New federal tax laws were designed to stimulate the economy. But depending on what state you do business in, those benefits may not trickle down to the local level.
One of the most difficult -- and often overlooked -- aspects of tax planning involves reconciling the objectives of deferring or reducing federal taxes with the liability for state and local taxes. Often, planning to take advantage of a legitimate "loophole" in the federal tax laws will reduce or even eliminate the benefits that transaction generates on the state tax return.
A recent example is the Job Creation and Worker Assistance Act of 2002 (JCWA), which was signed into law by President Bush on March 9, 2002. The bill made a number of significant changes designed to stimulate the economy, several of which were retroactive to the 2001 tax year.
Because most states use the Internal Revenue Code, the federal tax law, as the base for their state income taxes, the federal cuts threatened to reduce state revenues. Faced with budget shortfalls, it's not surprising that many states are balking at adopting tax breaks included in the federal economic stimulus package and other federal tax-related legislation. The quandary for the states is this: Should they go along with the tax breaks and suffer another revenue hit, or should they refuse, thereby denying business taxpayers some benefit and complicating an already complex tax code?
Many state legislatures have opted to avoid a loss of tax revenue, which in turn reduces the amount of savings that many remodelers might otherwise enjoy as a result of the economic stimulus package.
Federal tax breaks -- 2002 style
With states reducing or eliminating the benefits of the JCWA, how can remodelers hope to fully stimulate their businesses? The answer lies in the systems -- both federal and state.
Businesses ranging from large multinational companies to self-employed remodeling contractors received the lion's share of the tax breaks under the JCWA. That stimulus bill included a provision for a "bonus" 30% depreciation deduction on capital equipment purchased between September 11, 2001, and September 11, 2004. A second provision extended the time period for using net operating losses (NOLs) to offset taxes, creating, in essence, refunds of previously paid taxes for many troubled remodeling operations.
Because of the implications for state budgets, however, a majority of state legislatures have declined to fully adopt both the depreciation "bonus" and the NOL provisions.
The result will be increased complexity for remodelers, who will have to account for their income and assets differently for state and federal purposes.
The JCWA allows remodeling professionals an additional first-year depreciation deduction equal to 30% of the adjusted basis of qualified property, such as equipment, software, and even improvements made to leased business property. On the company's federal tax returns, the "bonus" depreciation is allowed for both regular and alternative minimum tax (AMT) purposes for the tax year in which the property is placed in service.
Of course, any "bonus" depreciation claimed on the tax return will reduce the book value of the underlying asset and the amount of depreciation deductions that can be claimed in later years.
Thirteen states have laws that conform to the new federal provisions on "bonus" depreciation; another 24 plus the District of Columbia have not conformed, and three -- Nevada, Washington, and Wyoming -- impose no corporate income tax. Of the remaining 9 states with personal income taxes, or corporate or other types of business income taxes, most require taxpayers to add back a portion of the federal depreciation "bonus" when figuring their state tax, but then allow for the remainder of the "bonus" to be taken in later years.
In Texas, corporations that qualify and elect to use the federal income tax method of reporting taxable capital (including S corporations and corporations with taxable capital of less than $1 million) will be allowed to use the bonus depreciation as long as the same method was used on the corporation's most recent federal income tax return.
Thanks to that new but temporary bonus, a remodeling contractor who purchased a backhoe for $20,000 in 2002 could enjoy an immediate $6,000 tax write-off on his 2002 tax return ($20,000 x .30).
To qualify, depreciable expenses must have a recovery period of less than 20 years. The exception is for property leased by the remodeling business, including the operation's offices. These expenditures are covered by the temporary bonus depreciation rule, even though structural improvements are usually assigned the same life or recovery period as that of the underlying property -- 39 years in the case of an office building.
To take advantage of the federal tax breaks, remodeling businesses operating in non-conforming states will find themselves compelled to keep multiple sets of records on the current book value (the "basis") for each asset that qualifies for the federal provision.
Net loss carry-over
Under federal tax rules, most net operating losses can be carried back two years; some, such as casualty losses, are usually carried back for three years. The JCWA temporarily extends the carryback period to five years. The new law also allows a taxpayer's NOL deduction to reduce its alternative minimum taxable income (AMTI) up to 100%.
Although this extended carryback period for NOLs may help some troubled remodeling contractors, it is not for everyone. That's because the extended carryback period applies only to the operation's 2001 and 2002 NOLs. Many remodeling contractors, however, may not have been in business five years ago, or may not have had profitable years against which they can offset their current losses. Because the NOL carryback produces a reduction to the federal tax bill in the year to which it is carried, without profitable years, many contractors will choose to save the loss to be used to reduce tax bills in future years.
In other words, instead of a refund of previously paid taxes, the contractor is "banking" the NOL to be used to reduce taxable income -- and their tax bill -- next year or anytime in the next 20 years. Once a contractor opts out of the carryback, however, the decision is final.
Only four states -- Alaska, North Dakota, Oklahoma, and Vermont -- have adopted the NOL provision as written in the federal law. Three others -- Delaware, New York, and Wisconsin -- have adopted the basic NOL provision but have limited the amounts that can be carried back.
Of the remaining jurisdictions, 40 states and the District of Columbia have not adopted the NOL provisions; Nevada, Washington, and Wyoming don't impose corporate or personal income taxes.
Keep in mind that the fact that a state is out of conformity with the JCWA or other federal tax breaks now doesn't mean it will necessarily remain so. A number of states synchronize their tax laws to the federal provisions as of January 1 of each year. However, with state legislatures scrambling for dollars and dragging their feet, it is not "business as usual" in many states. Best to check to determine the current situation in states where you work. --Mark E. Battersby is a tax and financial advisor, lecturer, author, columnist, and freelance writer with offices in the suburban Philadelphia community of Ardmore, Pa. For more than 25 years, Mr. Battersby's features and columns have appeared in the pages of the country's leading trade publications. He is also the author of four books.
Basics of tax planning
No matter what your state laws are, each year you should go over at least the following with your accountant.
- Reassess your personal tax situation.
- Develop and implement tax-reducing strategies.
- Review your form of doing business (sole proprietorship, partnership, S corp., etc.).