Taxpayers, and even tax practitioners, can be easily
confused about how to properly complete state
tax forms, especially in Minnesota, where nonconformity
seems to be the norm.
Federal tax conformity refers to the degree to
which the state tax code conforms to the U.S. tax
code -- the Internal Revenue Code (IRC). Most
states conform to the IRC in some respect, with
certain provisions left out. The most common
federal tax provisions that are left out or decoupled
are bonus depreciation, expensing of depreciable
business assets (IRC Section 179), and the
Domestic Production Activities Deduction (IRC
Section 199). It's no surprise that these federal
provisions are the biggest non-conformity items
affecting taxpayers, since they have the greatest
impact on state tax revenues.
States may approach federal conformity in one of
several ways to calculate their taxable income. Some
states, like New York, adopt a rolling conformity
date and, as such, automatically conform to
the latest version of the IRC. Other states, like
Minnesota and Wisconsin, use a fixed or static IRC
conformity date. They calculate state taxable income
under the IRC in place as of a certain date. Still other
states, including California, take a selective approach
to federal conformity by adopting only specific
provisions as of certain dates.
Having identified the type of conformity adopted
by a particular state and whether the state includes
the relevant provision, a taxpayer or preparer must
determine what modifications to the federal base
the state requires to derive state taxable income.
Modifications required by a specific state may
result from state fiscal policies, the encouragement
of economic development within that state, or
As with most tax issues, when taxpayers hear or read
something from the President (or any public official) regarding
treatment of a new tax law, they must think about how it
affects them on a state level as well as a federal level. State-bystate
determination is necessary when determining if a state
conforms to any given federal provision.
What's happening in Minnesota?
The following focuses on Minnesota's treatment of some of
the more important IRC provisions. Note that the latest IRC
conformity date for Minnesota was April 14, 2011. That means
that any federal tax legislation passed after that date will not
apply to Minnesota tax law until the next IRC conformity date
is chosen by the Minnesota legislature.
Bonus depreciation and Section 179 expensing
Whether it's the American Recovery and Reinvestment
Act (ARRA) of 2009, the Small Business Jobs Act (SBJA)
of 2010, the 2010 HIRE Act, or the Tax Relief Act (TRA) of
2010, Minnesota has generally not adopted recent federal
changes that allow businesses to recover the costs of capital
expenditures faster than the ordinary depreciation schedule
would allow. Minnesota's lack of conformity to the IRC extends
to bonus depreciation and the increased expense limit on the
cost of qualified property.
- Minnesota bonus depreciation: Taxpayers must add back 80
percent of the federal bonus depreciation to their Minnesota
return in the first year, and then 20 percent of the addback
amount can be subtracted in each of the next five years.
- Minnesota Section 179 expensing: Taxpayers must add
back to federal taxable income 80 percent of the amount by
which the deduction allowed by current Sec. 179 exceeds
the deduction allowable under Sec. 179 as amended through
Dec. 31, 2003. This is the old $25,000 expensing election,
which has now been increased to $500,000. Like Minnesota
bonus depreciation, 20 percent of the addback amount can
be subtracted in each of the next five years.
Minnesota is not the exception to the rule when it comes
to federal conformity. With regard to IRC Sec. 179, roughly
one-third of the states decoupled from the increased
small-business expensing provisions, while two-thirds of
the states decoupled from bonus depreciation. Further, as
a result of the economic downturn, the number of states
decoupling from recent federal tax changes is greater than
those decoupling from provisions put in place almost a decade
ago. As states continue to face budget shortfalls, the trend may
become even more widespread.
Section 199, Domestic Production Activities Deduction
While bonus depreciation and Section 179 expensing are
merely time value of money savings to taxpayers (but shortterm
revenue losses in the case of Minnesota), IRC Section 199
allows for permanent deduction from federal taxable income.
The Domestic Production Activities Deduction (DPAD) permits
businesses to deduct a portion of their profits attributable to a
broad range of qualified production activities. Nine percent of
this income is deductible in 2010 and subsequent years.
- Minnesota did not adopt the federal DPAD deduction.
Corporations must add back to federal taxable income the
amount of the deduction allowable under IRC Sec. 199.
To understand the tax benefit that Minnesota taxpayers
miss out on, consider a hypothetical corporation with
$10 million in domestic production activities income.
Considering Minnesota's corporate income tax rate is 9.8
percent and, for 2010, 9 percent of that income would
have been deductible if DPAD was allowed, the total tax
reduction would be $88,200.
The political and fiscal issues connected with DPAD are
significant. Currently, 25 states allow the deduction, even
though certain groups see it as an expensive and inequitable
tax loophole. They argue that such a broadly available tax break
carries too much of a fiscal cost to the federal and conforming
state governments. The 25 states that allow the deduction
subsidize businesses to the tune of an estimated $500 million
a year, and that is just at the state tax level.
The chart below summarizes Minnesota's treatment of federal
tax conformity on the three items already discussed, along with
some other important tax topics.
|IRC||Does Minnesota conform?|
|Section 179 Expensing||No|
|Section 199 DPAD||No|
|Section 108 Discharge of Indebtedness||No|
|S Corporation Built-in-Gain||Yes|
|Tax Free Medical Coverage of Adult Children (up to age 26)||Yes|
It goes without saying that areas where state tax law diverges
from the IRC can create problems down the road. The absence
of Sec. 179 and bonus depreciation conformity produce
differences in the state and federal basis of depreciable assets.
The difference must be tracked in order to compute the proper
gain/loss when the assets are disposed.
Consequently, the degree to which a state conforms to federal
tax rules impacts state tax compliance for both businesses
and individuals. Any time there is a new federal tax law, it will
affect you or your client's state tax return. If a state does not
conform, which seems to be the norm for Minnesota, your
state income tax return will likely include more calculations
to reconcile the differences between federal taxable income
and state taxable income. That's why it's so important to
continually monitor not only federal tax law changes, but also
the impact at the state tax level.
Mark Bakko is a Tax Partner in the Minneapolis
office of Baker Tilly Virchow Krause LLP. He
is an MNCPA member and has a Master's
degree in Business Taxation from the University
of Minnesota. You can reach Mark at
Nick Marshall is a Tax Manager in the State &
Local Tax Group at Baker Tilly Virchow Krause
LLP. He specializes in state tax compliance,
consulting, and controversy work. You can reach