United States: SALT Outlook, Trends And Predictions For 2015

This 2015 SALT Outlook, Trends and Predictions alert focuses on how Grant Thornton thought 2014 would unfold from a SALT perspective, how these predictions lined up with what actually happened, and ten new predictions on critical SALT issues that may come to the fore this year.

In considering the current state of the states, the results of the November 2014 state elections are a good place to start. Republicans made significant strides in gaining control in more state legislative and executive branches, now controlling 30 state legislatures, and 31 governorships.¹ Many people were surprised that voters in Illinois, Maryland and Massachusetts, three "blue" states with predominantly Democratic legislatures, all elected Republican governors. Perhaps voters in these states thought that electing a governor from the opposite party would counterbalance state control, or that a strong anti-incumbent tide (both from a national and local perspective) helped the perceived "underdog" candidates. Likewise, the promises by many Republican candidates that taxes could be cut at the state level may have had something to do with their relative success. Whatever the root cause, the topic of lowering state income tax rates will be broached in many states, and very well could be the overarching state tax issue that captures the imagination of the popular press this year.

So far in 2015, the experience of what happens when lower state income taxes stress the budget to dramatic proportions is being felt in a few locales, but most prominently in one "red" state and one "blue" state. Kansas and Illinois are two instructive examples of states in current fiscal distress, in part caused by state tax rate cuts, and will require their governors to make tough choices in 2015.

In Kansas, a "red" state, Governor Sam Brownback supported legislation furthering the long-term goal of the state to fundamentally alter the tax structure by drastically reducing income tax rates. This legislation resulted in substantial reductions in the state's individual income tax from 6.45 percent to 3.9 percent (when the full phase-in of the reductions are complete in 2018), as well as targeted tax relief to businesses.² The tax rate reductions were promoted as a method by which the state's economy would grow more quickly.

Unfortunately, early indications appear that the tax rate reductions have not inspired the expected economic growth, resulting in a several hundred million dollar shortfall. In fact, the Governor was only narrowly re-elected in November in a state that is among the "reddest" in the nation. Based on the Governor's comments during his recent State of the State address, however, the push for a zero income tax rate will continue.³ It remains to be seen whether the legislature will follow that path, or take a more fiscally conservative approach.

In Illinois, a "blue" state, the numbers in play are much larger than in Kansas, and many of the ingredients needed for a financial disaster are now in place. The current situation is neatly described in a newly released report by the Fiscal Futures Project based at the University of Illinois.⁴ The report notes that the "the root of Illinois' problems is state government's long-established practice of pay-later budgeting," and covering the current difference between revenues and expenses in accounting maneuvers such as fund-shifting techniques, special fund borrowing and supplemental spending taken on after the budget process. In addition, many bills for services provided to the state remain unpaid, and unfunded pension liabilities continue to grow. In the report, the difficult fiscal conditions faced by the state are highlighted, and include a sharp decline in tax revenue that will result from a 1.75 percent decrease in the corporation and personal income tax rates in 2015,⁵ increasing pension liabilities, and the threat of lower bond ratings and higher borrowing costs. The report finds that increasing the income tax rates by 1.75 percent by itself would only reduce the deficit faced by the state in half. Other revenue options that could be considered to fully eliminate the deficit include increases in the sales tax rate and/or sales tax base, adoption of a more progressive income tax system, elimination of deductions or preferences in the corporate and personal income tax regimes, or adoption of a gross receipts tax or statewide property taxes on business. Alternatively, or perhaps in concert with revenue enhancements, spending would need to be cut at a substantial level to preserve fiscal stability. None of these options are especially palatable to incoming Governor Bruce Rauner, who has not yet clarified how the huge projected budget gap will be bridged.

2014 Predictions – A Review

• Continued contrast between the "red" and "blue" states on income tax rates.We predicted that while most states would keep income tax rates constant in 2014: (a) at least three "red" states would make broad reductions to corporate or personal income tax rates; and (b) at least three "blue" states would make targeted increases to corporate or personal income tax rates applicable to high-income residents as part of an overall effort to provide tax relief to middle-class residents. For the most part, this prediction did not come to pass. While several "red" states enacted relatively minor tax rate reductions in 2014, the story of the year relative to the division between "red" state and "blue" state policies was something different than we envisioned. Instead of a comparison of "red" state tax reductions and "blue" state tax increases, the tax reform efforts in a few of the "blue" states, including New York, Rhode Island and the District of Columbia carried more significance.
• The Compact three-factor election: six decisions, and no consensus. On the legislative side, we thought that four more states would modify or sever their relationship with the Compact; and on the judicial side, the California, Michigan, Minnesota, Oregon and Texas courts would come to vastly different conclusions on the applicability of the Compact, creating an inconsistent multistate jurisprudence. Our prediction on the legislative side did not verify, as the only state that broke away from the Compact in 2014 was Michigan.⁶ As for the judicial side, our prediction technically verified to the extent that the IBM⁷ court in Michigan differed from Texas' continued rejection of the election, evidencing a continued lack of consensus on the issue.⁸ However, the failure of California and Oregon to render decisions in 2014 in the Gillette⁹ and Health Net¹⁰ decisions, respectively, made this prediction somewhat inconclusive.
• Recommendations from Hearing Officer noted, but largely not followed.We predicted that where the Hearing Officer's report and the Multistate Tax Commission's model of the Multistate Tax Compact diverged, the Commission's model would largely stay unchanged, particularly in the areas of: (a) market-based sourcing of services; and (b) alternative apportionment. This prediction generally verified, at least with respect to market-based sourcing, as the Commission finalized its own version of market-based sourcing in the summer of 2014.¹¹ A second round of amendments by the Commission to the Compact have addressed some (but not all) of the Hearing Officer's concerns in the area of alternative apportionment.¹²
• Continued reliance on incentives to create and maintain jobs.Given the popularity and omnipresence of incentive deals, we had envisioned that two states would call special sessions to provide targeted tax incentive relief for one or a very small number of businesses in those states. The Nevada legislature called a special session to approve Tesla Motors' investment into the state, as well as approval for incentives to other companies.¹³ Other states provided targeted incentives to particular companies during regular legislative sessions, but the handful of states that called for special legislative sessions did not utilize them for this purpose.
• From recommendations to enactment: the DC Tax Revision Commission recommendations.We predicted that the District of Columbia City Council would follow several of the material recommendations of the Commission, and act to: (a) implement a single sales factor for purposes of apportionment; (b) impose the $25 per person "head" tax on District employees, with significant exemptions; and (c) increase the sales tax rate from 5.75 percent to 6 percent, with a modest expansion of the sales tax base. Ultimately, the City Council passed tax reform legislation which implemented single sales factor apportionment, and a modest expansion of the sales tax base to cover certain industry-specific services.¹⁴ The tax reform legislation did not impose the "head" tax or increase the sales tax rate.
• Significant change finally comes to New York as well. We predicted as part of the 2014 budget deal that: (a) real property tax increases would be stabilized; and (b) the banking (Article 32) and business (Article 9-A) corporation franchise taxes would be merged at long last. This prediction verified, as the New York tax reform occurred, and included a property tax freeze that is intended to stabilize real property tax assessment levels.¹⁵ In addition, the Article 32 tax was merged into Article 9-A for tax years beginning on and after January 1, 2015.¹⁶
• Independent tax tribunals progress.We thought that Alabama and one other state would adopt independent tax tribunals. While we correctly identified Alabama as a state that adopted an independent tax tribunal in 2014,¹⁷ no other state joined this growing movement last year.
• Individual taxes: residency audits.We predicted that at least two high-profile New York or California residency audits in which the resident moved (or purported to move) outside the state would be published by regulatory agencies or the courts. This prediction verified, with several high-profile personal income tax decisions in New York alone, including the Gaied¹⁸ and Noto¹⁹ cases relating to residency matters.
• Efforts to broaden the sales tax base to additional services are not going away.We thought that at least five states would attempt, and at least two states would enact statutes expanding the sales tax base to at least one additional service industry. While the District of Columbia (not a state, to be sure, but a material jurisdiction to many) expanded the sales tax base,²⁰ and North Carolina adopted a sales tax on certain service contracts,²¹ efforts to create sales taxes on new service industries never gained traction in 2014.
• Nevada initiative to pass a "margin" tax will fail.Finally, in predicting the result of a state initiative on the ballot in 2014, we had thought that Nevadans would reject the creation of the margin tax in a close vote. While our assessment that the Nevada tax would not be adopted was correct, we did not expect the margin tax to fail by such a wide margin.²²

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Footnotes

1. 2014 State and Legislative Partisan Composition (Post-Election), National Conference of State Legislatures, Dec. 2, 2014.

2. KAN. STAT. ANN. §§ 79-32,110(a); 79-32,117(c)(xx).

3. State of the State Address, Kansas Governor Sam Brownback, Jan. 15, 2015.

4. Richard Dye, Nancy Hudspeth and Andrew Crosby, "Apocalypse Now? The Consequences of Pay-Later Budgeting in Illinois: Updated Projections from IGPA's Fiscal Futures Model," Institute of Government and Public Affairs at the University of Illinois, Fiscal Futures Project, Jan. 19, 2015 (http://igpa.uillinois.edu/fiscalfutures).

5. Id.

6. Act 282 (S.B. 156), Laws 2014. For a discussion of this legislation, see GT SALT Alert: Michigan Enacts Legislation Designed to Eliminate Multistate Tax Compact Apportionment Election Refunds Allowed by IBM Case.

7. International Business Machines Corp. v. Department of Treasury, 852 N.W.2d 865 (Mich. 2014), motion for rehearing denied, 852 N.W.2d 865 (Mich. 2014). For a discussion of this case, see GT SALT Alert: Michigan Supreme Court Allows Multistate Tax Compact Three-Factor Apportionment Election for 2008 MBT Return.

8. Graphic Packaging Co. v. Combs, Travis County, Texas District Court, Cause No. D-1-GN-12-003038. On January 15, 2014, the district court denied the taxpayer's three-factor apportionment election claim by granting the Comptroller's motion for partial summary judgment. This case is being considered by the Texas Third Court of Appeals, Case No. 03-14-00197-CV.

9. Gillette Co. v. Franchise Tax Board, California Supreme Court, No. S206587.

10. Health Net Inc. v. Department of Revenue, Oregon Tax Court, Case. No. 120649D.

11. Multistate Tax Commission's Annual Conference, July 28-31, 2014. For additional information, see the Commission's Web site at http://www.mtc.gov. A discussion of these changes is provided in GT SALT Alert: Multistate Tax Commissioner Finalizes Compact Provision Amendments.

12. Proposed Multistate Tax Compact Art. IV.18(c), (d), (e). 5 Id.

13. Ch. 1 (A.B. 3), Ch. 2 (A.B. 2), and Ch. 3 (A.B. 1) (28th Special Session, Laws 2014).

14. Act 20-424 (D.C.B. 20-750), Laws 2014.

15. Ch. 59 (A.B. 8559 / S.B. 6359), Laws 2014. For a detailed discussion of this legislation, see GT SALT Alert: New York Enacts FY14-15 Budget Legislation Providing Extensive Tax Reform.

16. Ch. 59 (A.B. 8559 / S.B. 6359), Part A, § 1.

17. Act 146 (H.B. 105), Laws 2014. For a discussion of this legislation, see GT SALT Alert: Alabama Enacts Legislation to Create Independent Tax Tribunal.

18. Gaied v. New York State Tax Appeals Tribunal, 6 N.E.3d 1113 (N.Y. 2014).

19. Noto v. New York State Department of Taxation and Finance, New York Supreme Court, Suffolk County, No. 03392/2010, March 3, 2014.

20. D.C. CODE ANN. § 47-1810.04(n)(1)(V)-(AA).

21. N. C. GEN. STAT. § 105-164.4I.

22. State Question No. 3, Nevada General Election, Nov. 4, 2014. This proposal was rejected by more than 78 percent of the voters.

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