Tax Reform’s Implications on Illinois

The full impacts of federal income tax reform on Illinois taxpayers are just coming into focus.

Like many state income tax laws, the Illinois Income Tax Act (IITA) uses the Internal Revenue Code (IRC) as the starting point for calculating Illinois income tax liabilities. So, when sweeping federal tax changes come along, the first question is the extent to which Illinois will conform.

Unlike many other states, Illinois law provides for automatic conformity. In states that don’t automatically conform, maintaining conformity becomes a timing and legislative variable. In other words, conforming to or decoupling from federal tax law, and determining the state’s tax impact of doing so, is a daunting task. Fortunately, along with Illinois’ automatic conformity, most of the federal tax changes are effective for 2018 and beyond, which gives us some time to work through the implications for Illinois. Let’s get started.

First off, many of the headline-grabbing federal tax changes have little to no impact on Illinois’ tax base. For instance, the reductions and changes in corporate and individual income tax rates don’t have an impact on the Illinois tax base. Even the 20 percent deduction for pass-through entities pursuant to IRC Section 199A doesn’t affect the computation of the personal property replacement tax Illinois imposes on partnerships and S corporations.

In the case of individual taxpayers, net income subject to Illinois income tax is determined by federal adjusted gross income calculated before itemized federal deductions. In addition, the federal tax reform change reducing personal exemptions to zero doesn’t affect Illinois personal exemptions either because the federal personal exemptions weren’t repealed — just reduced.

As for corporate taxpayers, an impact could be felt by taxpayers and the state since the calculation of net income subject to Illinois income tax begins with federal taxable income, including federally authorized deductions, and is subject to certain state modifications. Corporations also use this same net income amount for calculating their personal property replacement tax liability in Illinois.

All that said, there are several federal tax law changes that will affect corporate income taxation in Illinois. Some will reduce the Illinois tax base, while some will increase the tax base. Here are some highlights:

• IRC Section 163(j) is amended to limit the interest expense deduction to 30 percent of adjusted taxable income plus the taxpayer’s interest income.

• IRC Section 199, the domestic production activity deduction, was repealed. However, Illinois “decoupled” from this federal deduction in 2017.

• IRC Section 243(a) is amended to reduce the dividends received deduction, which can reduce the foreign dividends subtraction allowed under IITA Section 203(b)(2)(O).

• IRC Section 965 is amended to require deemed repatriation of certain income for federal income tax purposes. Much of this income will be excluded from Illinois income taxation by the foreign dividend subtraction under IITA Section 203(b)(2)(O). We’re awaiting further guidance from the Illinois Department of Revenue on this.

• IRC Section 951A provides for federal taxation of a U.S. shareholder’s share of global intangible low-taxed income of a controlled foreign corporation. However, a portion of this income will also be excluded by the foreign dividend subtraction (awaiting guidance).

• The 100 percent bonus depreciation enacted at the federal level pursuant to IRC Section 168(k) will flow through to Illinois tax returns, reducing Illinois income tax liability. The IITA was amended a few years ago to decouple from federal bonus depreciation; however, because of the mechanics of Illinois’ law, 100 percent depreciation federally is not subject to an add-back at the Illinois level. This deduction is likely to cause the biggest reduction in Illinois’ tax base in 2018 — allowing immediate expensing in the year the item is acquired and placed in service shifts the deduction to that first year rather than spreading the deduction over the useful life of the item.

• IRC Section 179, a small business deduction, is amended to double the maximum depreciation deduction from $500,000 to $1 million and to increase phase out of the deduction to $2.5 million. Among the federal changes, the one spurring Illinois legislators into action is the state and local tax (SALT) deduction at the federal level being limited to $10,000. This limitation doesn’t affect an individual’s Illinois income tax liability. However, the limitation will increase federal income taxes for many individuals, especially those who live in areas with high property taxes.

This has triggered Illinois legislation to “work around” the federal limit by recharacterizing SALT payments as “charitable deductions” for which there is no comparable federal limitation. Recently introduced in the Illinois General Assembly, HB 4237 would authorize the establishment of charitable funds at the state and county level. Taxpayers could make payments to the charitable funds in amounts equal to their local property tax and Illinois income tax liabilities and then receive charitable deductions for federal income tax purposes. Further, HB 4563 would allow taxpayers to receive a credit against their property taxes for donations made to a local school district foundation. Both proposals depend on the IRS agreeing that the “donations” would qualify as charitable donations for federal income tax purposes. Without going into detailed analysis of federal law, I believe it’s unclear the IRS will agree to qualify these donations for charitable deductions.

At this point, it’s too soon to tell if Illinois will see a net gain or loss in income tax revenues because of federal tax reform, but there’s plenty going on as the federal legislation is implemented and the effects flow down to the state level.