On January 1, an additional degree of uncertainty was introduced to the area of state income taxation. Recently, the Internal Revenue Service issued final regulations on the treatment of repairs to tangible property. The rules in these regulations are collectively referred to as the “Repair Regulations,” and they clarified and added new provisions to the previous federal rules dictating the capitalization of certain repairs made to tangible property.
In typical fashion following an announcement of a substantial federal tax law change, the states are pondering the effects and have yet to issue guidance. As such, the impact of the Repair Regulations on state income taxes is still uncertain, but is bound to create another layer of complexity to tax compliance.
From a state income tax perspective, the Repair Regulations are likely to create timing differences between federal and state taxable income. In the coming months, we anticipate guidance from the states to trickle in. But until we hear otherwise, we can only surmise the treatment based on a state’s adoption, or lack thereof, of the Internal Revenue Code (IRC).
Flavors of Federal Conformity
Generally speaking, states piggyback off of federal taxable income (either before special deductions like net operating losses or after such deductions) and then make modifications to that figure. Some of these modifications are dependent upon how the state incorporates the IRC into its tax regime. States will either:
- Adopt the IRC on a rolling basis (“Rolling Conformity”)
- Adopt the IRC as of a fixed date (“Fixed-Date Conformity”)
- Pick and choose provisions of the IRC that suit the needs of their taxing regime (“Hybrid”)
Setting aside those Hybrid states—which are the minority of states—most of the Rolling and Fixed-Date Conformity states decouple from IRC provisions that they don’t like. States tend to dislike provisions that accelerate deductions, and as such, we suspect add-back provisions targeting the Repair Regulations are on the horizon.
If you’re thinking that a Rolling Conformity state is going to automatically follow the federal treatment prescribed in the Repair Regulations, think again. As previously mentioned, decoupling from certain federal provisions throws a wrench in what might otherwise be a fairly easy evaluation of state tax treatment. Let’s look at some examples of how Rolling and Fixed Date Conformity states have historically handled bonus depreciation in hopes of drawing a baseline for their yet undecided handling of the Repair Regulations:
Rolling Conformity: State such as Colorado, North Dakota, and Utah adopt the IRC on a rolling basis and do not decouple from the federal bonus depreciation provisions. But then there are the states with Rolling Conformity such as District of Columbia, New York, and Rhode Island that specifically decouple from federal bonus depreciation provision.
Fixed-Date Conformity: These states are all over the board when it comes to when and what provisions of the IRC they adopt. For instance, California adopts the IRC as of a fixed date, yet decouples from the federal bonus depreciation provisions.
What’s the take away? Don’t assume Repair Regulation conformity based solely on Rolling and Fixed-Date Conformity. Take the additional step to see if the state(s) have historically decoupled from federal provisions that provided for accelerated deductions.
The Repair Regulations contain substantial changes regarding the capitalization of certain repairs made to tangible property, which may create discrepancies in the adjusted basis of certain items of tangible property for federal purposes, which could then be compounded at the state level. States that do not implement the Repair Regulations could create a situation where the adjusted state basis of the property is different than the adjusted federal basis.
A couple of examples where a state may choose to depart from the Repair Regulations are with the partial disposition deduction and the de minimis election. The Repair Regulations allow taxpayers to elect to deduct the net book value of a portion of an asset in certain circumstances. If a state chooses not to adopt this it would create a basis difference in an asset for federal and state purposes. Another example is the de minimis election where taxpayers may substitute a higher capitalization threshold used on their financial statements instead of the tax threshold. If a state chooses not to adopt this provision it would capitalize items as fixed assets where the federal rules allow for immediate expensing.
IRC Section 481(a) Adjustment
The Repair Regulations will inevitably lead to accounting method changes, which calls IRC Section 481(a) into play. When Section 481(a) is applied, a taxpayer must determine income for the taxable year preceding the year of change under the old method and income for the year of change and subsequent years under the new method—as if the new method had always been used. What does this mean for state income tax? It means that you’re going to pick up income or loss relating to prior years in the current year and have to decide how to apportion it. The question becomes, does it make sense to apply the current year apportionment factor to income or loss that’s related to the prior year(s)? Unfortunately, this is an undeveloped area of state taxation with little guidance. Taxpayers should consider alternative apportionment when a Section 481(a) adjustment results in a distortion of state tax liability.
It is uncertain how states will treat the new Repair Regulations, but it could create even more complexity in the way state taxes are reported. If you have questions or want additional information, please contact your Eide Bailly service provider or Kathleen Clark or John Worden in Eide Bailly’s SALT group with questions or for additional information.