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Which States Conform to Federal Tax Rules?

Why Conformity Matters in Tax Planning

When you think about your client’s tax liability, federal taxes are only one piece of the puzzle. State taxes matter, too. This is especially true for entities that operate in more than one state.

Tracking your client’s activity across multiple states can be difficult, especially when you realize that each state treats deductions and credits from the federal return differently. Some states fully adopt all federal tax laws, but many states pick and choose which provisions they adhere to.

State conformity to federal tax law will have a big impact on your tax planning strategies. Let’s explore state conformity as a concept so you can best serve your multistate clients.

How Does Conformity Impact State Tax Calculations?

Federal and state taxes are calculated very differently.

Federal Tax Calculation

To determine your client’s federal tax liability, you start with a clean state. On Form 1040, the IRS asks you to report each item of income, each deduction, and each credit to determine federal taxable income and federal tax liability.

State Tax Calculations

To determine your client’s state tax liability, you don’t start from scratch like you do for federal; your starting point is a number that’s pulled from the federal tax return. For example, many states begin their tax calculation with federal adjusted gross income (AGI) or federal taxable income. From there, non-conforming states will adjust that number to determine state taxable income.

But how exactly does conformity work? What provisions are states conforming (or not conforming) to? And how will these adjustments affect your client’s tax plans?

Which Federal Tax Provisions Require Conformity?

Many aspects of the federal tax code are automatically adopted by all states. For example, all states tax earned and unearned income, and all states allow businesses to deduct ordinary and necessary expenses on their corporate returns. But beyond these basic principles, states can choose to veer away from most federal tax laws, including (but not limited to):

  • Due date extensions
  • Net operating loss carrybacks or carryforwards
  • Tax credits (like the R&D or child tax credits)
  • Bonus depreciation and Section 179 depreciation
  • Business interest deductions
  • State and local tax deductions
  • Subpart F income
  • Capital loss carryforwards
  • Start-up expenses from pass-through businesses

Is State Conformity Good or Bad?

State conformity isn’t – by design – a pro-taxpayer or pro-government concept. When jurisdictions distance themselves from federal tax treatment, their stance may either benefit or harm taxpayers. For example, most taxpayers will benefit if their state chooses not to conform to the following federal tax provisions:

  • Limiting the state and local tax deduction to $10,000.
  • Reducing their dividends received deduction from 70% to 50%.
  • Limiting the mortgage interest deduction to interest incurred on indebtedness of $750,000 rather than $1 million.
  • Limiting NOL carryforwards to offset only 80% of income rather than 100%.

At the same time, most taxpayers will be worse off if their state chooses not to conform to the following federal tax provisions:

  • Deducting bonus depreciation or Section 179 depreciation.
  • Increasing the standard deduction.
  • Increasing the child tax credit.
  • Deducting 20% of qualified business income (QBI).

As you can see, conformity and nonconformity both have their pros and cons. Your client’s state tax liability can swing in either direction depending on which federal provisions their state adopts and which they deny.

What Are the Types of State-Level Tax Conformity?

States can choose to conform or not conform to any federal tax provision as long as it’s written into law. However, most states’ conformity paradigms follow one of the following five models:

Non-Conformity: Does not conform to federal tax policies.

For non-conforming states, no federal tax policies are adopted. However, some non-conforming states pass their own tax laws that mimic federal law, e.g., denying federal bonus depreciation but allowing its own version of accelerated depreciation.

Rolling Date Conformity: Conforms to federal tax policies automatically.

When the Internal Revenue Code (IRC) changes, states that have rolling conformity will automatically adopt those changes.

Fixed Date Conformity: Conforms to federal tax policies as of a certain date.

States may choose to adopt all IRC provisions, but only as of a certain date. Under fixed date (or “static”) conformity, any new federal tax laws passed will not be adopted until the jurisdiction passes a law that moves their conformity date forward.

Static Pre-TCJA Conformity: Conforms to federal tax policies as they existed prior to the Tax Cuts and Jobs Act of 2017.

Because the TCJA was such a noteworthy tax bill, in today’s tax environment, states often declare explicitly whether they conform to the TCJA’s provisions.

Selective Conformity: Incorporates only some federal provisions.

If states do not follow any of the previous conformity models, they are considered to have selective conformity where they pick and choose the federal provisions they adopt.

How Do You Report Adjustments for Nonconforming States?

There are two different ways you may need to adjust your client’s state tax return if they file in a non-conforming or partially conforming state.

Option 1: Make an adjustment for the federal provision.

To record an adjustment for not conforming to a federal tax provision, you must post an addition or a subtraction on the state tax return to either raise or lower your client’s state taxable income.

Example: In 2020, the IRS excluded the first $10,200 of unemployment compensation from taxable income. Colorado does not conform to this provision. If your client filed a return in Colorado in 2020, they were required to add unemployment compensation back into their state taxable income calculation.

Option 2: Perform a separate state tax calculation.

In many cases, you’ll need to post another entry that records the tax item under state tax policies.

Example: Your client operates in Florida, which does not conform to bonus depreciation. Instead, Florida has its own deduction that allows bonus-eligible assets to be depreciated equitably over a seven-year period. After adding back bonus depreciation to state taxable income, you must subtract one seventh of that amount to determine Florida’s depreciation deduction.

How Should Conformity Affect State Tax Planning?

A good tax preparation software will be updated each year to reflect changes to state conformity. But as your client’s tax planner, you’ll need to be thinking about conformity issues well before tax preparation software is released. Here is how you can prepare tax planning estimates for your clients:

  1.  Determine the states your clients will be filing in.
  2. Verify the conformity method for each of those states.
  3. Calculate the adjustments you’ll need to make for non-conforming or partially conforming states.
  4. Repeat steps 2 and 3 whenever a new federal tax law is passed.

A good tax planning software will help you estimate state adjustments you’ll need to make for non-conforming states. This will help you predict your client’s state tax liability as reliably as you can predict their federal tax liability.

If you want to see how our tax planning software addresses non-conforming and partially conforming states, reach out to us today to request a demo.

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