17 December 2017
Tax reform is in the news lately, and I have fielded more than a few questions about the anticipated impacts of the current proposals. I usually try to side-step the question. While I spend a lot of time analyzing tax laws I try not to spend too much time analyzing tax bills. I can’t predict what our government is going to do, and I don’t find a lot of value in trying to figure it out in advance. Hopefully you aren’t too distressed by that. If you are, look at it this way - if I could accurately predict what the government was going to do with tax laws and how that would impact each individual tax situation, you could not afford me.
I will make one observation on the flurry of activity coming out of the beltway, however; I believe we are about to see increased chaos at the state income tax level. Here’s why:
There are two bills floating around, one passed by the House and the other by the Senate. Our legislators are reportedly working to reconcile the differences between the two bills, so they can get something for the President to sign into law. Both bills contain the following provisions:
• Standard deduction nearly doubles
• Personal exemptions are eliminated
Unless the states scramble to change their own laws, both of those changes at the federal level will have significant impacts on state income tax returns. Let’s look at the impacts they would have on a Virginia income tax return. If you’re in another state, you may be able to use this discussion to determine if it will apply to your state’s income taxes as well.
Virginia is what we call a ‘conformity state’, meaning many of the tax laws in Virginia conform to federal tax law. The first line on a Virginia income tax return is “Federal AGI”, which is line 38 from your federal form 1040. That means that everything the federal government counted as income, and everything the federal government counted as an adjustment to income is embedded in the first line of your Virginia income tax return. There may be subsequent additions or subtractions to your federal adjusted gross income to calculate your Virginia adjusted gross income, but they start from the same point because Virginia conforms to federal tax law unless the Virginia code expressly stipulates otherwise.
Let’s look at the personal exemptions issue. Virginia currently allows you to take a $930 personal exemption for each person listed on your tax return - you, your spouse, and your dependents. The Virginia definition of ‘dependent’ (for tax purposes) conforms to the federal definition of dependent. If the federal personal exemptions go away, how and where are dependents going to be defined for Virginia tax purposes? If you don’t need to enter dependent information for your federal return, is Turbo Tax going to ask you for that information for your state return? Will personal exemptions on Virginia tax returns also need to be eliminated if the federal personal exemptions are eliminated?
To compensate for the loss of personal exemptions, the federal bills double the standard deduction. There is no bill pending in Virginia to double the standard deduction. If the Virginia personal exemption goes away, Virginia taxable income goes up.
Under Virginia law, if you claim the standard deduction on your federal return, you must claim the standard deduction on your Virginia return. If you itemize deductions on the federal return you must itemize deductions on your Virginia return. With the doubling of the federal standard deduction, many more taxpayers will elect to use the standard deduction on their federal return. That means they will be forced to use the standard deduction on their Virginia return.
The Virginia standard deduction is $3,000 for single filers and $6,000 for married couples filing jointly. Not much. In this situation, it might be better for someone to use the federal standard deduction on the federal return, but significantly better to itemize deductions on their Virginia tax return. This puts taxpayers in the position of needing to figure their taxes both ways (using the standard and itemized deductions) to determine which gives the best overall result. Is it best for your wallet to pay a high federal tax bill and a low Virginia tax bill, OR is it better for your wallet to pay a low federal tax bill and a high Virginia tax bill. Good luck getting Turbo Tax to help you through that. (I’m not trying to knock TT, but they would literally have to program the software to calculate this using the tax laws in the 43 states that have an income tax. That’s a tall order.)
One of the stated intentions of tax reform is to simplify filing for Americans. I don’t see that happening in the short term if you are required to file a state income tax return. State legislators will undoubtedly move to adjust their state tax laws once the federal tax law is settled. That strikes me as something that will likely take a few years to sort out. That means we are likely looking at a few years of changes before things settle down again and people know the most advantageous way to file.
If greater income tax simplicity becomes a reality down the road, then it may be worth the temporary increase in chaos, but I think temporary increase in chaos is inevitable with this iteration of tax reform. There are too many moving parts and interactions between Virginia law and federal law, and the impact to state returns does not seem to have been fully analyzed.
I am not advocating for or against the federal income tax proposals currently making headlines. I just wanted to point out that tax simplification is not a simple process. All tax software, including my rather expensive professional version, starts with the federal tax return and then uses the data from the federal return to populate the state tax return. If there is a disconnect between federal and state law I expect to see more people in my office this year who have completed and filed their federal tax return, but need help with their state return(s). Hopefully I am wrong. Time will tell.
If you need help with your taxes, please contact me.