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Inc. Magazine, June 2005

FIFTY STATES, A THOUSAND NEW TAX LAWS

States are increasingly “decoupling” their tax codes from the federal government’s, creating big headaches for business owners.

With all the talk in Washington about tax simplification, perhaps the thorniest tax issue today is the one that nobody’s talking about — the increasing gulf between the ways that states calculate your tax bill and the way that the Internal Revenue Service does.

For most of the 92 years since the federal income tax was established, the states followed Washington’s lead concerning how to tax people and businesses. That ended in 1981, when 21 states adopted their own rules on depreciation in response to a Reagan tax cut. Many of these renegades — California being a notable exception — later went back to a more uniform tax code. But the precedent was set. When Congress began slashing federal rates in 2001, many cash-strapped legislatures opted to go their own way once again.

Tax experts call this “decoupling.” That’s a jargony name for a practice that can, and most likely will, cause you to run screaming to your accountant. “It is a zoo,” says Jere Doyle, an estate-planning and tax expert in Mellon Financial’s Boston office. “Everybody thinks ‘federal, federal, federal’ and assumes that the same rules will apply at the state levels. But they do not.”

So what rules do apply? Well, that depends on where you live and whether you do business in just one state or in many. In general, if you live and work on the East or West Coast, your state probably doesn’t follow the Feds completely. And, in general, the more states you do business in, the greater complexity you’ll face.

The two key areas of divergence between the Feds and the states are depreciation and estate taxes. But even less ballyhooed tax breaks — QPAI, anyone? — can cause a split. And decoupling is only likely to become more common. “The states can always raise rates, but they don’t like having to say that they’re raising rates,” says Alan Kaden, a tax attorney at the firm Fried, Frank, Harris, Shriver & Jacobson in Washington, D.C. “As revenues become scarcer and states are under more pressure, more will do this.”

With respect to depreciation, as you probably know, the federal government has lately added provisions to the code that allow extra depreciation to be taken in the first year and that let businesses choose to expense equipment under certain circumstances rather than depreciate it. But even as the Feds have added these provisions, many states have stuck with the old system (or adopted only part of the new rules), creating a maze of possibilities for dealing with capital expenditures for tax purposes.

The two main differences between some state codes and the federal code concern something called bonus depreciation, which allows businesses to write off up to 50% of an asset in the first year rather than depreciating the full amount over the long haul, and what’s known as Section 179 expensing, which permits businesses to expense up to $105,000 (for tax year 2005) in office furniture, computer equipment and the like rather than depreciating those assets over a long period.

Only 13 states currently permit bonus depreciation, and another four don’t have a corporate income tax, according to John Logan, a senior state tax analyst at CCH, a company in Riverwoods, Ill., that publishes information on tax laws. The rest, that is, the vast majority, may give partial breaks or adjustments, or offer nothing at all. And there’s a similar patchwork of rules on Section 179 expensing.

What all of this means is that you may have to track each of your assets, that warehouse you bought in New Jersey, those laptops purchased for your traveling employees, differently for the entire time you’ve got them for the states and for the Feds. If you do business in multiple states, you could end up with “five or six different depreciation schedules for the same set of assets,” says Philip J. London, an accountant at Freeman & Davis in New York City.

And should you sell that warehouse, since you’ve now taken different amounts of depreciation at the state and federal levels, the gain or loss that you report for federal tax purposes won’t match the one you claim for state tax purposes. “You wish it would jibe together but it doesn’t, and every state has its own peculiarities,” says Stephen Herskovitz, president of health care consultancy Hammond Hill, based in Acton, Mass.

Herskovitz has been working with his CPA on a depreciation schedule for mundane stuff like office furniture and computers. “You start to feel like you have a lot of hands grabbing for your wallet,” he says.

If you feel that way about the depreciation of relatively inexpensive assets, just imagine how your heirs will feel when they find themselves paying multiple estate taxes. That’s right, even as Congress debates the permanent repeal of the estate tax, 18 states plus the District of Columbia have decoupled, according to CCH’s Logan.

Tax experts believe the state estate taxes are here to stay. For entrepreneurs, then, this creates a new twist on the age-old problem of how to structure your business so that your heirs won’t face a large tax bill when you die. The first estate-tax question you’ll face concerns the exclusion, that is the amount you can bequeath without prompting the estate tax. Congress has increased that amount to $1.5 million this year, and it’s slated to rise until the estate tax (as it stands now) disappears (at least momentarily) in the year 2010.

But different states have set the exclusion at different dollar figures. New York’s exclusion is $1 million, for example, while Massachusetts’ is $950,000, and Connecticut’s is $675,000. That means that if you’ve got a $1.2 million business, you won’t be hit with the federal estate tax but if you’re liable for taxes in any of those states (or others with a lower exclusion amount), your estate still faces a tax liability.

And there’s another wrinkle. The 2001 federal tax cut phased out the state estate tax credit, which permits those taxes paid at the state level to net out at the federal level; it disappeared completely this year and was replaced by a deduction for the payment of state estate taxes. This may not sound like a big deal, but because many states had geared their estate taxes to the credit, its disappearance means your effective hit could be different than you were expecting.

For example, if an entrepreneur died in New York in 2004 and left a $2 million estate, that estate would owe $99,600 in state estate tax. Yet it would receive a federal credit for those taxes of only $24,900, according to calculations from Fiduciary Trust — a shortfall of $74,700, In some cases, tax experts warn, you could even wind up with a total estate tax bill that’s even bigger than it would have been before the Bush cuts were enacted in 2001.

What can you do? Moving to a tax haven like New Hampshire, Texas or Florida is one possibility. There are some other less drastic measures you can take. You may be able to sidestep some state estate taxes by folding assets such as real estate holdings into an LLC, thus turning a tangible asset into an entity that cannot be taxed if you live out of state. At a minimum, you should look for a tax advisor that has offices in all of the states in which you do business, or else assemble a team of accountants state by state that can properly advise you. Most of all, you need to be proactive in figuring out the decoupling labyrinth.

The bottom line, unfortunately, is caveat taxpayer. Bio photo