Non-conformity of state tax law to federal tax law

The impact on Minnesota taxpayers

by Mark Bakko, CPA, MBT and Nick Marshall

 The President, Congress, and many state governors have been debating the use of tax policy to stimulate the economy. It can be challenging to determine what tax policy is under discussion versus what has actually passed into tax law. The expiration dates of various tax laws add to the confusion. And federal-state tax conformity rules (or lack thereof) further compound the problem.

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.

What is federal tax conformity?

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 social objectives.

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.

IRCDoes Minnesota conform?
Bonus DepreciationNo
Section 179 ExpensingNo
Section 199 DPADNo
Section 108 Discharge of IndebtednessNo
S Corporation Built-in-GainYes
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 Nick at

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