Pass-Through Deduction Won’t Flow Through to Most States

December 19, 2017

If states simply do nothing in response to federal tax reform, most will experience an increase in revenue due to the provisions of the federal tax reform bill. That’s because the base-broadening provisions flow through to most state tax codes, but the corresponding rate reductions do not. And now we discover that one significant base narrower—the pass-through deduction—won’t affect most states, either.

That provision provides a 20 percent deduction against qualified pass-through business income for those with incomes below $315,000 (joint filers). For filers above that threshold, the deduction is limited to the greater of (a) 50 percent of wage income or (b) 25 percent of wage income plus 2.5 percent of the cost of tangible depreciable property, and many service businesses are excluded. (The benefit phases out between $315,000 and $415,000.)

There’s no question that the pass-through deduction is significant. The Joint Committee on Taxation estimates that it will cost $414.5 billion over the next ten years. Equally significant, however, is that in the conference report, it is structured as a deduction against taxable income, not adjusted gross income (AGI).

That matters because 29 states and the District of Columbia use federal AGI as their starting point for taxation, while only six begin with federal taxable income. The remaining states which impose individual income taxes either use federal gross income or a state-specific calculation. This means that while 41 states tax wage income, only six of them have to worry about the pass-through deduction due to their income starting point. (A seventh, Montana, arguably conforms to the provision separately.)

Those six states are Colorado, Idaho, Minnesota, North Dakota, Oregon, and South Carolina, and it’s a good bet that legislators in those states will be thinking about decoupling from the pass-through deduction. They should.

The additional revenue that states will receive due to federal tax reform may provide opportunities to cut rates or, better yet, adopt meaningful tax reform. Ideally, states receiving the benefit of base-broadening provisions won’t decouple from the handful of provisions which narrow bases to good effect, like the enhanced Section 179 deduction that eliminates some of the current tax code’s disincentives for small business investment. The pass-through deduction, however, doesn’t make the tax code more neutral. It’s a targeted preference, and there’s no reason why those six states should feel bound to it.

For policymakers in most states, the fact that the pass-through deduction doesn’t affect AGI should come as a relief. For those in the six states which use federal taxable income as their starting point for conformity, decoupling from the provision is an entirely viable option.

Errata: This post has been updated since its initial publication to correct the list of affected states based on subsequent research. For more on this topic, click here.

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