The One Big Beautiful Bill Act's potential state impact

In addition to its significance for federal income taxation, many provisions of the One Big Beautiful Bill Act (OBBBA), have immediate and substantial consequences on state and local taxation (SALT), ones that will be vital for jurisdictions and taxpayers alike to closely consider over the next several months.

As states are laser-focused on balancing their budgets each year, they will need to respond to the OBBBA’s changes to the treatment of research and experimentation (R&E) expenditures, bonus depreciation, the adoption of a full deduction for qualified production property, and changes to the interest expense deduction limitation. Further, the OBBBA’s temporary increase in the cap on the federal SALT deduction, without any restrictions on how the states’ pass-through entity (PTE) tax regimes work, will require states to evaluate the continued utility of these regimes.

Because states are likely to be flexible and relatively inconsistent with their approaches, taxpayers will have to be prepared to react and respond accordingly. This will be essential to ensure accuracy in their financial statements, adjust estimated state tax payments for the last two quarters of 2025 as needed, make extension payments for their 2025 state income tax returns, and complete the filing process later in 2026.

Invariably, an examination of state income tax treatment to a significant federal income tax bill requires a consideration of how each state conforms to the Internal Revenue Code (IRC), along with a comparison of where the states stood with respect to specific provisions in the IRC before and after the adoption of the bill.

For purposes of their corporate income tax codes, a slight majority of the states conform to the IRC on a rolling basis, meaning that they look at the current IRC as it reads today, for the current tax year. Independent of any other policy, these states essentially adopted the OBBBA concurrently with the federal enactment. The remaining states typically conform to the IRC on a static basis, meaning that they conform to the IRC as it reads on a certain date, for the current tax year. Since none of the static states currently have an IRC conformity date on or after enactment of the OBBBA, these states decouple from the OBBBA provisions for now. In these states, it generally takes at least several months to flip the switch and adopt legislation that moves the conformity date past the adoption date of a new law. Further, all states have the ability to be, and often are, highly selective in their conformity policy. Picking and choosing which federal income tax policies are worthwhile for the states’ corporate income tax code has always been popular, and that adds to the complexity and inconsistency of these regimes.

The OBBBA provisions relating to corporate income taxpayers garnering the most attention include the treatment of R&E expenditures, the bonus depreciation deduction, the adoption of a full deduction for qualified production property, and the changes to the interest expense deduction limitation, all of which tend to narrow the federal income tax base. Therefore, it is important to understand where the states stood with respect to these provisions prior to the OBBBA, where they stand in an OBBBA world, and what we might expect to see over the next several months as conformity policies take shape and potentially evolve.

Bonus depreciation

Following five years of 100% bonus depreciation beginning in 2018, the TCJA legislated a phasedown beginning in 2023, with the benefit reduced by 20 percentage points each year. The OBBBA permanently reinstated 100% depreciation for qualifying property placed in service on or after Jan. 19, 2025, under Section 168(k), but while the adoption of this provision is a boon to businesses, by no means should a taxpayer expect the same result for state income tax purposes. A majority of states historically have decoupled from the preferential federal income tax treatment of bonus depreciation, in part because states have been reticent to adopt the front-loaded nature of this deduction. States decoupling from 100% bonus depreciation have preferred to even out the deduction through slower depreciation regimes and reduce unplanned state revenue swings over time.

In lieu of pure adherence to federal bonus depreciation, states have taken several approaches. Many states have applied the IRC without reference to Section 168(k), under which a slower depreciation method generally is used. A few states have decoupled from full bonus depreciation but have struck a middle ground by allowing a state-specific bonus depreciation method under which the deduction is more accelerated than under regular depreciation.

In contrast, several states consistently have maintained direct conformity to federal bonus depreciation. That strategy has led to unintended consequences in the past couple of years, as the percentage that could be immediately deducted for federal purposes fell substantially from 100% in 2018-2022 to 80% in 2023 and 60% in 2024. Accordingly, a few states decoupled from the bonus depreciation regime entirely to allow for full depreciation regardless of federal treatment. In doing so, these states also allowed taxpayers flexibility to use slower methods of depreciation if that was preferable.

Full deduction for qualified production property

When the federal government adopts a new provision into the IRC, the disparity in treatment between rolling states and static states becomes very evident. A prime example is the enactment in the OBBBA of Section 168(n), which provides for a full deduction for qualified production property expenses (for qualifying property on which construction begins after Jan. 19, 2025, and before Jan. 1, 2029, and which is placed in service before Jan. 1, 2031). One might expect states’ treatment of this new provision to align directly with its treatment of bonus depreciation since they are contained within the same IRC section. However, that is not the case, because most states that decouple from bonus depreciation restrict the decoupling to Section 168(k) itself, leaving a solid majority of states conforming to most of the other parts of Section 168. That may come as a surprise to the states that find they suddenly conform to Section 168(n), such as Illinois and New York, and have to enact a decoupling measure if they want to remove the state from this regime.

Interest expense deduction limitation

Section 163(j) is another area of the federal tax law that has changed several times in recent years, leading states to diverge from a uniform conformity policy. The provision as adopted under the TCJA was intended to limit interest deductions to 30% of adjusted taxable income, albeit with the ability to carry forward disallowed amounts indefinitely. The TCJA provision replaced a former regime under Section 163(j) that was far less restrictive to taxpayers, often resulting in no effective interest limitation. The determination of adjusted taxable income was originally based on an earnings before interest, taxes, depreciation and amortization (EBITDA) amount, measured on a tax basis. However, for the 2022 tax year and thereafter, the depreciation and amortization amounts were required to be deducted from earnings, resulting in an EBIT measure and a lower limitation that reduced the ability of taxpayers to deduct interest when incurred. Under the OBBBA, the shift from EBIT back to EBITDA for purposes of determining adjusted taxable income subject to the 30% interest expense deduction limitation is a positive for businesses that incur significant debt. This change could make it more likely for businesses to take larger interest deductions and in some cases begin to tap into carryforward amounts that might not have been possible had the EBIT calculation remained in effect.

Based on all these changes, state conformity to Section 163(j) has been predictably inconsistent. Many rolling states have maintained their conformity to Section 163(j), now using an EBITDA calculation. Many static states conform to the version under the TCJA and so now use an EBIT calculation. A third group of states have either fully decoupled from Section 163(j) or reverted to a pre-TCJA version of that statute, essentially resulting in an unrestricted interest deduction.

Interaction of the business tax base regimes and elections

Based on the above discussion, the three major domestic business tax base changes addressed in the OBBBA is each important on its own for states to address and taxpayers to consider as they structure their business activities. However, understanding the individual changes to the tax base and the extent to which states will follow them is just a starting point for the analysis. 

Beyond the issue of federal and state consistency in tax elections, states diverge from the federal consolidated filing concept in many respects. Some states require separate entity filings, while others require combined filing groups that can be far more expansive than the federal consolidated group, or nexus consolidated groups in which only entities that are independently taxable in that state are eligible to file. This issue is critically important because a taxpayer’s state tax posture could be vastly different in each jurisdiction depending upon the filing method used, and a taxpayer’s tax attributes, including Section 163(j) and net operating loss carryforwards, may also differ. Given this issue and the fact that not every state will conform to each of the OBBBA provisions, the tax benefits that may be achieved for federal income tax purposes may not consistently be obtained in the states.

The SALT cap and the state PTE tax regimes

The business tax deduction changes in the OBBBA are by no means the only tax provisions that will have SALT implications. The contentious negotiation relating to the cap on the federal SALT deduction  was a dynamic part of the overall legislative process, driven by concerns among representatives from higher-tax states that many individuals were being unfairly shortchanged by the $10,000 cap set by the TCJA.

By itself, the OBBBA’s increase in the SALT cap from $10,000 to $40,000 in 2025, plus a 1% annual increase through 2029, is significant to many individuals that do not surpass the new modified adjusted gross income (MAGI) limits. However, with respect to owners of pass-through business, the appeal of electing into one or more state PTE tax regimes in order to work around the cap also remains, transforming capped individual tax deductions into uncapped business deductions taken by the PTE against an elective state entity-level tax imposed on the PTE. That result was not a guarantee when the OBBBA was first conceived; the original House bill and an early Senate draft of the legislation placed significant and complex restrictions on the ability to utilize the state PTE tax regimes. In the final version, however, this language was absent, and the law does not make any changes. Accordingly, guidance contained in IRS Notice 2020-75, which permitted the broad use of PTE tax regimes following enactment of the TCJA, is still fully in effect.

Barring a dramatic and unlikely change in federal policy post-OBBBA, the PTE tax regimes will continue to be appealing for many individual PTE owners who could still exceed the elevated SALT cap or are over the MAGI limit. This may be especially true in tax years in which an outsized gain is recognized. However, there is no guarantee that the states will continue to provide PTE owners a state PTE tax regime in all circumstances or in the same manner in which they have accommodated PTE owners over the past several years. Some states provided for these regimes to last only through 2025, after which the SALT cap from TCJA was set to expire, and they will have to address extensions of the sunset date.

California is an example of a state that just went through this process to extend its PTE tax regime in late June, recognizing the imminent adoption of the OBBBA and the extension of the SALT cap – albeit at a higher level. In extending its PTE tax regime through 2030, California also fixed a rule that previously prevented a PTE from making the election if a required payment that had to be made by June 15 of the tax year was underpaid or not made. This rule was inconsistent with applicable rules for most state PTE tax regimes. Under the new California legislation, the PTE may still make the election, though a PTE owner will lose 12.5% of the credit in the case of a shortfall in the June 15 required payment.

Next steps

With the significant business and individual tax changes included in OBBBA, it is important that taxpayers do not assume these changes will automatically be followed by the states. The next several months will be critical as states evaluate the extent to which they will follow federal policy. To that end, taxpayers will be well served to track what is happening in state legislatures, particularly in jurisdictions in which they have a significant physical and/or market presence resulting in high SALT liability.

Likewise, as taxpayers begin to address the viability of making special elections to optimize their federal tax posture, they should also account for how these elections will affect their overall state tax posture as part of a holistic analysis. This has never been more important given the fact that state corporate income tax liabilities in the aggregate have become more relevant over time as a percentage of overall taxes, in part given the massive reduction in federal corporate income tax rates under the TCJA, combined with the numerous base narrowing provisions contained in the OBBBA. Finally, for businesses operated in PTE form, it will be important for PTEs and their owners to have detailed conversations regarding the continued vitality of PTE tax regimes.