Quandary Ahead as State Digresses from Conformity

by Lowell L. Kalapa, Tax Foundation of Hawaii

For more than 35 years the state has adhered to a policy of conforming with the federal income tax Code as a means of reducing administrative and compliance costs for not only the tax department, but also for taxpayers.

Prior to 1977, if anyone wanted to know if some federal Code provision was applicable for state income tax purposes, they needed a complete set of public laws going back nearly 20 years as Hawaii law adopted provisions of the federal law that either established that provision or amended a provision that had been adopted for state income taxes. Thus, as the years went by the task of determining what was applicable for state income tax purposes became more and more arduous.

Realizing that using the federal public law to determine if a federal provision was operable for state tax purposes was impractical, the legislature decided to conduct a study of just what was or was not applicable for state purposes and then list those sections of the federal law that did apply to Hawaii. This task took nearly an entire year to accomplish, but it formed the basis for the modern-day form of what is known as conformity to the federal Code. Rather than listing those sections of the federal law which are effective for state tax purposes, the conformity provision announces that all of “subtitle A of chapter 1” of the federal Code is operable for state income tax purposes EXCEPT for the list of Code provisions listed in the statute. This way the practitioner merely has to check to see if the section of the federal law he is trying to apply is on or is not on the list.

A couple of years ago as the state sank into the morass of a budget shortfall, lawmakers seemed to turn a blind-eye to many of their own policies, one of which was its former religious adherence to maintaining conformity between the state and federal law as a means to generate additional revenue.

Although the federal government had recently repealed a limitation on the amount of itemized deductions, at the end of 2009 local lawmakers thought it might be a good way to raise the much needed revenue to fill the gap. So in the 2011 legislative session, lawmakers adopted a temporary limitation on the amount of itemized deductions that could be claimed by high-income taxpayers. They imposed a limit of $50,000 in itemized deductions under section 68 of the Internal Revenue Code (IRC) on couples with $200,000 of federal adjusted gross income (FAGI); $25,000 for taxpayers filing a single return or married persons filing separately with a FAGI of $100,000 or more; and $37,500 for taxpayers filing as a head of household with FAGI of over $150,000. The limitations were applicable to tax years beginning after 2010 and not for tax years beginning after 12/31/15.

This was not the first time lawmakers tried to impose such limits. When they tried to do so in 2010 the proposal was nixed by then Governor Lingle who called it “a de-facto tax increase that will adversely hurt certain individuals and businesses at a time when we should be encouraging investment and spending to recharge the economy. The tax increase not only impacts taxpayers, but also dis-incentivizes activities such as charitable giving and home ownership. Since itemized deductions are allowed for qualifying medical and dental expenses, contributions to qualifying charitable organizations, payment of certain taxes, home mortgage interest, and qualifying job‑related expenses, capping the deduction will act to discourage these expenses. Nonprofit and charitable organizations that depend on contributions to serve needy populations are particularly concerned that their ability to raise funds through donations and charitable giving would be adversely affected.”

One of the unintentional consequences of the limitation on itemized deductions was for charities that benefitted from the good hearts of taxpayers, especially the wealthy taxpayer who just happened to have “spare change” to donate thousands, if not millions, of dollars, to see their donations disappearing. Charities and other nonprofit organizations took this phenomenon to lawmakers in the first year after adoption noting that they were seeing their contributions from generous donors disappear. And while lawmakers held a hearing on the issue in the middle of the session, the issue went nowhere.

Finally, the plea was made to the administration who proposed a change this past year. With a lot of pressure from nonprofit organizations and charities, the bill sailed through this year’s session. The bill lifted the limitation of itemized deductions with respect to charitable contributions and became law. However, the overall limit on all itemized deductions will remain through 2015.

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