It’s All About that Base, ‘Bout that Base, (and No Trouble)

Guest columnist Chris Martin of PricewaterhouseCoopers examines a Minnesota bill to accomplish prospective or “rolling” federal tax conformity, the rationale for pursuing it, and why the issue has special relevance for 2016.  From our July-August 2015 edition of Fiscal Focus.

Lost in the tension and political drama marking the end of the last legislative session, a rather low profile bill was introduced in late April to stave off considerable headaches and stress for taxpayers, practitioners, and government itself next tax filing season. The bill, HF 22821, tackles the always important and ever present issue of federal tax conformity -- but doing it prospectively rather than after the fact.

Since Minnesota bases the starting point for corporate, individual, and pass-through entity income on federal law, federal conformity is an issue that affects all taxpayers and arises every year. But timing is a recurring problem. Typically, Minnesota’s legislature adjourns in May while Congress regularly waits until December to extend certain expiring tax deductions and income adjustments -- often for a two-year period. As a result, federal conformity bills are commonly at the very top of the agenda in the early weeks of Minnesota legislative sessions before tax filing season kicks into high gear. For example, last year Congress did not pass a 2014 federal tax extender bill until mid-December 2014 with Minnesota expeditiously conforming to most provisions by January 24, 2015.

The additional wrinkle for conforming to any impending 2015 changes is that, due to the renovation of the Capitol, Minnesota’s legislature is not meeting again until March 8, 2016 -- a mere 5 weeks before tax filing day. As a result, individuals and businesses must either wait for the Minnesota legislature to decide which federal changes to adopt and file at the relatively last minute, or file earlier knowing they may well have to amend their return later. The motivation and purpose behind HF2282 is to offer a third alternative: conform Minnesota’s tax laws prospectively to any federal tax extensions (temporary tax provisions that expired at the end of 2014) that Congress may adopt later this year.

The Bill Specifics

HF 2282 lays out the federal tax extender provisions to which Minnesota would conform, and in which order; contingent upon Congress adopting some or all of them later in 2015 when the Minnesota legislature is not in session. The bill lists 22 "eligible federal tax preferences" and the order in which Minnesota would adopt them given the amount of tax revenue each is expected to cost the state. The items include continued addback of 80% bonus depreciation, full Sec. 179 expensing conformity, discharge of cancellation of debt income from a principal residence, treating mortgage insurance premiums (“PMI”) as deductible interest, treating certain qualified tuition costs and costs by teachers as deductible expenses, treatment of certain charitable contributions, subpart F exception for active financing income, and several other individual and business income tax deductions.2

The bill allocates $105 million from the general fund to a special contingent federal conformity account in anticipation of paying for these overall revenue reducers for tax years 2015 and 2016. (A second draft of HF 2282 -- never formally introduced -- was less ambitious in conforming to only one year of federal tax extensions and excluding full conformity to Sec. 179 expensing, reducing the cost to Minnesota’s general fund to $20 million.) Under the language of HF 2282, even if the legislature failed to act in the following year by passing a federal tax conformity bill, the provisions of HF 2282 would stand as law in outlining which sections of the Internal Revenue Code (“IRC”) Minnesota chose to conform.

Beware the Ides of April

The rationale for pursuing something like this has extra currency in 2016 given the highly compressed time frame. The impacts start with government. The headache felt by the Minnesota Department of Revenue (“Department”) whenever Congress extends the temporary tax provisions later in the year will likely be a migraine next year with the legislature adjourned until March.3 Any delay in federal conformity would assuredly result in wasted effort and taxpayer dollars by the Department. Even if the Department knows federal conformity will likely be pursued in some form, it must still draft tax return forms and instructions based on current law as written and cannot assume Minnesota will follow the federal updates.4 If the Minnesota legislature were to update conformity in March, the Department must then update the forms and instructions a second time. Plus, the Department will spend additional resources processing and correcting any “now inaccurate” tax returns filed before the legislature conformed, sending out notices, and processing amended returns filed (likely in paper form) after Minnesota eventually conforms.

The prospects for taxpayers are not any better. With the Department and tax software providers unable to update tax forms and instructions until March, individual tax returns intended to be prepared and filed in January and February will be pushed further out toward the April 15 deadline. This is even more of a concern for corporate filers that have a March 15 deadline, without extension.

Given the circumstances, many taxpayers may wait to file their 2015 tax returns in order to see how Minnesota will conform to the federal tax extenders. Taxpayers could decide to file returns before the legislature returns in March in order to request a refund for overpayment of taxes rather than waiting until April to file. According to IRS data, nearly 75% of individual taxpayers claimed a refund when filing 2014 federal returns with the average refund nearing $2,800.5 One would expect a similar percentage of Minnesota taxpayers receive a refund. Whether one views tax refunds as an interest-free loan to the government or a forced-savings vehicle, the number of taxpayers anticipating, and possibly relying on, their tax refund in a timely manner is not insignificant. Any delays in conformity or in processing returns due to inaccuracies or due to a large volume of filers in March and April may impact households expecting a refund.

Not only do many taxpayers file for refunds, a sizable percentage file returns close to the deadline. Nearly one-third of federal individual income tax returns filed by the original due date were filed with the IRS in the three weeks preceding April 17, 2015.6 Assuming a similar ratio in Minnesota, any delay in conformity would likely mean an even greater percentage of returns will need to be prepared, filed, and processed by the Department during the last several weeks before April 15.

Given the potential ramifications for so many different stakeholders, it is not clear why this issue generally and the bill specifically went under the radar. A big part of the problem was timing—the bill was introduced after the House Tax Committee passed its omnibus tax bill. Meanwhile, tax practitioners and taxpayers may not have been aware of the impending consequences of the later start date for the 2016 legislative session, were focused on filing existing 2014 tax returns, or were distracted by tax policies the 2015 Minnesota Legislature was proposing to modify. Nevertheless, this issue will become very palpable next year, especially for tax preparers, practitioners, and taxpayers faced with an even shorter and busier spring tax filing season.

Concerns: Practical, Policy, and Constitutional

For all the advantages potentially offered by this bill, it is important to recognize some potential limitations and concerns. For starters, if Congress were to make any additional changes to federal taxable income beyond the 22 common federal tax extenders included in HF 2282, then this bill would not conform Minnesota’s tax laws to those additional provisions. As a result the Department would need to update the forms once in January and then again in March when the legislature returned. Some may say that conforming to most of the federal changes that affect Minnesota taxpayers is better than nothing, but it demonstrates how difficult it is for Minnesota to fully address the issue of contingent conformity.

The more important concern with HF 2282 relates to the policy implications. Government in general -- and elected officials, specifically -- should be held accountable for their action and inaction. A case can certainly be made that blindly conforming to federal tax law without a robust debate among Minnesota legislators bypasses the discussion of the policy rationale for conforming to or not conforming to certain federal tax provisions. Worse, conforming based solely on the amount of resources available for conformity does not lead to good tax policy.7 Without knowing which provisions are truly at stake, it seems difficult to have a debate on which ones to conform to and in which order.

A skeptic might argue that HF 2282, if it were to be heard in Committee, would not yield a vigorous debate among legislators on all 22 extenders since the bill is contingent upon Congress passing them. For example, it is unlikely legislators would spend time discussing whether to conform to some or all or the numerous charitable contribution provisions, or whether to conform to education expenses for teachers but not PMI as deductible interest, and in which order since it would all be hypothetical. While HF 2282 on its face seems to solve the problem of conforming prospectively, an engaged taxpayer should want its legislators to thoughtfully consider which provisions to adopt based on what is good for Minnesota's citizens and businesses.

There may also be constitutional concerns with HF 2282. The bill itself cites Wallace v. Commissioner, 289 Minn. 220 (1971), the seminal case that found that per the Minnesota Constitution current legislatures cannot bind future legislatures nor can current legislatures delegate their authority to make laws to the commissioner of an agency or to Congress.8 Section 1 of HF 2282 states that it is consistent with the Wallace decision because the bill’s language is specific as to which federal provisions to adopt and in which order. However, this may be up for debate. The bill gives the Department the power to calculate the tax impact of the federal tax extenders, or to rely on congressional fiscal estimates as applied to Minnesota, listing which provisions Minnesota would adopt depending on when the contingency fund runs out of money. This could be viewed as giving the Department the power to determine where to draw the line regarding which provisions become law and which exceed the $105 million threshold.

Under HF 2282, the legislature would be conforming to federal tax extenders Congress may or may not pass. If Congress extends the tax provisions but modifies the language with respect to how they are implemented or computed, the legislature would be adopting those measures sight unseen. Or if Congress adopted twelve of the extenders, but sidestepped passing the other ten, the Minnesota legislature would be agreeing prospectively to conform to the twelve without knowing exactly which twelve those are. A constitutional challenge to a bill like HF 2282 would certainly raise the need for state resources to defend it and additional resources to adjust taxpayer returns already filed, if it were struck down.

Special Session Vol. III?

Since HF 2282 did not receive a hearing, what are other solutions to addressing federal conformity for 2015 and future years? One possibility would be for Minnesota to automatically conform to the IRC as seventeen states and the District of Columbia do.9 However, automatic conformity would likely require a constitutional amendment10 given the constitutional concerns outlined above.

Another option would be for Governor Dayton to call a special session in early January once it is clear which federal tax extenders Congress adopted. It may lack the emotional tug of a walleye lake, but it may be a wise decision and a lot more popular. The prospect of unhappy individual taxpayers unable to file tax returns claiming a refund during an election year is a situation every state elected official should want to avoid -- and on a bipartisan basis. This would also allow the Department the chance to update tax forms and instructions, tax software providers to update their software code, more time for tax practitioners to prepare returns, and taxpayers to file timely, accurate returns.11 If the legislature does not meet until March 8 as currently scheduled and even assuming the legislature passes a federal tax conformity bill a few days later, that leaves only five weeks until the individual return filing deadline, with all the consequences highlighted earlier. When it is all about the (federal tax) base, taxpayers want no trouble.

Sometimes the perfect can be the enemy of the good, and while the language of HF 2282 was not perfect, it may have served its purpose by setting the stage for increased awareness of potential trouble brewing next spring. If the taxpayer and tax practitioner community come together and bring this concern before the Governor and legislators, a one-day special session in January may be just the fix needed that avoids constitutional concerns and makes the spring tax filing season as stress-free as possible for all those involved.

Endnotes
  • 1 See Minnesota House File 2282 (introduced by Rep. Lenczewski on April 30, 2015)
  • 2 Note: some of the tax extenders, such as bonus depreciation and Sec. 179 expensing, are considering “timing” differences and relate to which year a deduction can be taken, while other tax extenders, such as discharge of cancellation of debt income and taking education costs as deductions, are “permanent” items and if not conformed, would be lost by Minnesota taxpayers.
  • 3 In odd years, the legislature is required to begin session during the first week of January, leaving plenty of time for Minnesota to update its tax rules. In even years, the legislature sets its own start date, usually in late January or early February, with still enough time to prevent a time crunch for taxpayers.
  • 4 Tax software providers, such as TurboTax and H&R Block, would also need to expend additional resources in writing and re-writing the software code used in the tax preparation programs.
  • 5 See http://www.irs.gov/uac/Dec-26-2014
  • 6 See http://www.irs.gov/uac/2015-and-Prior-Year-Filing-Season-Statistics
  • 7 All of the legal, political, and policy implications that go along with the fact that 35 states piggyback off of the federal tax code and use some line from the federal tax return as its own starting point are beyond the scope of this article. For an in depth discussion, see Ruth Mason, Delegating Up: State Conformity with the Federal Tax Base, 62 Duke L.J. 1267 (2013).
  • 8 See Wallace v. Commissioner, 289 Minn. 220 (1971), citing Minn. Const. Art. X, s. 1, which reads in part, “The power of taxation shall never be surrendered, suspended or contracted away.”
  • 9 See http://www.taxadmin.org/fta/rate/stg_pts.pdf. States that automatically conform to the IRC for individual income tax purposes include Colorado, Connecticut, Delaware, Illinois, Kansas, Louisiana, Maryland, Michigan, Missouri, Montana, Nebraska, New Mexico, New York, North Dakota, Oklahoma, Rhode Island, and Utah.
  • 10 Missouri did just this in 1968. See Missouri Constitution, Article X, Sec. 4(d).
  • 11 Special sessions may be called by the Governor and adjourned by the legislature. WCCO reported that special sessions cost taxpayers approximately $51,000 per day. Given the amount of time and resources to be saved by having clarity on Minnesota’s tax law, the cost of a special session may be well worth it.