In June and July 2020, Colorado enacted legislation, promulgated a regulation and issued administrative guidance, all as part of an effort to address the state’s conformity to the Internal Revenue Code (IRC) and the federal CARES Act.1 Specifically, on June 2, 2020, the Colorado Department of Revenue issued an emergency regulation2 in response to several provisions of the CARES Act, clarifying that the state’s rolling conformity to the IRC applies only on a prospective basis. The Department permanently adopted this regulation at the end of July.3 On June 26, 2020, Colorado enacted legislation, H.B. 20-1024, which amended the net operating loss (NOL) deduction statute to decouple from the unlimited carryforward enacted by the Tax Cuts and Jobs Act of 2017 (TCJA).4 Colorado subsequently enacted H.B. 20-1420, on July 11, 2020, which formally decoupled the state from several CARES Act provisions. The Department also released additional administrative guidance for taxpayers to assist in filing their returns under these new rules.
Prospective adoption of IRC
Colorado law provides that the state conforms to the IRC in effect on the current date, automatically incorporating changes that may occur at any time.5 After enactment of the CARES Act on March 27, 2020, the Department released an emergency regulation to clarify the state’s conformity to IRC changes.6 On July 31, 2020, the Department permanently adopted this regulation.7 The CARES Act includes provisions that are retroactive to various effective dates, as early as Sept. 27, 2017. In its regulation, the Department explains that its interpretation of the Colorado conformity statute is that IRC changes are effective only on a prospective basis.8 Any changes made by the CARES Act will therefore not be effective for Colorado purposes for tax years ending before March 27, 2020.
Treatment of NOLs amended
Prior to the enactment of the CARES Act, the Colorado legislature began to consider legislation, H.B. 20-1024, to address the unlimited carryforward of NOLs provided by the TCJA. This legislation, which was enacted in June 2020, amends Colorado law to provide that NOLs of corporations generated in tax years beginning on or after Jan. 1, 2021, may be carried forward for 20 years.9 NOLs generated in tax years beginning prior to Jan. 1, 2021, may be carried forward for the same number of years as allowed for a federal NOL. As NOLs generated in tax years beginning after Dec. 31, 2017, may be carried forward for an unlimited number of years (per the TCJA),10 Colorado allows the unlimited carryforward of NOLs for tax years beginning in 2018, 2019, or 2020. However, Colorado is prospectively decoupling from the TCJA’s unlimited carryforward of NOLs for tax years beginning in 2021 and beyond. Also, the CARES Act allows taxpayers to carry back NOLs generated in tax years beginning in 2018, 2019, or 2020 for up to five tax years preceding the year of the loss.11 Colorado does not conform to any of the NOL carryback provisions of the CARES Act, consistent with existing law which prohibits the carryback of a Colorado NOL.12
As amended, the general NOL carryforward period of 20 years also applies to financial institutions for NOLs generated on or after Jan. 1, 2021.13 For NOLs generated in tax years beginning prior to Jan. 1, 2021, the 15-year carryforward period provided under existing law for financial institutions continues to apply.
The Colorado legislature also addressed other aspects of the treatment of NOLs in subsequent legislation, H.B. 20-1420. Prior to the enactment of the CARES Act, the use of NOL deductions for years beginning after Dec. 31, 2017, was limited to 80% of taxable income, for corporate and individual taxpayers. Colorado automatically conformed to this provision. Under the CARES Act, the 80% limitation on the use of NOL deductions is temporarily suspended for tax years beginning in 2018, 2019, or 2020.14 However, Colorado decoupled from this change to the 80% limitation in H.B. 20-1420.15
Decoupling from other CARES Act provisions
In addition to the NOL limitation decoupling provision discussed above, H.B. 20-1420 decoupled from several other tax provisions in the CARES Act. The main areas of decoupling include the interest expense deduction limitation under IRC Sec. 163(j), a limitation of the IRC Sec. 199A qualified business income deduction, and the noncorporate excess business loss limitation suspension under IRC Sec. 461(l).
Interest expense limitation
Under the CARES Act, the IRC Sec. 163(j) limitation on interest expense deductions has been temporarily increased from 30% to 50% of adjusted taxable income (ATI). Because Colorado has legislatively incorporated the IRC Sec. 163(j) limitation adopted under the TCJA, and has decoupled from the increased 50% limitation enacted by the CARES Act, the 30% of ATI limitation will continue to apply for corporate and individual taxpayers in Colorado.16
In addition to the different limitations in place for federal and Colorado income tax purposes, Colorado is departing from federal income tax provisions regarding the ability to utilize an interest expense carryforward resulting from these rules. For federal income tax purposes, any amount of interest expense not deductible in the current year, due to the operation of the IRC Sec. 163(j) limitation, may be carried forward indefinitely. The interest expense carryforward may be deducted in any year where the current year IRC Sec. 163(j) limitation exceeds the current year interest expense available for deduction. However, Colorado has not provided a specific statutory subtraction for prior-year business interest deductions subject to a higher limit for federal purposes than for Colorado purposes, and the Department has confirmed that as a result, no future subtraction is allowed for any interest expense deducted for federal purposes but disallowed for Colorado purposes.17
For tax years beginning in 2020, the CARES Act allows taxpayers the election to use their 2019 ATI in computing the 2020 IRC Sec. 163(j) limitation in lieu of their 2020 ATI. Colorado does not specifically decouple from this provision, and the Departmental guidance further provides that no adjustment will be required to Colorado taxable income for the impact of this election.
Qualified Business Income Deduction
Under the TCJA, qualifying individual taxpayers may deduct 20% of their qualifying business income from taxable income.18 Colorado was one of a handful of states that originally conformed to this provision. The legislation has placed new limitations on taxpayers qualifying for this deduction. For the 2021 and 2022 tax years, the IRC Sec. 199A deduction generally will be limited to taxpayers with adjusted gross income of $500,000 or less for single filers, and $1 million or less for joint filers.19
Qualified improvement property
The CARES Act made a technical correction to the treatment of qualified improvement property (QIP).20 For purposes of 100% bonus depreciation, established by the TCJA, QIP was classified as property with a 39-year depreciable life, not qualifying for bonus depreciation. The CARES Act has corrected this provision, reverting QIP back to having a 15-year depreciable life, thus qualifying for bonus depreciation. This change is retroactive to the effective date of the enactment of 100% bonus depreciation, Sept. 27, 2017. Taxpayers may amend their 2017 and 2018 federal income tax returns to reflect this revision, or file an accounting method change in order to claim bonus depreciation on QIP.
While the Colorado legislation does not address this provision, the Department’s regulation provides that the correction to the depreciable life of QIP is effective on a prospective basis only. Taxpayers will not be permitted to claim bonus depreciation on QIP for the 2017 and 2018 tax years. The Department’s administrative guidance also provides that no subtraction will be allowed for the federal depreciation disallowed in the 2017 and 2018 tax years. As these assets were fully expensed in the year placed in service for federal purposes, taxpayers will not be allowed future basis recovery for these assets on their Colorado tax returns.21 This disallowance of basis recovery in Colorado will create a permanent basis difference for federal and state income tax purposes. Colorado will prospectively conform to the federal treatment of QIP, beginning with tax years ending on or after March 27, 2020.
Excess business loss limitation
The CARES Act suspended the noncorporate excess business loss limitation for the 2018 through 2020 tax years.22 For individual income tax purposes, Colorado decouples from the suspension of the excess business loss limitation.23
Amended returns
Depending on the positions taken on 2017 and 2018 federal and Colorado income tax returns, taxpayers may need to take action to correct their Colorado taxable income for those years.24 For example, if taxpayers have already filed Colorado returns for a tax year ending before March 27, 2020, that include the effect of any CARES Act provisions, an amended Colorado return may be required to remove the impact of CARES Act changes from Colorado taxable income. It should be noted that taxpayers amending their 2017 or 2018 federal income tax returns to claim CARES Act benefits should be aware that such changes will not impact their 2017 and 2018 Colorado income tax returns, as the state does not conform to the CARES Act changes for those tax years.
Likewise, for calendar-year taxpayers filing Colorado income tax returns for the 2019 tax year, federal taxable income should be calculated without reference to the CARES Act provisions. This adjusted federal taxable income should be entered on line 1 of the Colorado return. If taxpayers filed their 2019 returns prior to the issuance of Colorado’s emergency regulation and the enactment of the CARES Act decoupling legislation, those 2019 returns should be amended to reflect the required changes to federal taxable income on line 1 of the Colorado return.
Since the state does not have any provision for taxpayers to deduct in future years any amount of interest expense or depreciation expense disallowed in the current year, taxpayers should not claim subtractions for these items on any current or future Colorado income tax return.
Commentary
There are several issues raised by the Department’s interpretation of the state’s IRC conformity statute, along with the numerous decoupling provisions provided in Colorado’s recently enacted legislation. The regulation promulgated by the Department that prospectively adopts the IRC appears to conflict with the language of the conformity statute. Colorado law defines the IRC as “provisions of the federal ‘Internal Revenue Code of 1986,’ as amended, and other provisions of the laws of the United States relating to federal income taxes, as the same may become effective at any time or from time to time, for the taxable year.”25
The statutory inclusion of the language “at any time” has been widely interpreted to mean that Colorado is a “rolling conformity state,” which incorporates changes to the IRC as immediately effective, whenever enacted. The apparent conflict between the statute and regulation may provide taxpayers with an opportunity to challenge the Department’s interpretation.
In its administrative guidance, the Department indicates that any federal deductions resulting from the retroactive application of the CARES Act will be disallowed for Colorado purposes. No subtraction will be allowed in future years for these disallowed amounts. Typically, states decoupling from federal depreciation and interest expense limitation provisions will eventually allow for disallowed deductions to be taken in future years on the state return. For example, states which do not conform to bonus depreciation allow taxpayers to depreciate the full basis of those assets, using federal rules as if bonus depreciation had not been taken. This effectively creates a timing difference between the federal and state deduction. Colorado, however, indicates that there will be no future subtraction, creating a permanent difference between federal and Colorado taxable income.
Taxpayers may find some relief in the statute allowing gain on the disposal of an asset to be reduced, not beyond zero, for any excess of state basis over federal basis.26 Taxpayers will need to separately track their Colorado basis in QIP assets in order to claim this benefit. However, if assets are scrapped, or otherwise disposed of without generating a gain, no adjustment is allowable for Colorado purposes.
Colorado’s unique IRC Sec. 163(j) decoupling provision also may create additional complexity for taxpayers. While taxpayers may already have multiple disallowed interest expense carryover schedules for varying federal and state carryovers, Colorado’s treatment will necessitate additional tracking.
The Department’s position that federal IRC changes apply only to taxable years ending after the federal enactment date runs the risk of creating conformity scenarios that are difficult to track for both calendar and fiscal year-end taxpayers. For example, the Department’s administrative guidance provides that no adjustment to Colorado income will be required for taxpayers electing to use their 2019 ATI in 2020 for purposes of computing the IRC Sec. 163(j) limitation. Elsewhere, the Department’s guidance provides that federal changes enacted by the CARES Act will only be effective for tax years ending on or after March 27, 2020. Under this policy, any taxpayers with a fiscal year end, or short tax year ending date, between Jan. 1, 2020, and March 26, 2020, should not be able to make this election, as it would be a retroactive application of federal law. However, the Department’s guidance notes that the provision is effective for federal purposes for any tax year beginning in 2020 and “[f]ederal taxable income reported to Colorado will reflect this election without adjustment.”27 This appears to be an inconsistent application of the principle of prospective IRC conformity and may lead to confusion when future IRC changes are enacted.
The Department’s current interpretation of the IRC conformity statute that adopts federal changes on a prospective basis has the effect of increasing taxable income as reported for Colorado purposes in many cases. This interpretation, which allows the Department to decouple from provisions of the CARES Act that the legislature did not choose to address, could have far-reaching implications as future changes to the IRC are considered and enacted. For example, if the upcoming federal election results in a change in administration, taxpayers may see favorable federal income tax reform provisions modified or repealed. If that were to occur, Colorado may, under its own newly adopted administrative guidance, be forced to delay the effective date of what would otherwise be revenue-raising provisions for at least a year. When the TCJA was enacted on Dec. 22, 2017, creating a retroactive income inclusion under IRC Sec. 965, the Department quickly reminded taxpayers that the state automatically conformed to this new code section.28 Guidance was released instructing taxpayers to adjust their 2017 income tax returns to include any IRC Sec. 965 income. It will be interesting to see which path the state will follow if it becomes the beneficiary of future federal income tax reform.
1 Coronavirus Aid, Relief, and Economic Security Act, P.L. 116-136, March 27, 2020.
2 COLO. CODE REGS. § 39-22-103(5.3) (emergency regulation, effective June 2, 2020 through Sept. 30, 2020).
3 Id., permanently adopted July 31, 2020, effective Sept. 30, 2020.
4 P.L. 115-97 (2017).
5 COLO. REV. STAT. § 39-22-103(5.3).
6 COLO. CODE REGS. § 39-22-103(5.3) (emergency regulation, effective June 2, 2020, through Sept. 30, 2020). Note that the existing Colorado regulation that provides apportionment and allocation definitions also was amended to adopt the prospective definition of “code” as provided in COLO. CODE REGS. § 39-22-103(5.3). COLO. CODE REGS. § 39-22-303.6–1(1)(f).
7 Id., permanent regulation, effective Sept. 30, 2020.
8 Id. The regulation provides that the IRC “does not, for any taxable year, incorporate federal statutory changes that are enacted after the last day of that taxable year. As a result, federal statutory changes enacted after the end of a taxable year do not impact a taxpayer’s Colorado tax liability for that taxable year. Changes to federal statutes are incorporated into the term ‘internal revenue code’ only to the extent they are in effect in the taxable year in which they were enacted and future taxable years.”
9 COLO. REV. STAT. § 39-22-504(3).
10 IRC § 172(b)(1)(A)(ii).
11 P.L. 116-136, § 2303(a)(1), amending IRC § 172(a); § 2303(b)(1), adding IRC § 172(b)(1)(D)(i).
12 COLO. REV. STAT. § 39-22-504(3).
13 COLO. REV. STAT. § 39-22-504(4).
14 P.L. 116-136, § 2303(a)(1), adding IRC § 172(a)(2)(A).
15 COLO. REV. STAT. §§ 39-22-104(3)(l); 39-22-504(1)(b).
16 COLO. REV. STAT. §§ 39-22-104(3)(n); 39-22-304(2)(i).
17 CARES Act Tax Law Changes & Colorado Impact, Colorado Department of Revenue, June 2020.
18 IRC § 199A.
19 COLO. REV. STAT. § 39-22-104(3)(o).
20 IRC § 168(k)(6).
21 CARES Act Tax Law Changes & Colorado Impact, Colorado Department of Revenue, June 2020.
22 IRC § 461(l).
23 COLO. REV. STAT. § 39-22-104(3)(m).
24 See CARES Act Tax Law Changes & Colorado Impact, Colorado Department of Revenue, June 2020.
25 COLO. REV. STAT. § 39-22-103(5.3).
26 COLO. REV. STAT. § 39-22-304(3)(c).
27 CARES Act Tax Law Changes & Colorado Impact, Colorado Department of Revenue, June 2020.
28 Supplemental Instructions for Colorado Income Tax Filing, Colorado Department of Revenue, June 11, 2018.
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