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Virtue of Conformity will be Challenged

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By Lowell L. Kalapa

We have looked at the changes made by the federal law to the estate tax, this week let’s look at some of the new provisions of the federal income tax which have been altered by the recently signed federal tax reform bill.
Of particular interest will be those provisions which help to define income for federal and hopefully state tax purposes. Since Hawaii usually does not adopt federal tax credits or for that matter federal income tax rates, the focus will indeed be those provisions which determine adjusted gross income.
Among the new or amended provisions that will define adjusted gross income are those which provide incentives to support or encourage education. For example, the current annual exclusion from gross income of employer-provided education assistance was set to expire at the end of the year. The new tax bill makes this provision permanent. Since this provision is already operative for state tax purposes, one would assume that the legislature will also adopt it as a permanent fixture of the state income tax law.
Another change Congress made was an increase in the amount one can contribute to an educational IRA. Besides increasing the amount that one can contribute annually, the new law now allows taxpayers to make the contribution right up to the filing deadline of April 15th. While the contribution is not deductible, the earnings accumulate on a tax-free basis and distributions used for qualified educational expenses would also not be included in the taxpayer’s income. Earnings distributed from an educational IRA can be excluded from income only to the extent the distribution does not exceed expenses.
The new law also expands what would qualify as education expenses to include elementary and secondary education. Contribution and distribution limitations are waived for special needs students. These new provisions would also have to be considered in conforming state law to the changes made to the federal law.
Another new provision of the federal tax law that state policy makers will have to look at is the deduction for qualified higher education expenses. Since the deduction will define how much income will be subject to tax, state officials will have to determine if Hawaii will also recognize the deduction. The federal law permits a deduction of up to $3,000 for such expenses in 2002 and 2003 and $4,000 in expenses for the years 2004 and 2005. However, the deduction would be available based on the income of the taxpayer with upper caps set at $65,000 for single taxpayers and $130,000 for joint returns. Those single taxpayers with incomes between $65,000 and $80,00 ($130,000 and $160,000 for joint returns) will only get a maximum $2,000 deduction and then only for the years 2004 and 2005.
An interesting twist is that the deduction is not available to the taxpayer in the year the federal HOPE or Lifetime Learning tax credit is claimed. Since the state law does not recognize these credits, it will be interesting to see if state officials will also impose the same prohibition if they adopt the higher education deduction.
Finally, the new federal tax law will recognize distributions from qualified tuition plans or programs as excludable from income when the distribution is used for qualified higher education expenses. These plans known as 529 tuition plans allow taxpayers to contribute to a tuition savings program that is usually established by state law. Such a plan is about to get up and running here in Hawaii. Under current law, the earnings realized from those distributions are included as taxable income of the beneficiary.
In order to maintain conformity such that the amount of adjusted gross income of the taxpayer at the federal is similar, if not identical, to what is reported as adjusted gross income will have to take into account whether or not these distributions will also be excluded for state income tax purposes. An added twist to this exclusion is that there is a coordination between this exclusion for distributions from a qualified tuition program and the deduction for qualified higher education expenses. The new law provides that the deduction for higher education expenses cannot be claimed if the amount was paid with a distribution from a qualified tuition plan that represents earnings realized from the tuition program, but the deduction can be claimed for that portion that represents a return of the original investment in the tuition program.
Many of these new provisions of the federal tax law which may be applicable in defining what is adjusted gross income will have to be carefully reviewed as part of the state’s annual conformity process.

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