Since the enactment of the Tax Cuts and Jobs Act (TCJA), Minnesota’s Department of Revenue (DOR) has been analyzing what the TCJA will mean for Minnesota. The TCJA marks the most significant changes to the Internal Revenue Code since 1986, and it affects nearly every major aspect of federal tax law. In the 2018 Legislative Session, legislators will need to consider what changes should be made to the State income tax based on analysis of the impacts of the TCJA.
Minnesota is one of six states that use federal taxable income as a starting point in determining taxable income. The impact that the TCJA will have on Minnesota taxpayers thus depends on how the changes to the Federal Code affect the determination of federal taxable income. Preliminary estimates by the DOR suggest that the net result of the TCJA is an increase to Minnesota’s tax base which, under current law, would increase tax revenues.
Traditionally, Minnesota has conformed to federal tax changes to simplify filing for Minnesota taxpayers. Because the TCJA is effective for tax year 2018, Minnesota should make conformity decisions in 2018 for any changes to apply to tax return filings due April 15, 2019. It is important to remember that a conformity bill means adopting the federal definition of income, not adopting the rate and credit changes that Congress made.
The Department of Revenue recently released estimates of the increase in tax collections if Minnesota conforms to federal tax changes, which are as follows ($000s):
|FY 2018||FY 2019||FY 2020||FY 2021|
|Individual Income Tax||$8,320||$395,480||$406,820||$492,320|
|Property Tax Refund||$0||$0||$84,410||$84,830|
|Corporate Franchise Tax||$26,980||$418,200||$217,400||$204,700|
|General Fund Total||$35,300||$813,680||$708,630||$781,850|
NOTE: This document is a preliminary estimate of the impact of adopting recent changes to the Internal Revenue Code with no corresponding Minnesota tax policy changes.
Understanding the issues facing the legislature requires an understanding of the new federal regime. Some of the key changes affecting the taxation of individuals, businesses, and multinational taxpayers are highlighted below:
- Standard deduction increased. The increase nearly doubles the current standard deduction to $24,000 for married joint filers, $12,000 for individuals and $18,000 for heads of households. This increase, coupled with the fact that many itemized deductions are repealed or limited, will likely force many more taxpayers to claim the standard deduction.
- Personal and dependent exemptions repealed or limited. The federal law repeals the exemption a taxpayer could claim for each person included on the return.
- Most itemized deductions repealed. The TCJA also repeals or limits certain popular itemized deductions. Perhaps the most significant limitation was to the State and Local Tax (SALT) deduction, which is now limited to $10,000.
- Deduction for pass-through income. The federal law provides non-corporate taxpayers with a 20 percent deduction for qualified business income earned from a partnership, S corporation, or sole proprietorship. The deduction for income from specified service businesses including law, accounting, brokerage services and investment management services will be subject to limitation at higher income levels.
For businesses, the TCJA permanently cuts the corporate tax rate and allows full and immediate expensing of many types of capital investments while also significantly limiting certain types of business deductions.
- Corporate tax rate change. The federal law includes a permanent reduction in the corporate tax rate, imposing a flat tax rate of 21 percent. While this has no impact on Minnesota’s corporate tax rate of 9.85 percent, the legislature will likely evaluate whether a rate change is appropriate.
- Bonus depreciation and Section 179 expensing. Bonus depreciation is increased to 100 percent from 40 percent through tax year 2022 and then phased out 20 percent per year. Section 179 expensing is increased to $1 million and the phase out increased to $2.5 million. Under current Minnesota law, 80 percent of federal bonus depreciation is added back and depreciated over a five year period. The DOR analysis assumes that this provision will remain in place.
- New limits on the deduction of business interest. Net interest expense (whether paid to related parties or not) is limited to 30 percent of the business’s adjustable taxable income for taxable years beginning before January 1, 2022. For taxable years beginning on or after January 1, 2022, the 30 percent limitation is measured by adjustable taxable income plus depreciation and amortization.
- Repeal of the AMT. The TCJA repealed the corporate alternative minimum tax (AMT) and contains rules for how AMT credit carryovers can be utilized beginning in 2018.
- Methods of Accounting. Any taxpayer with average gross receipts over the prior three years of $25 million or less can use the cash method, including C corporations. If they meet the $25 million test, businesses may also use the completed contract method if the contract is within 2 years from commencement.
The most significant changes were made to the taxation of multinational groups. The TCJA shifts the United States from a worldwide tax regime to a modified territorial system. Many of the key international changes are complex and will take time for Congress and practitioners to digest. Some of the major provisions the legislature will need to consider include:
- Deemed Repatriation Tax on Untaxed Foreign Profits. The TCJA implements a so-called “toll charge” on a U.S. shareholder’s pro rata share of its foreign subsidiaries post-1986 undistributed earnings and profits (E&P) as reduced by the shareholder’s share of the aggregate foreign E&P deficits of other foreign subsidiaries. The one-time tax is intended to provide a partial dividends-received deduction on the distribution and imposes the tax at an effective rate of 15.5 percent for all undistributed earnings attributable to cash and other liquid assets, and 8 percent rate on all amounts in excess of the cash position. Taxpayers may pay the toll-charge in installments over eight years.
The Minnesota legislature has several difficult conformity issues to address in responding to TCJA’s deemed repatriation tax. First, it’s not entirely clear how Minnesota law would characterize this deemed repatriation after it hits the taxpayer’s federal return. In addition, the legislature will likely need to decide to what extent Minnesota’s 80 percent dividends-received deduction will apply to this repatriated income, what tax rate will apply to the repatriated profits, and whether the state will conform to the federal law’s election to pay the tax over an extended period of time.
- Participation Exemption. Beginning in 2018, federal law provides for a 100 percent deduction (i.e. “participation exemption”) for foreign source dividends that a domestic C corporation (other than a regulated investment company (RIC) or real estate investment trust (REIT)) receives from a foreign subsidiary in which it owns 10 percent or more of the stock vote or value.
Some practitioners have argued that, as federal law moves to a territorial system, so should the state. As stated above, Minnesota law currently allows an 80 percent dividends-received deduction for dividends received by a corporation in which it owns 20 percent or more of the stock, unless that foreign corporation meets the definition of Foreign Sales Corporation under I.R.C. § 922. The Minnesota legislature may decide to follow the TCJA’s lead by allowing a 100 percent deduction for foreign source dividends.
Conformity With Federal Tax Law at State level
The TCJA was passed rather quickly and without much discussion regarding its impacts. The DOR is still analyzing the bill and learning how it relates to Minnesota’s tax code. There is talk of a federal corrections bill to address some concerns within the TCJA, but the timing of such a bill is uncertain.
The Legislature will be tasked with deciding whether or not to conform to the definition of federal taxable income during the 2018 Session. Once that decision is made, the tax committees in the House and Senate will begin discussing whether and how to conform to the new federal law. Likely topics will revolve around simplifying filing, providing tax relief by lowering rates and making investments in the state. This is likely to be a contentious debate, as Governor Dayton has stated he would like to address provisions from the 2017 Omnibus Tax Bill that became law. Leaders of the House and Senate have said they will not capitulate to the Governor’s demands to revisit provisions from last year’s bill, leaving the ability to pass a conformity bill uncertain.
The DOR has begun reaching out to the Legislature and interest groups about the need to pass some type of conformity in 2018 so the DOR can prepare their systems to address the 2018 filing season. The absence of a bill prior to the opening of the 2018 filing season will make filing extremely complicated because of the different definitions for federal taxable income for federal and state returns. One option the legislature may explore is converting Minnesota’s starting point for individuals to federal adjusted gross income. The DOR has urged caution regarding that idea, raising concerns about whether it would have sufficient resources to handle such a significant change to Minnesota’s tax system.
Given the complexities involved with responding to the TCJA, tax counsel for the legislature has suggested addressing conformity by separate groups — individuals, businesses and multinational groups — in order to get a better picture of how the changes affect each taxpayer. Plus, some of the TCJA provisions are permanent and some are temporary, which will need to be taken into account when looking at future budgets and fiscal stability of the state.