Keep an Eye on Your State to Avoid Unpleasant Income Tax Surprises

By Steven Roll

Since December, 2007, Congress has enacted nearly a dozen tax measures, some of which offer a multitude of tax breaks for both businesses and individuals

Many small business owners don’t realize that the states may not conform to these tax breaks and they are sometimes not available at the state level. This means that federal taxable income might not be an accurate indicator for determining how much tax will be owed to a state.

The differences between federal and state tax income tax laws could require business owners to use different methods at the state and federal levels for tracking items such as depreciation expenses.

I.R.C. (Internal Revenue Code) conformity is an important issue for the states too. Incorporating a federal tax break into their own tax codes means less revenue in state coffers. The recession has made this problem particularly acute because of the downturn in state revenues.

Internal Revenue Code. About half the states conform to the “current” version of the federal Internal Revenue Code.

Most of the remaining states conform to the I.R.C. as of a fixed date. One of these states is California, which conforms to the I.R.C. as of June 1, 2005. This means that the state does not adopt any of the federal tax changes adopted after that date.

Even a state that adopts the “current” version of the I.R.C. can choose to “decouple from” or not adopt a specific federal tax break.

When a state does not adopt a federal tax break, it requires the taxpayer to adjust federal taxable income when reporting state taxable income by adding back the amount of the federal deduction.

State Adjustments to Federal Tax Breaks. Over the past couple of years, the amount of these state add back adjustments has proliferated. Some of the recently enacted federal tax breaks that many states have chosen not to adopt include:

• bonus depreciation provisions,
• enhanced depreciation expensing for small businesses,
• a provision allowing qualified taxpayers to defer certain cancellation of indebtedness income, and
• special net operating loss rules for small businesses.

Understanding your state’s approach in conforming to the I.R.C. when computing state taxable income will help you avoid unpleasant surprises at tax time. It can also help you decide which states offer the best fiscal climate for continuing or expanding your operations.

Steven Roll is a senior tax law editor with BNA Tax & Accounting (bnatax.com)