Colorado amends pass-through entity tax

Colorado recently enacted legislation containing important income tax changes to the elective pass-through entity (PTE) tax regime developed by the state in 2021. Most notably, the legislation amends Colorado’s PTE-level tax to allow retroactive elections going back to tax years beginning on or after Jan. 1, 2018.¹

PTE tax election

In 2017, the Tax Cuts and Jobs Act (TCJA) placed a limit on the state and local tax (SALT) deduction at the individual taxpayer level.² This limit allows a deduction for only the first $10,000 in state and local taxes for individual income taxpayers.³ The “SALT cap” impacts mainly high-income tax earners who have the ability to itemize their deductions.

Last year, Colorado enacted legislation to provide an elective PTE tax as a means to provide a level of parity on the deductibility of state income taxes for C corporations and PTEs alike.⁴ That legislation allowed partnerships and S corporations to annually elect to pay Colorado income taxes on behalf of the owners at the entity level for tax years beginning on or after Jan. 1, 2022.⁵

Colorado recently amended the 2021 legislation to permit partnerships and S corporations to retroactively elect to pay Colorado income taxes on behalf of the owners at the entity level for tax years beginning on or after Jan. 1, 2018.⁶ The tax is imposed at the corporate income tax rate applicable to each of the tax years covered by the retroactive election—4.63% for 2018 and 2019, 4.55% for 2020, and 4.50% for 2021.⁷

The election to participate in the PTE tax regime on a retroactive basis must be made on or after Sep. 1, 2023, and before July 1, 2024.⁸ PTEs electing into the regime are required to file a composite amended tax return on behalf of all the PTE’s owners.⁹

Deduction converted to credit

Colorado’s 2022 legislation also amends the state income tax deduction for electing PTE owners. While Colorado’s 2021 legislation provided for an exclusion from Colorado income for the PTE owners’ share of income taxed at the entity level, the 2022 legislation replaces this deduction with a refundable tax credit at the PTE-owner level for each electing owner’s distributive share of the state income tax imposed on the electing PTE.¹⁰

Commentary

While more than half the states in the U.S. have enacted various PTE tax regimes since the passage of the TCJA, Colorado is the first state to permit PTE elections retroactive to 2018. This opportunity gives owners of partnerships and S corporations the opportunity to mitigate owner-level impacts of the federal SALT deduction cap for all tax years to which it has been applicable. However, the amended return process may be labor-intensive for certain businesses—particularly larger organizations with numerous partners.

The legislation does not specifically address several logistical and practical issues that will need to be resolved in the near future. For example, there is no mention of whether a PTE may choose to elect to enter the PTE tax regime for selected years from 2018-2021, or whether an electing PTE is compelled make the election for all of these years. The Colorado Department of Revenue is tasked with providing regulations and setting up a process to facilitate the new PTE tax regime. Further, the Department is entitled to audit the amended composite return filed by the PTE within one year of filing. Finally, questions surrounding how to reflect the federal tax benefit accruing from such retroactive election will need to be resolved.

As a result of these uncertainties and the potential prospect of significant tax compliance necessary to properly effect the retroactive election, PTE owners should examine their specific facts and circumstances to determine whether such election in Colorado may be worth pursuing. Because retroactive elections must be made between Sep. 1, 2023 and July 1, 2024, PTE owners do have a significant amount time to evaluate the benefits and costs of a possible election.