Decoding the One Big Beautiful Bill’s Impact on State Income Taxes

Keith Staats, JD Special Counsel, Duane Morris LLP
Deciphering Today's State & Federal Tax Law

No doubt, the recently enacted H.R. 1 (also known as the One Big Beautiful Bill Act) will most likely impact and further complicate state income taxes. But the extent of that impact will depend on whether individual state income tax laws conform to the federal Internal Revenue Code (IRC).

Most states with personal and corporate income taxes piggyback, to varying degrees, off the IRC. Some states, like Illinois, automatically use the current version of the IRC as the starting point for their state income tax. Others adopt the IRC as of a fixed date and require state legislation to change to a later version of the IRC. And others still adopt different IRC provisions at different dates with significant variations.

Additionally, states use different points of the federal individual (Form 1040) and corporate (Form 1120) income tax returns as the starting point for their state income taxes. For example, Illinois uses the federal adjusted gross income (line 11 of Form 1040 for tax year 2024) as the starting point for the Illinois individual income tax. That means the Illinois calculation begins prior to any federal itemized deductions. The Illinois corporate income tax return begins with federal taxable income (line 30 of Form 1120 for tax year 2024).

THE ART OF DECOUPLING

States also decouple from certain provisions of the IRC. When the Illinois Income Tax Act (IITA) was first enacted, for example, the tax simply piggybacked on the IRC. At that time, drafters of the act hoped the change would simplify things, removing the need to audit taxpayers. Of course, that pipe dream never materialized.

Many years ago, Illinois decoupled from the IRC provisions that governed net operating losses and now has its own provisions. In addition, on multiple occasions, Illinois has adopted legislation temporarily restricting the use of net operating losses as a means of increasing state corporate income tax revenues in the short term.

Illinois also decouples from federal provisions dealing with depreciation and immediate expensing of capital purchases. In the year in which the item being immediately expensed is purchased, this method allows the state to increase its tax revenues over what they would be if Illinois followed the IRC. (I realize that expensing an item in year one versus taking depreciation deductions over a predetermined useful life yields the same deduction amount—but remember, legislators and departments of revenue don’t deal in the long term.)

As is sometimes the case, this decoupling makes things a bit more complicated for taxpayers. For instance, Illinois taxpayers are required to add federal depreciation deductions and the 100% expensing of capital purchases back to federal taxable income before calculating the depreciation authorized by Illinois and subtracting those amounts from Illinois taxable income. The complications of documenting and tracking the differences between federal and state taxable income invariably leads to audit issues.

To further generate more tax revenue, Illinois recently amended the IITA during the spring legislative session to require affected taxpayers to add back 50% of global intangible low-taxed income (GILTI), which is calculated at the federal level. In my estimation, there are problems associated with this change without addressing the additional income in a company’s apportionment formula—but that’s a discussion for another day.

Over the years, Illinois, like other states, has made a host of other modifications to the calculation of the federal tax base, which has added further complexity to state income tax calculations.

FEDERAL TAX LAW CHANGES

So, what changes can taxpayers expect next?

H.R. 1 contains changes that’ll reduce individual income taxes at the federal level; however, it won’t affect Illinois income tax receipts because the federal adjustments are made after the calculation of adjusted gross income (the starting point for the individual income tax calculation in Illinois).

Additionally, the increases to the federal standard deduction and the special deduction for seniors that could potentially reduce or eliminate federal income tax on Social Security benefits won’t affect Illinois income tax revenues. That’s because Illinois already exempts Social Security retirement income from its income tax. The increases to the federal standard deduction are “below the line,” (after the calculation of adjusted gross income) so they don’t affect adjusted gross income.

The provisions of “no tax on tips,” “no tax on overtime,” and “no tax on auto loan interest” are all structured at the federal level as deductions from adjusted gross income. In other words, these are also “below-the-line” deductions that don’t affect adjusted gross income.

The increase in the federal state and local tax (SALT) cap deduction (from $10,000 to $40,000) is also a “below-the-line” item. One of the components of the SALT cap deduction is property taxes. In some states, the amount of the state property tax deduction is tied to the amount of the federal deduction. In those states, the federal SALT cap can limit the state property tax deduction. Illinois has a property tax deduction, but that deduction is 3% of the property taxes paid on a personal residence. As a result, the Illinois deduction is unaffected by what happens at the federal level.

Importantly, there are some changes in H.R. 1 that’ll flow through to Illinois (unless Illinois decouples). Some of these include:

• The new qualified production property deduction for manufacturing [IRC Section 168(n)].
• Research and experimentation cost recovery, which will return to the immediate expensing authorized prior to 2022 (IRC Section 174).
• Small business expensing, which will increase from $1 million to $2.5 million, with subsequent inflation adjustments (IRC Section 179).

However, based on history and the fact that Illinois is facing state budget challenges, I wouldn’t be surprised if the Illinois Department of Revenue introduces legislation to decouple from some or all of these changes.

As I previously mentioned, the IITA was amended for taxable years ending on and after Dec. 31, 2025, to add back 50% of the amount of GILTI received under IRC Section 951A. However, H.R. 1 changes the GILTI to a new net controlled foreign corporation tested income regime. In the interest of brevity (a word some might think isn’t in my lexicon), I won’t go into the specifics of these changes. But it appears that for tax years beginning after Dec. 31, 2025, the IITA will need to be amended to address this federal change.

Also, let’s not forget that, as noted above, H.R. 1 retains the SALT cap deduction limitation, along with increasing the cap from $10,000 to $40,000. As a workaround to this, Illinois adopted legislation that allows for a pass-through entity tax (P.A. 102-0658). However, because the federal SALT cap was scheduled to sunset at the end of this year, the Illinois legislation was drafted to apply only to tax years beginning prior to Jan. 1, 2026. In anticipation of legislation extending the federal SALT cap, legislation was introduced in Springfield this spring (House Bill 2702 and Senate Bill 2021) to eliminate the sunset date. Neither bill passed during the spring session, but I hope there’ll be further consideration during the fall veto session.

While the future of Illinois income taxes is difficult to predict, one thing is clear—they won’t get any easier. I anticipate that we’ll continue to see more efforts at the state level to decouple from any federal changes that could threaten Illinois’ tax revenue. For now, the only certainty we have is uncertainty.

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