Do you know that your state income tax decisions can reshape your federal return? With tax season around the corner, understanding this connection is essential—especially with new changes in 2025.
According to the New York Post, Donald Trump has proposed restoring the full SALT deduction, potentially shaking up taxes for millions. In this article, explore how your state income, credits, and IRS rules intertwine—and how smart tax strategies can help you save more.
How Do State Income Taxes Affect Your Federal Return?
What Is the Connection Between State and Federal Tax Returns?
Your state return often starts where your federal return ends. If you’re in one of the 31 states (plus D.C.) that use federal AGI, or one of the five that use federal taxable income, your numbers flow directly from your IRS filing. In plain terms:
Your federal numbers set the tone for your state taxes.
Here’s why it matters:
- If you claim deductions federally, they often carry over.
- If federal tax law changes, your state may adopt—or reject—those rules.
- Your tax software (or CPA) pulls federal info to complete your state return. One mistake on your federal return? It’ll trickle down.
For business owners, this link is crucial when reporting pass-through income, deductions, or credits across both returns.
Can State Refunds Affect Your Federal Income Tax?
Yes—but only if you itemized deductions in the previous year and deducted your state income taxes.
Here’s the rule of thumb:
- Standard deduction last year? Your state refund is not taxable.
- Itemized last year and deducted state income taxes? Your refund may be taxable—but only the portion you benefited from.
The IRS clarified this in Notice 2023-56. And thanks to the $10,000 SALT cap, many who itemize still don’t have to claim the full refund as income—because they couldn’t deduct all their state taxes anyway.
If you're unsure? Check last year’s Schedule A or ask your tax pro. It’s not worth guessing.
Further Reading: Discover which states have no income tax
What Role Do IRS Rules Play in State Tax Filing?
How Do States Use IRS Definitions and Guidelines?
Most states piggyback off IRS rules to keep things simple. It means:
- You calculate your federal AGI, and your state just says, “Copy that over.”
- Definitions of income, adjustments, and deductions stay aligned unless the state decides to break away.
There are two approaches:
- Rolling conformity: State laws update automatically with federal law (think: California, Colorado).
- Static conformity: State lawmakers must vote to accept new federal rules (think: New York, Virginia).
This affects everything from depreciation rules to tax credits. If you’re tracking business deductions, make sure you know if your state decouples from any key IRS rules.
What Happens When IRS Rules Change?
Your state tax laws might shift without any action from your state.
For example:
- The Tax Cuts and Jobs Act (2017) changed the federal rules for personal exemptions and business income.
- Oregon and South Carolina kept the federal taxable income system—but removed the 20% pass-through deduction.
- Vermont switched to AGI to avoid letting federal changes mess up their system.
IRS law changes are a domino effect. If you’re running a business in multiple states, know which ones roll and which ones freeze. It affects how you report your income and claim deductions.
Are There State Tax Credits That Impact Federal Taxes?
Which State Credits Are Based on Federal Programs?
Plenty of states use federal formulas to create their own credits. If you qualify for a federal credit, you might automatically qualify for a state one.
Examples:
- Earned Income Tax Credit (EITC): Some states offer 5–30% of your federal EITC.
- Child Tax Credit (CTC): A few states offer additional help based on your federal CTC.
- Dependent Care Credit: States may piggyback off your federal child care expenses.
Check your state’s tax site or let your accountant know—many business owners miss these because they think they only apply to individuals. But if you’re claiming these for dependents while running a sole prop or LLC, they absolutely matter.
Can State Credits Reduce Your Federal Income?
Not directly. State tax credits won’t lower your federal tax bill. But here’s where they can sneak back into your federal return:
If a state credit leads to a refund, and you itemized deductions last year (including state taxes), you might have to report part of that refund as federal taxable income the following year.
In short:
- Credits = less state tax = potential refund
- Refund = potentially taxable on your federal return if you itemized
It’s a domino. And if you're a business owner, those refund amounts can be large enough to trigger a notice if you skip reporting it.
Further Reading: Discover how living in a community property state impacts your taxes
How Can You Strategically File State and Federal Taxes Together?
Should You Itemize or Take the Standard Deduction?
Unless you have significant expenses, the standard deduction wins—and most people know it. The IRS said 90% of taxpayers took it in 2021.
But if you’re in a high-tax state (like CA, NY, NJ), itemizing might look tempting—until you hit the $10,000 SALT cap.
If you're married, earn over $150k, and own property? You probably pay more than $10k in state/local taxes—but only get to deduct $10k. Anything above that? Wasted, at least federally.
Here’s the trick:
- Run both calculations every year.
- If you’re itemizing only to claim a few thousand more but it risks taxability of a refund later? It may not be worth it.
What’s the Best Way to Coordinate State and Federal Filing?
Sync your numbers—especially AGI. That’s the launchpad for both returns.
As a business owner:
- Make sure your federal AGI flows accurately into your state return.
- Double-check any state-specific adjustments, especially for business deductions or depreciation rules.
Multi-state business? Things get trickier:
- Some states allocate based on revenue earned in-state.
- Others use apportionment formulas based on payroll, property, and sales.
Using a tax prep service like Taxfyle ensures your federal and state returns match up, keep you compliant, and avoid triggering audits. Don’t DIY this if you operate in multiple states—it’s not worth the headache.
Key Takeaways
- State income tax starts with your federal AGI, making your federal return the base for your state filing.
- IRS rules directly impact state tax codes—especially in rolling conformity states.
- Claiming the standard deduction? Your state tax refund is likely not taxable federally.
- Many states mirror federal tax credits, like the EITC and Child Tax Credit, reducing your overall tax burden.
- Coordinating federal and state taxes strategically helps you stay compliant and maximize deductions.
How can Taxfyle help?
Finding an accountant to manage your bookkeeping and file taxes is a big decision. Luckily, you don't have to handle the search on your own.
At Taxfyle, we connect small businesses with licensed, experienced CPAs or EAs in the US. We handle the hard part of finding the right tax professional by matching you with a Pro who has the right experience to meet your unique needs and will manage your bookkeeping and file taxes for you.
