States Face Conformity Decisions With Sunsetting Trump Tax Cuts

Federal income tax changes are coming, through either expiring provisions in the 2017 Tax Cuts and Jobs Act or new federal legislation. In either case, impending federal changes may push states to protect their tax revenue bases in 2025 and beyond, including through greater conformity with the federal tax code.

Some of the more notable TCJA provisions set to expire at the end of 2025 include individual tax rates (the highest bracket will rise to 39.6% from the current 37%), the standard deduction (which the TCJA nearly doubled), and the qualified business income deduction under Section 199A for certain partnership income (which will expire). Further, the TCJA’s $10,000 limit on the state and local tax deduction and its provisions limiting the application of the alternative minimum tax will both expire at the end of 2025 absent congressional action.

Despite some TCJA provisions expiring at the end of 2025, many consequential provisions were made permanent, including the 21% corporate income tax rate; the revised business interest deduction limitation of Section 163(j); the required capitalization of research expenses under Section 174; the 80% limitation net operating loss utilization in tax years beginning after Dec. 31, 2020, under Section 172; and the limitations on the deductibility of meal and entertainment expenses under Section 274.

From an individual perspective, the TCJA’s $10,000 SALT deduction cap is arguably the most meaningful provision sunsetting in 2025. For residents in high personal income and property tax states such as California and New York, this would restore a significant tax deduction to many individuals.

That said, it may be wise to view the restoration of an uncapped SALT deduction through the lens of the pre-TCJA alternative minimum tax calculation, which is similarly set to return in 2026. Because the SALT deduction is historically a preference item added back in the alternative minimum tax calculation, the parallel return of the pre-TCJA alternative minimum tax may blunt the potential benefit of an uncapped SALT deduction for individuals.

As a related matter, the expiration of the TCJA’s SALT deduction cap may soften the perceived need for state pass-through entity tax rules. Since 2017, more than half the states have adopted a pass-through entity tax system. Generally, state pass-through entity tax rules are intended to allow individual owners of pass-through entities to shift their state income taxes to business entities not subject to the TCJA’s SALT deduction cap.

As a result, some states could view the restoration of an uncapped SALT deduction in 2026 as diminishing the need for such rules. Many states already incorporate operative dates that mirror the expiration of the SALT deduction cap. For example, California only allows a pass-through entity tax election to be made in tax years beginning on or after Jan. 1, 2022, and before Jan. 1, 2026, and contains an automatic repeal provision triggered if the TCJA’s amendments to Section 164(b)(6) are repealed before Dec. 1, 2026.

Although many state pass-through entity tax rules are designed to end conterminously with the SALT deduction cap, few have accounted for the possibility of the cap being extended. If the TCJA’s amendments to Section 164(b)(6) remain beyond 2025, many states would need to re-evaluate or extend their rules quickly.

Concerning the relevance of state pass-through entity tax rules, the alternative minimum tax calculation looms large. To the extent both a pre-TCJA alternative minimum tax and pre-TCJA SALT deduction return, a state could still potentially benefit individual state residents by allowing them to deduct state taxes federally at the pass-through entity level, rather than at the individual owner level, where there is risk of the SALT deduction being disallowed as part of the alternative minimum tax calculation. For this reason, some state pass-through entity tax systems may be extended beyond 2025 even if the SALT deduction cap expires.

Due to the TCJA’s reduced 21% corporate tax rate, the qualified business income deduction under Section 199A was intended to provide a degree of effective tax rate parity on income earned by businesses organized as C corporations versus income earned by pass-through entities. Because the 21% rate is permanent (absent changes by the next Congress or presidential administration), it’s plausible that the qualified business income deduction may be extended to avoid the appearance of a preferential atmosphere for businesses organized as C corporations.

Only Colorado, Idaho, North Dakota, and Iowa have contemplated whole or partial conformity to Section 199A since the TCJA was enacted. The small number of states is no surprise because states set their own corporate income tax rates that are untethered to the federal rate. A state therefore wouldn’t share the same effective tax rate parity concerns that undergird the Section 199A deduction. If Section 199A expires, the few states that allow a qualified business income deduction may decide to eliminate it, either through conforming to the federal sunset or passing legislation.

State nonconformity to permanent TCJA provisions can in certain instances create beneficial state adjustments. For example, not conforming to the limitation on business interest deductibility under Section 163(j) and the required capitalization of research expenses under Section 174 can create tax savings opportunities in states that adopt the pre-TCJA federal tax code.

If state budgetary concerns and revenue needs grow in 2024 and beyond, states without a high degree of TCJA conformity may be motivated to explore selective conformity to permanent TCJA provisions that limit deductions. For this reason, it wouldn’t be surprising to see a trend of states selectively adopting the TCJA’s amendments to Sections 163(j), 174, and 274 to limit business deductions.

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

Author Information

Josh Grossman is principal at Moss Adams in San Francisco specializing in California income tax matters.

Glenn Walsh is partner at Moss Adams in Irvine, Calif. specializing in M&A and multistate income tax planning.

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