The impact of inflation on state and local tax planning will be particularly important and complex for businesses and investors to consider, given the diversity of taxes that are imposed by state and local tax jurisdictions. Inflation has the potential to affect corporate and personal income taxes, sales and use taxes, and property taxes, and, in many cases, could markedly change the amount of tax liability a person or business will owe in the coming years.
Inflation could be particularly painful for individual state income taxes, as many of the highest tax states do not index their tax brackets. That may be balanced against targeted relief, as states flush with revenue response offer tax breaks to compensate for inflation. Businesses will feel the state tax impact in various ways. The de minimis thresholds for sales and use taxes for remote sellers are generally not indexed and will shrink in relative terms with inflation. Inflation could also affect the calculation of state income even more than federal income, and how businesses apportion income among states. Both businesses and individuals will potentially be affected by property tax bills as inflationary pressure drives real estate valuations higher.
This piece will discuss these and other key state and local tax considerations for an inflationary environment and is part of our series of articles covering the tax planning implications of inflation. Our first article provides a high-level introduction to the series, while other articles provide a deeper dive into considerations for federal and estate and gift tax planning.
Potential effects of inflation on overall state tax policies
Inflation is likely to have interesting implications with respect to how states evaluate and undertake their overall tax policies. Most states currently are in a very solid financial position with budgetary surpluses as a result of economic expansion, along with the influx of funding from the federal government through the American Rescue Plan Act (ARPA). In addition to ARPA, states are seeing increased income tax collections from several sources, including nominally higher profits reported by businesses and substantially higher wage income reported by individuals. Further, sales tax collections from taxable transactions of goods and certain types of services have risen in the past several years, in part due to the effects of the landmark U.S. Supreme Court decision in Wayfair v. South Dakota requiring many remote sellers to collect and remit sales and use taxes to the states.
In response to these historically favorable budget conditions, numerous states have either proposed or enacted reductions in income and/or sales tax rates or have enacted one-time tax relief for their residents. California, for example, recently used some of its budget surplus to enact legislation providing for tax rebates of up to $1,050 per family, as a means to counteract the effects of inflation. Many states also have reacted to the recent rise in oil prices with temporary suspensions in state and local gas taxes. In the short term, as long as state budgets remain in good shape, these policies may be able to continue as a means to ensure temporary tax relief for taxpayers feeling real economic pain from inflation, despite rising wages. The long-term outlook, however, might not be so rosy. The effects of ARPA funding will abate in the near future, and if the inflationary environment continues, or, in an effort to drive away inflation, the economy is tipped into a recession, states may be stuck with the unpalatable choice of steep tax increases or drastic reductions to services that they provide.
Corporate income taxes
Inflation may impact both the measure of state income and how it is apportioned in important ways. Most states impose corporate income taxes on businesses based on a measure of federal taxable income, as adjusted by a series of addition and subtraction modifications. This modified amount is then typically divided between the states through a process known as allocation and apportionment, generally through a measure of in-state to overall activity.
Modified state tax base
One aspect of the state corporate tax base that often differs from the federal income tax base is the treatment of tax deductions for depreciable assets. For federal income tax purposes, as a means to incentivize businesses to purchases assets, taxpayers have been able to apply special bonus depreciation provisions designed to allow taxpayers significant deductions in the early years of an asset’s life for many years. Between the tax years of 2022 and 2025, however, without legislation, bonus depreciation provisions will begin to taper off, lengthening the amount of time in which taxpayers can fully capture these deductions. In an inflationary environment that extends for several years, the de-emphasis on bonus depreciation provisions can significantly devalue the ability of the deduction to offset income. For example, if a business purchased a property that is subject to reduced bonus depreciation amounts in 2022, remaining deductions on such property taken in later years might not be able to significantly offset other income that is markedly higher due to inflation.
With respect to state corporate income taxes, this problem may already be occurring in 2022, because many states decoupled from bonus depreciation provisions entirely, and hence, the permissible deductions for these assets are spread out over a far longer period of time. So, in a state in which bonus depreciation does not apply, depreciation deductions that might be larger than the ones taken for federal purposes might, at first blush, seem like a good thing, but such deductions, which may have already been deferred for far longer than for federal purposes, are not going to be as effective in offsetting a more highly inflated income amount. It should be noted that in response to the reductions to the federal bonus depreciation benefit, Oklahoma became the first state to react by permanently allowing for full expensing of property currently subject to the Section 168 bonus depreciation and Section 179 expensing provisions, regardless of future changes to the federal income tax treatment.
As noted in our prior piece detailing federal income tax consequences from inflation, other tax attributes that may eventually be modified for state corporate income tax purposes, like net operating loss and Section 163(j) carryforwards, will decline in value over time as inflation continues to persist. The challenge with respect to these attributes on the state side is determining how detrimental that effect will be, as many states do not follow federal rules. For example, state net operating loss rules often are more restrictive and do not provide as much benefit for state corporate income taxes as they do for federal income tax purposes. On Section 163(j), states are all over the map with respect to whether such limitation even applies at all, or whether a 30% or 50% limitation applies with a variety of state-specific calculation nuances to consider, including other limitations on interest expenses that already exist in the intercompany context.
Inflation may also have significant effects on the calculation of the apportionment factor, especially to the extent that such an environment causes asset holders to decide to divest their holdings. Many states have eschewed the historic three-factor property, payroll, and sales factor formula to apportion income, and instead have focused on the use of a heavily weighted or single sales factor. The amount of sales and where they are considered to occur determine the sales factor ratio that drives the state tax liability calculation. Depending on the type of sale at issue, such a sale can be sourced to a state via market-based sourcing or, in some instances, the location where the costs of performance by the seller occur.
How does inflation play into apportionment? To the extent an asset holder decides to sell, the amount received for that asset, and the gain recognized from such sale, might be substantially higher this year than when compared to what they would have been last year due to inflation. For purposes of apportionment, the method of inclusion and sourcing of a large sale of this nature is vitally important. Inclusion of the sale as a measure of gross receipts, or as net gain, can either raise or lower the overall apportionment factor depending upon whether state-specific rules source such amounts to the state or not. High value sales will in some cases “blow up the calculation,” resulting in artificially high or low sales factors which have a consequent effect on tax liability. Some states, in their construction of the sales factor, require the exclusion of what they characterize as occasional sales precisely because of their potentially distortive effect on the sales factor and, by extension, tax liability.
Personal income taxes
Inflation has the potential to drive up state personal income tax bills in a number of ways. While individuals may consider an inflationary environment to be bad from the perspective of consuming goods and services, the labor market in the past couple of years has also run hot from the perspective of wages. As a result, individuals’ state and local personal income tax liabilities may be higher this year than in the past. To make matters potentially worse, states that impose personal income taxes at progressive and relatively high rates, like New York, New Jersey and Connecticut, do not index their personal income tax brackets, or their standard deductions and/or personal exemptions for inflation. As a result, taxpayers that received a salary increase may find themselves in a marginally higher tax bracket next year with more overall tax liability than expected. In response to the current inflationary environment, states might be more inclined to consider whether permanently raising bracket amounts, changing their bracket structures or using an inflation index may be warranted to address unintended income tax increases that are seeing less real wage growth as the result of being bumped into higher tax brackets.
For some individuals that derive their income from ownership of a pass-through entity (PTE), the diminishing effect of the non-indexed $10,000 federal cap on state and local tax deductions created by the TCJA in 2018 (and currently in place until 2025) could have a very interesting follow-on effect. The $10,000 cap has given rise to more than 25 states adopting optional PTE tax regimes in which the PTE becomes subject to state taxes and takes an unlimited deduction for such state taxes paid, reducing federal taxable income. Individual owners of the PTE benefit through the reduction of federal taxable income and the ability to take a state tax credit for amounts paid by the PTE (or in some cases, a deduction of income from the PTE). By keeping the cap at $10,000 rather than raising it to keep up with inflation, individuals that have ownership interests in businesses may have even more reason to consider whether the PTE should elect into these regimes.
Sales and use taxes
On the sales tax front, following the landmark U.S. Supreme Court decision in Wayfair v. South Dakota, states have rushed to implement legislation designed to require remote sellers to register, collect, and remit sales and use tax to a state if certain sales and/or transactional thresholds are met. The state sales thresholds range between $100,000 and $500,000 of in-state sales. To date, states adopting this legislation generally have not indexed the sales thresholds to inflation. As a result, as inflation continues to push prices higher, remote sellers will tend to reach these thresholds more quickly, requiring more of them to register, collect and remit in more states. This might be considered a positive result for states that want to ensure payment of the sales tax on transactions with their in-state consumers, while increasing revenues because of the higher prices charged on transactions overall. However, it places an added burden on the businesses that will be required to shoulder the administrative compliance and risk with the tax collection and remittance process. One potential path for states to relieve some of this burden would be to index the $100,000-$500,000 sales thresholds for inflation, either through 5% increments or an annual adjustment.
Inflation hits different asset classes in disparate ways, and nowhere is this more valid than in the area of property taxes. These taxes, which are generally based on formulas that take the value of property into account can be notoriously sensitive to inflation. Commercial property values took a big hit at the outset of the pandemic, but with people returning to cities to work at least part of the time, and a reimagination of what work could look like post-pandemic, these values are again moving north. The rise in residential property values during the pandemic may have foretold the story with respect to the economy sustaining widespread inflation. With values that have gyrated over the past several years due to the effects of the pandemic and inflation, one would expect that these changes would have caused instability for purposes of property tax revenues. However, many states and localities try to dampen the effect of rapid changes in asset values for their property taxes by limiting consequential changes in the tax base from year to year. Property tax revenues eventually may increase more noticeably, but by the time they do, inflation might have run its course.
Given the significant impact that inflation is likely to have across the spectrum of state and local taxes, taxpayers should consider planning opportunities. With respect to income taxes, the changing posture of bonus depreciation in an inflationary environment has highlighted inconsistent ways in which states historically have treated these federal benefits over time. If a significant amount of property eligible for bonus depreciation has just been purchased, consider performing a holistic review of federal and state bonus depreciation deductions in order to ensure that such deductions are properly utilized. With interest rates rising quickly, it might be worthwhile to analyze how interest income derived from investments should be sourced for purposes of apportionment. For PTEs with owners concerned about the ongoing negative effect of the $10,000 cap on federal deductions for state and local taxes as such taxes rise, the potential ability to opt into one or more state PTE tax regimes may warrant consideration.
Planning considerations designed to mitigate the impact of inflation on indirect taxes should not be ignored. Businesses running up against the remote sales thresholds more quickly due to the power of inflation should prepare for potential registration, collection and remittance responsibilities. Finally, in the realm of property tax, inflation is likely to lead to some level of increased assessments in the coming year, even though in many cases, commercial properties are still recovering from the effects of the pandemic. If property tax increases seem unreasonable, it may be time to appeal some of these assessments.
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