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.

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For 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 state 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 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 tax rates, but they don't like having to say that they're raising rates. Decoupling makes it easier to mask an increase in taxes," 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 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 you 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.

You wish it would jibe together but it doesn't, and every state seems to have peculiarities. You feel like you have a lot of hands grabbing for your wallet."

Stephen Herskovitz, founder of Hammond Hill in Acton, Mass.

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 seems to have 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.

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