by Nicholas Harrison, CPA
A hot topic in the General Assembly each year is the extent to which Virginia conforms to the federal Internal Revenue Code (IRC) for purposes of state income taxation. The commonwealth has historically conformed to varying degrees, but generally lawmakers have passed this legislation fairly quickly.
This provides certainty to tax preparers early in their “busy season.” In recent years, however, the debate over conformity has at times continued further into the General Assembly session. This can have serious consequences for taxpayers, tax preparers and the Virginia Department of Taxation. Following is a brief discussion of the issues surrounding Virginia’s conformity to the IRC, and the impact of conformity on stakeholders.
Conformity and Virginia
The concept of conformity is frequently mentioned in the context of state personal and corporate income taxes, but not always fully understood. In sum, the concept of conformity refers to the degree to which a state’s tax code conforms to the IRC. In most states that levy a tax based on net income, the starting point in computing state taxable income is federal adjusted gross income (for individuals) and federal taxable income (for corporations).
Generally, federal adjusted gross income and federal taxable income are defined to have the same meaning as within the IRC of 1986, including subsequent revisions and amendments. However, as we all know, Congress frequently modifies the IRC. As such, the definition of federal taxable income can be a moving target for states. To address the uncertainty resulting from congressional action, states typically have adopted the IRC in one of two ways: rolling conformity or static conformity.
Rolling conformity states automatically adopt or conform to the latest version of the IRC. As such, a rolling conformity state effectively adopts any changes made at the federal level on a real-time basis unless the legislature passes specific laws to the contrary. This method provides clarity for taxpayers and preparers as they complete state filings and generally provides the state tax departments with additional time to adjust published guidance and forms as necessary.
Static conformity states, on the other hand, adopt the definition of federal taxable income in the IRC as it exists on a specific date, or adopt only specific provisions of the IRC. Some states, such as Texas, leave this date unchanged for years. Others update annually, thereby approximating rolling conformity as much as possible without actually adopting such a provision. In either case, some would argue that static conformity offers protection for the states against the budgetary impact of unpredictable federal legislative changes. For example, if the federal government enacts a taxpayer favorable law change that will decrease federal taxable income for a large number of taxpayers, a static conformity state will not be impacted unless it takes specific action to adopt the new provisions. However, in the case of states that update conformity to some extent on an annual basis, this can lead to uncertainty during the course of the year regarding which federal changes the state will adopt and from which ones the state will decouple.
For many years, Virginia was a rolling conformity state. In 1993, Virginia briefly switched to static, or fixed-date, conformity as of Dec. 31, 1992. However, this change was retroactively repealed the following year and rolling conformity was reinstated as the Virginia legislature realized that rolling conformity provided stability to the tax system for both the commonwealth and taxpayers. In 2002, Virginia again adopted fixed-date conformity and has since continued that practice, decoupling on occasion from certain federal provisions such as bonus depreciation, extended net operating loss carry-backs and a portion of the IRC Section 199 deduction.
The importance of timely conformity
Rolling and static conformity both have valid policy rationales. Whether one method is preferable over the other is a discussion beyond the scope of this article. However, when a state, like Virginia, has adopted static conformity, what is of utmost importance is that taxpayers and their advisers have annual resolution as expeditiously as possible on what version of the IRC must be used in their tax calculations.
The impact of delayed conformity legislation on taxpayers and service providers is clear. Changes occurring late in the busy season unnecessarily complicate the process. Taxpayers who file before the original due date without extension may be forced to amend their returns. In the case of pass-through entity owners, the trickle-down effect is more severe. Not only do the pass-through entities have to amend, but each owner’s filing may require correction as a result of receiving modified Virginia forms VK-1. Such a result is particularly unpalatable given the recently enacted nonresident withholding tax regime implemented with respect to pass-through entities.
The nonresident withholding rules require pass-through entities to withhold tax on the distributive share of Virginia source income attributable to non-resident owners. Consequently, changes to already filed pass-through entity forms resulting in amended returns can also create multiple rounds of cash movement within a partnership structure to satisfy the withholding tax requirements.
Putting taxpayers in a position to try to change their tax returns at the last minute also increases the risk of unintentional errors, particularly when dealing with extensive calculations such as those created by adjustments to bonus depreciation. These adjustments require not only a reconciliation of book amounts to tax amounts, but also federal income tax amounts to state income tax amounts.
Finally, taxpayers and their service providers often take the opportunity at year-end, or early in a new calendar year, to forecast and understand the tax consequences of significant recent or expected events, such as capital investments in property or equipment. These events may be affected by tax provisions intended by the federal government to encourage (or occasionally dissuade) certain behaviors, such as investment in new equipment. These business analyses are clouded by any uncertainty regarding which version of the IRC will be in effect for a particular year’s state income tax calculation.
The end result is additional administrative and financial burden to taxpayers as they struggle to accommodate unnecessarily late changes to rules they are attempting to apply in good faith. But the consequences extend beyond the taxpayer and tax preparer community. Any changes to conformity also strain the resources of the Virginia Department of Taxation. Decoupling from portions of the IRC often requires specific updates to the related forms and instructions to ensure accurate compliance by taxpayers. Without sufficient time to re-work the forms, we are at best left with taxpayers trying to fit a “square peg into a round hole” because the forms are unchanged or the instructions supply only passing guidance. At worst, we are left with form changes that do not conform to the actual statute as enacted.
In addition to stresses on the form preparation teams, late legislative changes tend to increase call volume to the Department of Taxation’s telephone help lines, which has both cost and service level consequences. Late changes also potentially increase the volume of tax returns and the related tax return processing needs and may result in pulling department resources from other areas of importance, such as audit/appeals resolution and regulatory initiatives. These items represent real costs to Virginia that must be paid for out of the public coffers in an economic time when budgetary concerns are still very prominent on the radar screens of all involved parties.
To summarize, swift legislative action on IRC conformity each year is critical not only to taxpayers and tax preparers, but also the Department of Taxation. It helps alleviate unnecessary administrative and financial burdens, lessens the risk of reporting errors and allows for timely and informed decision-making by taxpayers and their advisers. As the beginning of the 2012 General Assembly session draws near, the tax community must work closely and quickly with its legislative representatives and the Department of Taxation to ensure timely passage of a bill that fulfills the commonwealth’s policy objectives while providing certainty to taxpayers.
Nicholas Harrison has been a part of KPMG’s State and Local Tax practice for over nine years and is based out of KPMG’s Richmond office. This article represents the views of the author only, and does not necessarily represent the views or professional advice of KPMG LLP.Tweet
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