Colorado’s rolling conformity to IRC includes retroactive federal changes

On Nov. 17, 2022, the Colorado Court of Appeals held that taxpayers could file an amended state individual income tax return claiming a refund based on a retroactive amendment to the Internal Revenue Code (IRC).¹ Specifically, the court allowed the taxpayers to file an amended 2018 tax return relying on a provision of the Coronavirus Aid, Relief, and Economic Security (CARES) Act that was enacted in 2020 and expressly applied to prior tax years.² In a case of first impression, the Colorado Court of Appeals determined that changes to the IRC that lower a taxpayer’s federal taxable income for prior years allow Colorado taxpayers to file a timely amended return to claim a refund.

Background

In April 2020, the taxpayers filed amended federal and Colorado joint individual income tax returns for the 2018 tax year in response to a provision of the CARES Act that retroactively suspended the limitation on the excess business loss deduction. In September 2020, the Colorado Department of Revenue (Department) rejected the taxpayers’ income tax refund claim based on an emergency rule promulgated in June 2020 that provides the state only adopt amendments to the IRC on a prospective basis.

The taxpayers appealed the denial of their refund claim to a district court and requested a declaratory judgment that “[w]hen Congress passed the CARES Act, the tax provisions included therein were immediately incorporated into Colorado tax law pursuant to Colorado statute.” The district court granted the Department’s motion to dismiss and concluded that the state’s IRC conformity statute was ambiguous. According to the court, the Department’s interpretation of the statute was reasonable, consistent with subsequent legislation that decoupled from certain provisions of the CARES Act, and entitled to deference. The taxpayers subsequently appealed the dismissal of their refund claim to the Colorado Court of Appeals.

Relevant CARES Act provision

The CARES Act was enacted on March 27, 2020, in response to the continuing COVID-19 pandemic. The legislation amended several sections of the IRC, including suspension of the excess business loss deduction for noncorporate taxpayers for the 2018 through 2020 tax years.³ Due to the temporary suspension of the limitation, taxpayers with excess business losses could retroactively reduce their federal taxable income as a result of claiming greater losses.

Colorado’s adoption of IRC

Colorado generally follows a “rolling conformity” approach of adopting the IRC. Specifically, a statute defines the “internal revenue code” as the “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.”⁴ Furthermore, a Colorado statute provides that “[a]ny term used in this article, except as otherwise expressly provided or clearly appearing from the context, shall have the same meaning as when used in a comparable context in the internal revenue code, as amended, in effect for the taxable period.”⁵ In June 2020, presumably in response to the CARES Act and its retroactive application of several significant federal income tax provisions, the Department issued an emergency rule providing:

“Internal revenue code” 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 further taxable years.⁶

The emergency rule subsequently was replaced with a permanent rule containing the same language that is relevant to this case.⁷

On July 11, 2020, Colorado enacted legislation in response to the CARES Act preventing taxpayers from using certain CARES Act provisions in calculating their Colorado taxable income for tax years beginning after enactment of the CARES Act and before Jan. 1, 2021.⁸ As an example, taxpayers were required to add back the amount of the increase in their excess business loss deduction as a result of the CARES Act.⁹ In January 2021, Colorado enacted further legislation providing that for tax years beginning in 2021, taxpayers could subtract up to $300,000 of excess business losses and could carry forward up to $150,000 per year in excess business losses from the 2021 tax year for up to the next four tax years.¹⁰

Adoption of IRC extends to retroactive provisions

The Colorado Court of Appeals agreed with the taxpayers that the state’s statutory definition of IRC automatically incorporates federal amendments to the IRC, even if the changes relate to previous tax years. The Department unsuccessfully argued that the state’s definition of IRC only incorporates amendments to the IRC to the extent they are in effect for the taxable year in which they were enacted and for future taxable years.

In determining the proper interpretation of the Colorado statute adopting the IRC, the court first considered the plain language.¹¹ The court explained that the statute “plainly and unambiguously states that the phrase ‘internal revenue code’ includes ‘the provisions of the [IRC], as amended, . . . for the taxable year,’ without any limitation as to when any amendment is enacted or goes into effect.” As a result, the court noted that a “taxpayer can take advantage of any amendment that is in effect for (not just in) a taxable year.”¹² The court determined that the plain language of the statute contradicted the Department’s suggested interpretations. Furthermore, the court was not persuaded by the Department’s reliance on the statutory presumption of prospective application. The language of the CARES Act expressly made the relevant provisions applicable to prior tax years. Furthermore, to the extent the Department’s argument was directed at an amendment to the state statute, the court concluded that the Department’s argument was misplaced because the CARES Act could not amend state law.

The court also rejected the Department’s argument that the taxpayers’ interpretation of the Colorado statute adopting the IRC was contrary to the legislative declaration in the state income tax code. Under the legislative declaration, one of the purposes of the act includes “[s]implifying the preparation of state income tax returns.”¹³ The Department argued that preparation of returns was not simplified because the taxpayers were required to file an amended return. The court concluded that an interpretation of the statute that requires taxpayers to determine which IRC amendments to consider, depending on when the provisions were enacted, creates complexity in preparing returns. A taxpayer’s preparation of state income tax returns is simplified by automatically adopting amendments to the IRC.

The Department unsuccessfully argued that the state’s emergency IRC conformity rule supported its position that the taxpayers could not apply the CARES Act provisions to prior tax years.¹⁴ The emergency rule specified that changes to federal tax law only apply prospectively, but the language that the Department used in the rule did not appear in the Colorado tax code until the legislation addressing the CARES Act became effective in July 2020.¹⁵ The court noted that if the state’s IRC conformity statute had provided for prospective application only, there would have been no reason for the Department to adopt the emergency rule. The Department previously stated that the emergency rule was intended to clarify that the state only adopts changes to the IRC on a prospective basis, but the court explained that this was more than a clarification. The court declined to defer to the emergency rule because its interpretation of “internal revenue code” was contrary to the conformity statute’s plain language.

The court rejected the Department’s argument that the Colorado legislation addressing the CARES Act that was enacted in 2020 and 2021 supported the Department’s interpretation. First, the court noted that these amendments did not apply to the taxpayers’ 2018 return because they expressly were limited to later tax years. Also, the Department argued that the fiscal note to the 2020 legislation indicated that the statutory language was a recognition of existing law as provided in the emergency rule. Because the court determined that the statutory language is not ambiguous, it did not need to consider the fiscal notes. Furthermore, the court explained that the value of the fiscal note was “suspect” because the Colorado Office of Legislative Legal Services determined that the emergency rule conflicted with the IRC conformity statute.¹⁶ The court noted that the legislature has the power to amend the state income tax to decouple from amendments to the IRC such as the legislation that it enacted in 2020 and 2021. However, unless statutes limiting adoption of the changes to the IRC are enacted, Colorado automatically conforms to amendments to the IRC.

The appellate court reversed the district court and held that the taxpayers could rely on retroactive changes enacted by the CARES Act to file an amended state income tax return for the 2018 tax year. The court concluded that the CARES Act provision applied to the 2018 tax year and nothing in the Colorado statutes limited that modification.

Commentary

Colorado generally is considered a “rolling conformity” state that automatically adopts the IRC as amendments are enacted. While one may think that a rolling conformity approach is relatively simple as compared to static conformity because the starting point to the state income tax calculation is always aligned to the federal income tax code, federal provisions that act in a retroactive manner have the potential to add unintended complexity at the state level. Conformity determinations have become especially complex in Colorado following the promulgation of the emergency rule limiting the state’s adoption of the IRC to a prospective basis and the enactment of legislation decoupling from certain provisions of the CARES Act.¹⁷ Notably, this decision clarifies that Colorado automatically incorporates on a retrospective and prospective basis the changes to the IRC for the tax year enacted. Due to the importance of this decision, the Department may appeal this case to the Colorado Supreme Court.

Taxpayers affected by this decision should watch for future updates regarding this litigation, and consider amending Colorado income tax returns to seek refunds for any overpayments which may have been made. While this case concerns individual taxpayers, there are at least two significant retroactive provisions of the CARES Act that should be considered by corporate taxpayers. First, the CARES Act amended the business interest expense limitation under IRC Sec. 163(j) that was enacted by the Tax Cuts and Jobs Act (TCJA)¹⁸ to temporarily increase the percentage threshold from 30% to 50% of a taxpayer’s adjusted taxable income for tax years beginning in 2019 and 2020.¹⁹ Also, the CARES Act included a retroactive technical correction to make qualified improvement property eligible for the TCJA’s 100% bonus depreciation provision.²⁰ While the Colorado legislature enacted subtraction modifications relating to certain retroactive provisions of the CARES Act for tax years beginning in 2020,²¹ taxpayers should consider amending returns to claim refunds for these amounts added back to their Colorado corporate income tax returns.

1 Anschutz v. Department of Revenue, Colorado Court of Appeals, No. 2022COA132, Nov. 17, 2022.
2 P.L. 116-136 (2020).
3 IRC § 461(l).
4 Colo. Rev. Stat. § 39-22-103(5.3). The court noted that the Colorado Constitution expressly allows state income taxes to be calculated “by reference to provisions of the laws of the United States . . . whether retrospective or prospective in their operation.” Colo. Const. art. X, § 19 (emphasis added by court).
5 Colo. Rev. Stat. § 39-22-103(11).
6 Colo. Code Regs. § 39-22-103(5.3), emergency rule effective June 2 – Sept. 29, 2020. Note that the court references the emergency rule throughout its opinion because this was the version of the rule that was in effect when the Department denied the taxpayers’ refund claim.
7 Id., permanent rule effective Sept. 30, 2020.
8 Colo. Rev. Stat. § 39-22-104(3)(l)-(n), enacted by Ch. 277 (H.B. 1420), Laws 2020. Note that this legislation also amended a corporate income tax statute to decouple from the retroactive IRC Sec. 163(j) business interest expense limitation changes enacted by the CARES Act. Colo. Rev. Stat. § 39-22-304(2)(i). For further discussion of this legislation, see GT SALT Alert: Colorado decouples from some CARES Act provisions.
9 Colo. Rev. Stat. § 39-22-104(3)(m).
10 Colo. Rev. Stat. §§ 39-22-104(4)(z); 39-22-304(3)(p), enacted by Ch. 5 (H.B. 1002), Laws 2021. For further discussion of this legislation, see GT SALT Alert: Colorado creates CARES Act modifications.
11 See Colo. Rev. Stat. § 39-22-103(5.3).
12 Emphasis added by court.
13 Colo. Rev. Stat. § 39-22-102(1)(a).
14 See Colo. Code Regs. § 39-22-103(5.3).
15 Colo. Rev. Stat. § 39-22-104(3)(l)-(n), enacted by Ch. 277 (H.B. 1420), Laws 2020.
16 The court noted that in December 2020, the Colorado Office of Legislative Legal Services issued a memorandum recommending that this rule not be extended because the Department’s interpretation of “internal revenue code” conflicted with the underlying statute.
17 For the Department’s guidance on the application of the CARES Act that illustrates these complexities, see CARES Act Tax Changes & Colorado Impact, Colorado Department of Revenue, revised Aug. 2021.
18 P.L. 115-97 (2017).
19 For tax years beginning or ending between March 27, 2020 and Dec. 31, 2020, Colorado taxpayers were required to add back business interest deductions taken on the federal return to the extent they were in excess of the limits imposed under IRC § 163(j) prior to amendments by the CARES Act. Colo. Rev. Stat. § 39-22-104(2)(i).
20 IRC § 168(e), (g). This change was retroactive and applies to QIP acquired and placed in service after Sept. 27, 2017 and before Jan. 1, 2023.
21 Colo. Rev. Stat. § 39-22-304(3)(p).