above the threshold—about 5 percent of sales of certain types of property if they purchase California filers—itemize their deductions and this a similar type of property within 180 days. The change will likely reduce their taxes. 2017 federal changes restricted these “like-kind exchanges” rules to apply only to real estate. As Provisions Primarily Affecting a result, tax filers who sell certain other types of Businesses tangible or intangible assets—such as vehicles, artwork, collectibles, franchises, and patents—may Limits Interest Deduction. Corporations and no longer defer paying tax on their capital gains other business entities generally can deduct through like-kind exchanges. Real estate has interest payments from their income. The 2017 historically accounted for most like-kind exchanges. federal changes limit the deduction of interest to Limits Deductions for Fringe Benefits. While 30 percent of a filer’s “adjusted taxable income.” most business expenses—including employee Interest expenses above 30 percent of income can compensation—are deductible, there are various be carried forward and deducted the following year. restrictions and limits on the deductibility There is insufficient data on how many businesses of business spending on “fringe benefits.” that claim deductions for interest will be affected by Fringe benefits are things like health benefits, the new limit. (Small businesses with revenue under employer-provided or reimbursed meals, and $15 million and utilities are exempt.) parking. The 2017 federal changes modified some Modifies NOLs. The 2017 federal changes of the existing restrictions and limitations on fringe modified the NOL provisions in three ways: (1) limits benefits. These changes likely will reduce the NOLs to 80 percent of income, (2) allows NOLS to amount of deductions that many corporations and be carried forward indefinitely, and (3) eliminates businesses will be able to claim. NOL carrybacks. Previously, a filer with a sufficient Increases Flexibility for Small Business amount of NOLs could reduce their taxable Accounting. Most large corporations and businesses income to $0. Now, a filer may only reduce their are required to follow specific accounting rules in taxable income by 80 percent. NOLs can now be preparing their tax returns. Smaller businesses are carried forward indefinitely instead of expiring after allowed flexibility to use less cumbersome methods. 20 years. The new limit on NOLs’ use could affect The 2017 changes to federal tax laws extend this roughly 100,000 PIT filers and 100,000 CT filers accounting flexibility to most businesses with gross annually. While filers with NOLs might pay more in receipts of less than $25 million. Previously there taxes in the current year, they would pay less in were various lower gross revenue thresholds ranging future years. from $5 million to $10 million. CONSIDERING INCOME TAX CONFORMITY In this section we (1) lay out a framework for Other Things Being Equal, Closer Conformity evaluating potential conformity provisions and Is Better . . . There are three primary arguments (2) provide an assessment of the major conformity for conforming the state’s income tax laws to some provisions based on our framework. of the recent federal changes: greater simplicity, improved tax administration, and a broader tax Framework for Evaluating Conformity base. First, in general, closer conformity between Figure 3 summarizes our framework for state and federal tax laws eases tax preparation, considering the merits of conforming to federal tax reduces filing errors, and reduces tax compliance changes. costs. Second, as mentioned above, closer conformity enhances FTB’s tax compliance 8 LEGISLATIVE ANALYST’S OFFICE analysis full gutter 2019-20 BUDGET activities by allowing states to benefit from federal 2026. Other provisions are permanent. In general, judicial rulings and tax filer audits. Lastly, a broader conforming based on to the federal timeline is tax base also usually results in a more horizontally reasonable. The Legislature may want to consider equitable tax structure, with fewer groups receiving other options in certain circumstances, however. preferential treatment. • Consider Rolling Conformity When Close . . . But Tax Laws Should Have a Clear Ongoing Conformity Important. If the Rationale. While greater simplicity, improved tax Legislature believes that close, ongoing administration, and a broader tax base are good conformity is important, consider conforming reasons for conforming to federal tax changes, to those provisions on a rolling conformity California has selectively conformed to federal basis. For example, the state conforms to tax laws in the past. The Legislature historically provisions affecting retirement accounts on a has chosen not to follow federal rules in areas rolling basis because a lack of conformity may where there was not a clear reason for the rule have serious consequences. or when the state had different policy objectives • Consider Making Some Changes from the federal government. Each of the major Permanently. If the Legislature believes that provisions enacted in 2017 have significant policy adopting a provision has merit, regardless of considerations that the Legislature will want to federal law, consider adopting the change weigh against the benefit of greater simplicity. For permanently, regardless of whether it expires example, the state may choose not to conform under federal law. State law has historically to the new federal limit on interest deductions if adopted a policy of selective conformity to there is not a sound justification for doing so. (We federal law, with differences reflecting different discuss the policy considerations of some of the policy priorities. major provisions in the next section.) • Consider Sunset Dates in Some Cases. If Fiscal Effects Uncertain and Likely Will adopting a new income exclusion, deduction, Change Over Time. The estimated fiscal effects or credit, the Legislature may consider of conforming to each of the major federal imposing a sunset date—regardless of federal changes are highly uncertain for three reasons. law—so that the continued need for the First, available tax filer data are in some cases provision may later be reviewed. (While this limited. Moreover, some estimates were based consideration does not apply to the major on adjustments to national estimates rather than provisions described above, this approach California specific information. Second, some tax law changes will affect filers’ choices, which in turn will affect Figure 3 tax revenue. Third, the estimates Conformity Assessment Framework do not account for the ways in which different provisions may 9 Would closer conformity increase simplicity and improve tax interact based on the Legislature’s administration? conformity choices. For example, 9 if the state limits noncorporate Would conformity treat filers more similarly? business losses but does not 9 Does the provision have a clear rationale? modify NOLs, the change in revenue could be smaller than 9 Does the provision support or conflict with another policy objective? estimated. 9 Consider Whether To Make What is the fiscal effect? Changes Permanently or 9 Temporarily. Many of the federal Is the federal change temporary or permanent? changes, especially those affecting 9 How broadly should the state conform? individuals, expire on January 1, www.lao.ca.gov 9 analysis full gutter 2019-20 BUDGET could be applied to Opportunity Zones should would better align the tax treatment of corporate the Legislature pursue that proposal.) and noncorporate taxpayers. Better aligning the treatment of noncorporate and corporate taxpayers Spot Conformity or Change Specified Date of could reduce the complexity business owners face Conformity? There are two general approaches to in deciding the legal structure of their businesses. conformity: (1) adopt a limited number of specific Miscellaneous Itemized Deductions: Reasons provisions in a “spot” conformity bill or (2) update to Keep Them . . . The deduction for unreimbursed the specified date of conformity. There are work-related expenses and certain other expenses trade-offs to each of these approaches. Generally, related to earning income can make income taxes spot conformity would result in fewer changes to more equitable. For example, consider two similar state tax law whereas changing the specified date workers: (1) one who makes $90,000 per year, of conformity would affect many provisions of the whose employer reimburses all of her work-related tax code. expenses; and (2) one who makes $95,000 per LAO Assessment year while incurring $5,000 of unreimbursed work-related expenses. The workers’ net pay is the In assessing whether to conform to any of same, so an equitable tax system would require the major conformity provisions, the Legislature them to pay the same amount of tax. Without will want to weigh the general benefits of closer miscellaneous deductions, however, the second conformity—more simplicity and improved worker pays more tax than the first. tax administration—with other state policy . . . And Reasons to Suspend Them. considerations specific to each provision. Figure 4 There are two reasons to consider conforming summarizes the major conformity provisions, our state law to also disallow these deductions. assessment, and the estimated revenue effect. We First, the existing threshold for qualifying for provide our assessment on some of the key policy the deductions—2 percent of AGI—limits their issues regarding the major conformity provisions effectiveness at addressing differences among below. similar filers because workers must incur significant Some Reasons to Consider Limiting Business expenses before qualifying for the deductions. Losses. Limiting the ability of some filers to use Second, conforming would make tax compliance business losses to reduce their taxable income and administration simpler. from nonbusiness sources could discourage Mortgage Interest Deduction Conformity investment in new or expanded businesses. New Worth Considering. The federal mortgage interest businesses often experience losses in the first few deduction changes primarily affect higher-income years. Allowing taxpayers to use business losses homeowners who likely would have been able to to offset other income lessens the impact of losses afford their home even without the deduction. For on business owners. In contrast, when losses these tax filers, the deduction is largely a windfall. cannot be used to offset nonbusiness income, the In addition, conforming to this change could impact falls more heavily on the business owner. temporarily slow price growth for homes priced Despite this possibility, conforming to the federal above $900,000 providing some relief to home limits on noncorporate business losses in excess buyers in expensive coastal markets. For home of $250,000 could make sense for several reasons. equity loans, conforming would make the cost of First, any losses in excess of the limit are converted borrowing more expensive for people who use to NOLs and will reduce future tax payments. these loans as lines of credit (rather than for home Second, some taxpayers create businesses not improvements). to engage in profitable activity but to generate Conformity to SALT Deduction Would Affect losses aimed at reducing the filer’s tax bill. Limiting Few Filers. Capping deductions for local tax business losses would discourage this kind of payments—primarily the property tax—would affect activity. Finally, requiring noncorporate business a small minority of state filers and would make the losses beyond the limit to be converted to NOLs state PIT somewhat more progressive. In 2016, 10 LEGISLATIVE ANALYST’S OFFICE analysis full gutter 2019-20 BUDGET Figure 4 Assessment of Major Federal Tax Conformity Provisions Estimated Revenue Effect (In Millions) Conformity LAO Provision Effects of Change Assessment 2019-20 2020-21 Provisions Affecting Individuals Limits Noncorporate Business owners with a loss over $250,000 would be + $1,200 $850 Business Losses unable to deduct the entire amount in the current year. For fewer than 100,000 filers, conforming would increase tax payments in the current year and reduce payments in future years. Suspends Miscellaneous Filers would be unable to deduct certain previously allowed +/- 1,700 1,100 Itemized Deductions work-related expenses. Conforming might increase the amount of taxes paid by about 12 percent of state filers. Limits Mortgage Interest Reduces amount of residential mortgage interest that filers + 550 410 Deduction could deduct from their income. The change does not affect those with existing mortgages, only those with new mortgages above $750,000. The change affects many with home equity loans. Limits Deduction for Local Conforming would cap at $10,000 the amount of local + 550 370 Taxes property taxes a state filer could deduct. The average amount of property taxes reported in 2016 by state itemizers earning less than $200,000 was just under $5,000. Suspends Limit on Conforming would remove the overall limit on the amount - -2,100 -1,400 Itemized Deductions of itemized deductions that high-income filers may claim, making the personal income tax less progressive. Provisions Primarily Affecting Businesses Limits Business Interest Limits business interest deduction to 30 percent of “adjusted - 800 700 Deduction taxable income.” Conforming would increase business borrowing costs. Modifies Net Operating Eliminates like-kind exchanges of personal property. + 200 210 Losses (NOLs) Conforming would mean that filers could no longer defer capital gains on personal property. Changes Like-Kind Eliminates like-kind exchanges of personal property. +/- 260 200 Exchange Rules Conforming would means that filers could no longer be allowed to defer capital gains on personal property. Limits Deductions for Changes rules regarding business deductions for + 200 160 Fringe Benefits entertainment, food, and transportation expenses. Conforming would somewhat increase business taxes. Increases Flexibility Increases to $25 million the annual revenue threshold for + -220 -100 for Small Business certain tax accounting rules. Conforming would eliminate Accounting differences between state and federal law that increase tax compliance costs for some small businesses. Legend + The arguments in favor of conforming are somewhat stronger than those against. +/- There are good arguments both in favor and against conforming. - The arguments against conforming are somewhat stronger than those in favor. www.lao.ca.gov 11 analysis full gutter 2019-20 BUDGET the average deduction was just under $5,000 for businesses’ ability to smooth income and tax filers who itemized their deductions and made less payments to some extent, businesses would than $200,000, and roughly $8,000 for itemizers retain significant ability to do so. At the same time, with income between $200,000 and $300,000. conformity—specifically limiting carrybacks—likely The small number of filers deducting more than would offer increased fiscal certainty for the state, $10,000 likely recently purchased expensive homes especially during a recession. Usage of NOL or own multiple homes. The Legislature, therefore, carrybacks tends to increase during economic could conform to this provision without increasing slowdowns as more businesses experience losses. most filers’ tax liability. Those living in the state’s Increased usage of carrybacks reduces businesses’ more expensive, coastal real estate markets could tax payments, exacerbating general weakness in be most affected. revenue collections during a slowdown. Eliminating Suspending the Limit on Total Itemized carrybacks would prevent this problem. (Only Deductions Would Make PIT Less Progressive. a minority of states permitted NOL carrybacks For a subset of deductions, California limits the even before the recent federal changes. The total amount of itemized deductions that may be Governor’s proposal applies only to the changes to claimed by filers with incomes above $187,203 carrybacks.) for single filers and $374,411 for married filing Restrictions on Like-Kind Exchanges Raise jointly. These limits increase as filers’ incomes Competing Considerations. The Legislature is increase. For those with very high incomes, total faced with competing arguments in considering deductions may be reduced by up to 80 percent. whether to conform to federal restrictions on Consequently, these limits significantly reduce like-kind exchanges. In general, there is a the value of deductions, increase filers’ taxable reasonable argument to defer capital gains taxes in income, and make the PIT more progressive. (As a like-kind exchange. If a taxpayer uses all of the noted earlier, however, the limit does not apply to cash from the sale of property to purchase new some large deductions, such as those for medical property, he or she may not have cash on hand to expenses and certain losses.) Conforming to the pay taxes on their capital gains. Like-kind exchange federal suspension of these limits would reduce rules allow taxpayers to defer their capital gains state taxes paid by high-income filers, making the taxes until they make a property transaction that state PIT less progressive. increases their cash on hand. At the same time, Limiting the Business Interest Deduction allowing like-kind exchange deferrals presents Could Affect State’s Business Climate. Business problems. In particular, property owners may income taxes are intended to tax net income choose a particular transaction to receive a tax after accounting for ordinary and necessary benefit when a different transaction would have business expenses. Consequently, businesses otherwise been more beneficial. For example, a may deduct their interest payments. For instance, business owner may sell an old delivery truck and if a manufacturer borrows money to purchase replace it with a new truck to take advantage of equipment, their interest payments are deductible. like-kind exchange rules but may have preferred By limiting the amount of interest businesses instead to use the cash to purchase a new can deduct, the 2017 change in federal tax law computer system to optimize deliveries. (We expect increases the cost of borrowing for some firms. there will be fewer like-kind exchanges of personal Conforming to this change could harm the state’s property than in the past because of the change business climate. in federal law. State conformity likely will have a smaller effect on behavior and state revenue may Modifying NOLs Could Offer Increased increase somewhat regardless of whether the state Fiscal Certainty. Conforming to federal changes conforms.) related to NOL deductions could allow the state to recognize some benefits while continuing to Deductions for Fringe Benefits Can Lack smooth corporations’ gains and losses. Although Policy Rationale in Some Cases. Federal conforming to the federal changes would restrict changes related to fringe benefits primarily affected 12 LEGISLATIVE ANALYST’S OFFICE analysis full gutter 2019-20 BUDGET transportation, entertainment, and meals. Those employees’ overall compensation is difficult, changes reduced or eliminated employers’ ability conforming to this federal change may be to deduct those benefits provided to employees. warranted. Typically, business expenses—including these Allowing Greater Accounting Rule Flexibility fringe benefits—are deductible because these Reasonable. Allowing greater accounting costs enable businesses to earn income. In some flexibility would simplify tax filing for roughly cases, however, transportation, entertainment, and 60,000 businesses in California. Given the meals may not be necessary to conduct business complexity associated with business accounting, and instead provide a tax-advantaged benefit to conforming to this change would reduce significant employees (because the employees do not have differences in tax filing for some medium-sized to pay income taxes on these employer-provided businesses. This additional flexibility, however, benefits). Because distinguishing between could result in some businesses reducing their tax necessary transportation, entertainment, and liability and lower tax payments somewhat. meal benefits and those that otherwise increase CONCLUSION Whether to conform to federal tax changes said, if the state conforms to the major provisions merits Legislative deliberation regardless of the discussed above, state revenues could increase revenue effects. While the Governor’s proposal by several billion dollars. The Legislature could appears to link conformity and EITC in order take a variety of steps—including reducing rates or to create a revenue neutral proposal, there are increasing the personal exemption—to mitigate the simpler means of raising additional revenue if effects of conformity the Legislature wishes to expand the EITC. That www.lao.ca.gov 13 analysis full gutter 2019-20 BUDGET 14 LEGISLATIVE ANALYST’S OFFICE analysis full gutter 2019-20 BUDGET APPENDIX: OTHER POTENTIAL CONFORMITY PROVISIONS These are other provisions that could be fiscal effects. Moreover, generally these changes included in a conformity package. Broadly, would not be inconsistent with existing state tax conforming to these provisions would simplify law. (Those provisions included in the Governor’s the state tax code. To our knowledge, most of updated conformity proposal are noted in the these do not affect many filers and/or have minor right-most column.) Other Potential Conformity Provisions Part of Governor’s Provision Effects of Conforming Proposala,b Changes “Kiddie Tax” Rules Simplifies rules regarding the taxation of the dividends, interest, and capital gains earnings of dependent children that are subject to filing requirements. Raises Limit on Charitable Contributions Increases the amount of certain charitable contributions an individual may deduct from 50 percent to 60 percent of their income. Allows Increased Contributions to Achieving Changes some rules regarding contributions to an ABLE account. The Better Life Experiences (ABLE) Accounts maximum total contribution of $14,000 per year remains unchanged. Allows Rollovers to ABLE Accounts Allows an individual with a disability to convert a “Section 529” educational savings account to an ABLE account without penalty. Treatment of Certain Individuals Performing Grants special tax benefits to military service members serving in the Service in the Sinai Peninsula of Egypt Sinai Peninsula of Egypt. There are currently similar provisions in state law. Treatment of Student Loans Discharged on Excludes the discharge of student loan debt in case of death or Account of Death or Disability disability from income. Suspends Exclusion for Moving Expense Includes employer reimbursements of moving expenses as income. Reimbursement Suspends Moving Expenses Deduction Eliminates the deduction for moving expenses. Limits Wagering Losses Clarifies the definition of “losses from wagering transactions.” Repeals Deduction for Alimony Payments Repeals the deduction for alimony payments for any divorce or separation executed after December 31, 2018. It is our understanding that this change was made to follow the rule of the United States Supreme Court’s (the Court’s) holding in Gould v. Gould, in which the Court held that such payments are not income to the recipient. Modifies Certain Depreciation Rules Adopts technical changes to certain depreciation rules (as applicable). Modifies Special Rules for Taxable Year of Modifies special rules regarding when businesses must recognize Inclusion certain income for tax purposes. Denies Deductions of Certain Fines, Changes business deduction rules to disallow deductions for penalties Penalties, and Other Amounts imposed for violating certain laws. (Continued) www.lao.ca.gov 15 analysis full gutter 2019-20 BUDGET Part of Governor’s Provision Effects of Conforming Proposala,b Denies Deductions for Sexual Harassment or Changes business deduction rules to disallow deductions for payouts Abuse Settlements and attorney fees related to sexual harassment or sexual abuse if the payments are subject to a nondisclosure agreement. Repeals Deduction for Local Lobbying Modifies rules for lobbying expenses deductions. Expenses Changes Rules Regarding Deductions for Modifies rules about deductions of specific types of employee Certain Employee Achievement Awards achievement awards. Modifies Partnership Taxation Rulesc Modifies several rules regarding how partnership income is taxed. Modifies Rules Related to Life Insurance Modifies several rules regarding the value of life insurance contracts when they are sold or transferred. Limits Deductions of Federal Deposit Limits the deduction of deposit insurance premiums paid by banks. Insurance Corporation Premiums Changes Electing Small Business Trust Changes several rules regarding ESBTs. (ESBT) Rules Changes Accounting Treatment of Changes several rules regarding a corporation that was previously a S Corporation Conversions subchapter S corporation. Expands Limits on Excess Employee Eliminates the performance-based compensation exception from limits Compensation on excessive employee compensation and expands the number of employees affected. Modifies Treatment of Qualified Equity Grants Modifies several rules related to qualified stock equity grants. Modifies Tax-Exempt Organization Rules Modifies rules regarding treatment of unrelated business taxable income of tax-exempt organizations. a As of March 1, 2019. b The administration also proposed to conform state law to a provision of federal law—Section 338—regarding the tax treatment of certain corporate stock transactions. This difference pre-dates the 2017 federal law. c The administration proposes only to conform to the repeal of “technical termination” of partnerships—tax rules that apply when there is a significant change in ownership of a partnership. LAO PUBLICATIONS This report was prepared by Brian Weatherford, Brian Uhler, Seth Kerstein, Justin Garosi, and Carolyn Chu. The Legislative Analyst’s Office (LAO) is a nonpartisan office that provides fiscal and policy information and advice to the Legislature. To request publications call (916) 445-4656. This report and others, as well as an e-mail subscription service, are available on the LAO’s website at www.lao.ca.gov. The LAO is located at 925 L Street, Suite 1000, Sacramento, CA 95814. 16 LEGISLATIVE ANALYST’S OFFICE