State conformity to the federal tax code is a messy and constantly evolving process. The conformity stakes are raised exponentially when Congress enacts substantial tax preferences, as it did in 2017 with the TCJA and again last year with the OBBBA. Despite the Treasury Secretary’s reproach, almost all states will decouple from certain federal tax provisions to some degree, especially as to OBBBA provisions that are both novel and risk substantial revenue losses for states.
Whether to conform to the federal Qualified Small Business Stock (QSBS) provisions of IRC 1202 is a uniquely difficult question for states. The QSBS provision, which has bipartisan roots, was expanded substantially with the TCJA and even more so with the OBBBA. If structured properly, many small (i.e., less than $50 million/$75 million in assets at formation) startup corporations can be sold for significant gain that is completely tax free (up to $500 million/$750 million total gain potentially excludable).
State QSBS conformity will be very costly. As such, states are considering decoupling from the QSBS provision, as the Oregon legislature did earlier this month. This past week, New York also proposed legislation that would decouple from the QSBS provision. New York received immediate and overwhelming criticism from the tech industry, and the New York Senate quickly withdrew the decoupling proposal.
States are in a difficult position. On one hand, if they conform to QSBS treatment they will give a monumental tax break to those selling businesses for hundreds of millions in gain. On the other hand, if states decouple they will appear hostile to small businesses and the tech industry, and (maybe most importantly) will likely lose the tax revenue anyway because of gaps in the existing personal income tax system. The QSBS shareholders will simply change their states of residence to a state that does not impose personal income tax before selling the QSBS stock and, absent a sea change in the personal income tax framework, avoid any state personal income tax on the gain as well.
