Colorado enacts elective pass-through entity tax

 

Colorado recently enacted two tax laws containing multiple corporate and individual income tax changes.1 For partnerships and S corporations, the legislation enacts an elective pass-through entity (PTE) level tax. For corporations, the state has adopted the Finnigan rule for combined reporting and a provision requiring inclusion of tax haven corporations in a combined group. The Colorado Department of Revenue also issued updated guidance on the income tax return reporting of CARES Act2 decoupling items and addressing decoupling from federal Paycheck Protection Program (PPP) loan treatment. 

 

 

 

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.3 This limit allows a deduction for only the first $10,000 in state and local taxes for individual income taxpayers.4 The “SALT cap” impacts mainly high-income tax earners, who have the ability to itemize their deductions. States across the nation have since enacted PTE taxes as a reaction to the SALT deduction cap.

Colorado recently enacted the “SALT Parity Act” 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.5 The legislation allows partnerships and S corporations to elect to pay Colorado income taxes on behalf of the owners at the entity level.6 To achieve this, the PTE must make an annual election, which is available for tax years beginning in 2022 and until the federal cap is no longer in place.7 The election is binding upon all PTE owners, except for unitary C corporation partners.8

An electing PTE is subject to tax at Colorado’s flat 4.55% rate.9 This rate is applied to a tax base comprised of the electing owners’ distributive/pro rata share of Colorado-sourced income as well as the resident owners’ distributive share of income attributed to other states.10 Any credits generated by the partnership are applied to the tax liability at the entity level, including a credit for taxes paid in other states.11 Net operating losses (NOLs) and excess income tax credits may be carried forward and applied at the entity level in a future year when the entity makes the election. However, making the election negates the Internal Revenue Code (IRC) Sec. 199A deduction for qualified business income available for Colorado purposes. If an individual taxpayer benefits from the IRC Sec. 199A deduction, and that individual is a partner, shareholder or member in an electing PTE, the IRC Sec. 199A deduction must be added back on that individual’s Colorado return.12

 

 

 

Corporate income tax

 

 

Combined reporting changes

 

States generally follow one of two rules to determine apportioned income for multistate corporations subject to combined reporting standards. If a state mandates unitary combined reporting, related corporations that fall under the unitary reporting rules are subject to either the Joyce or Finnigan approach. Under Joyce, nexus/connection to a given state is based on a separate company-by-company analysis, even when subject to combined reporting rules.13 Finnigan, however, stipulates that if one member of a combined group has sufficient nexus in a particular state, then all members are subject to reporting and tax within the state.14 Historically, Colorado has followed the Joyce rule in determining apportioned income for combined groups. Under H.B. 21-1311, Colorado will follow the Finnigan rule for the 2022 tax year and thereafter.15

Colorado follows a water’s edge rule to determine the composition of a combined filing group. Corporations with at least 80% of property or payroll outside the U.S. are excluded from the combined group.16 For tax years beginning in 2022 and thereafter, affiliated C corporations incorporated in foreign jurisdictions for the purpose of tax avoidance are also includible in the combined group.17 A C corporation is presumptively incorporated in a jurisdiction for the purpose of tax avoidance if it is incorporated in a tax haven jurisdiction.18 The statute includes a rebuttable presumption that a corporation incorporated in a tax haven country has a tax avoidance purpose, and the taxpayer must rebut the presumption by meeting federal economic substance standards described in IRC Sec. 7701(o).19

The statute further provides guidance on how taxable income and apportionment should be determined for these foreign incorporated affiliates. Any affiliate which is not included in a federal corporate income tax return must start with its audited book net income. This net income must then be adjusted according to U.S. generally accepted accounting principles, and then for any book/tax adjustments necessary under federal and Colorado rules.20 The legislation also includes certain subtractions in arriving at Colorado taxable income that are related to the new foreign corporation tax avoidance provisions.21

 

 

Meals and entertainment deduction

 

Under the federal CARES Act, IRC Sec. 274(n)(2)(D) allows for a temporary increase in the deductibility of meals expenses from 50% to 100%. Colorado has decoupled from this relief. Therefore, for tax years beginning in 2022, any amount of meals expense in excess of 50% of the total expense must be added back to Colorado taxable income.22

 

 

 

Individual income tax 


H.B. 21-1311 also enacted several changes to the individual income tax computation. The existing Colorado income cap for the allowance of the IRC Sec. 199A deduction for qualified business income (previously described in the PTE tax election section above) has been extended through tax years beginning before 2026.23 For tax years beginning in 2022 and thereafter, taxpayers with federal adjusted gross income of at least $400,000 must add back to Colorado taxable income itemized deductions over a capped amount ($30,000 for single taxpayers, $60,000 for married filing jointly).24

For tax years beginning in 2022, the deduction for contributions to Colorado IRC Sec. 529 qualified tuition plans, previously unlimited, has been capped at $20,000 per year, per beneficiary for single taxpayers, and $30,000 for joint returns. For tax years beginning in 2023 and thereafter, the allowable deduction will be adjusted annually based on the average change in the cost of attendance at a state higher education institution.25 The legislation also adopts an annual reporting requirement from the state’s IRC Sec. 529 plan administrator to the Colorado Department of Revenue, to include contribution and distribution data for each account holder who is a Colorado taxpayer.26

In addition, for tax years beginning in 2022, the amount of the state earned income tax credit has been increased.27 The state child tax credit also is expanded for tax years beginning in 2022 and thereafter. A credit is established for taxpayers who would have been eligible for a federal child tax credit but for the requirement that a qualifying child have a social security number.28

 

 

 

Updated CARES Act conformity guidance 

 

The Colorado Department of Revenue recently updated its guidance on state conformity to the CARES Act for corporate and individual income tax purposes.29 In July 2020, Colorado enacted H.B. 20-1420 in response to the CARES Act. In addition, the Department adopted a regulation in June 2020 to clarify that Colorado’s statutory conformity to the IRC should be applied on a prospective basis.30 These two actions decoupled Colorado’s corporate and individual income tax regimes from several major provisions of the CARES Act. In January 2021, Colorado enacted legislation to create a subtraction for certain deductions disallowed by the state.31 This legislation provides for a limited recapture of these disallowed deductions in tax years beginning in 2021 and thereafter. As explained by the updated guidance, the allowable subtraction is an aggregate amount, calculated in multiple steps, based on the taxpayer’s Colorado taxable income for each of the preceding tax years which were affected by the CARES Act. The subtraction is limited to tax years beginning in 2021, but excess subtraction amounts may be carried forward to subsequent tax years (though such carryforward is also subject to limitations). The guidance explains the computation of the subtraction and how various adjustments should be reported on the Colorado income tax returns.

The updated guidance also clarifies the state’s treatment of PPP loans. Expenses paid with proceeds from a forgiven PPP loan are deductible for federal income tax purposes under the Consolidated Appropriations Act, 2021, enacted on December 27, 2020.32 Under Colorado’s IRC conformity regulation,33 which interprets the rolling conformity statute to be applicable on a prospective basis only, taxpayers may not deduct such expenses for tax years ending before December 27, 2020.

 

 

 

Commentary 

 

Colorado has followed the trend of approximately 20 states in adopting a PTE tax election and providing a mechanism for owners to fully deduct state income tax expense on their federal returns. The state has incorporated guidance for NOL carryovers and provides for a credit for taxes paid to other states. Such provisions were not included in the first wave of SALT cap workarounds, making the election less advantageous in some states.

The interaction of the Joyce and Finnigan rules with the state’s throwback provisions may significantly impact sellers of tangible personal property. Under the Finnigan rule, sales to states where any member of the combined group has nexus are not subject to throwback. The impact of the change is heavily fact-dependent and will require taxpayers to reassess existing positions taken in apportionment calculations. 

The Department’s updated guidance on CARES Act conformity provides welcome clarity on the computation of the subtraction to recapture certain disallowed federal deductions. However, the Department’s interpretation of the state’s rolling conformity statute continues to add complexity as applied to the treatment of PPP loans. Most states have conformed to federal PPP loan forgiveness and allow a deduction to taxpayers negatively impacted by the COVID-19 pandemic. Colorado and Utah are among the few holdouts which have allowed unfavorable treatment under existing rules to stand. In the legislative declaration of H.B. 21-1311, the legislature states that “the purposes of this act are: (I) [t]o conform Colorado’s tax code with provisions commonly used in other states, so that Colorado is less of an outlier around the country in how taxpayers compute their taxes owed.”34 This conveniently allows the state to adopt the Finnigan and tax haven rules as revenue raisers. In the treatment of PPP loans, however, the state appears to have missed its goal to be “less of an outlier.”

The state’s newly adopted information reporting requirement for IRC Sec. 529 plan contributions and distributions appears to echo the obsolete remote seller sales and use tax reporting requirements. In the case of the sales tax reporting requirement, the U.S. Supreme Court upheld the state’s requirement that third parties provide the information required to trace uncollected sales and use tax.35 The state appears to be preparing to pursue a similar disclosure effort on education savings accounts. The individual income tax return already requires that beneficiary social security numbers be reported in order to claim a subtraction for contributions to 529 accounts. The new reporting provision requires CollegeInvest, the state’s 529 plan administrator, to provide similar information on all account holders who are Colorado taxpayers. While convenient for the Department for audit purposes, the automatic reporting of account information to a government agency may prompt privacy concerns.

 

 


 

1 H.B. 21-1311 and H.B. 21-1327, Laws 2021, enacted on June 23, 2021.
2 Coronavirus Aid, Relief, and Economic Security Act, P.L. 116-136, March 27, 2020.
3 P.L. 115-97. 
4 IRC § 164.
5 H.B. 21-1327, enacting COLO. REV. STAT. §§ 39-22-340–39-22-346.
6 COLO. REV. STAT. § 39-22-343.
7 COLO. REV. STAT. § 39-22-343(2). The $10,000 SALT deduction cap included in the TCJA currently is scheduled to sunset at the end of 2025. 
8 COLO. REV. STAT. § 39-22-342(2).
9 COLO. REV. STAT. § 39-22-344(1).
10 Id.
11 COLO. REV. STAT. §§ 39-22-344(3); 39-22-346.
12 COLO. REV. STAT. § 39-22-104(3)(r). Colorado is one of only three states that currently allows certain taxpayers to take the IRC § 199A deduction for state income tax purposes.
13 Appeal of Joyce Inc., Dkt. No. 66-SBE-070 (Cal. State Bd. of Equal. Nov. 23, 1966). 
14 Appeal of Finnigan, Dkt. No. 88-SBE-022 (Cal. State Bd. of Equal. Aug. 25, 1988).
15 COLO. REV. STAT. § 39-22-303(11)(c)(II)(B).
16 COLO. REV. STAT. § 39-22-303(8)(a).
17 COLO. REV. STAT. § 39-22-303(8)(b)(I). All businesses that are federally defined as C corporations are subject to this rule, and if a business is included because of this provision, such business is considered to be a C corporation for all aspects of the Colorado corporation income tax. COLO. REV. STAT. § 39-22-303(8)(b)(III).
18 The tax haven jurisdictions are listed in COLO. REV. STAT. § 39-22-303(12)(b).
19 COLO. REV. STAT. § 39-22-303(8)(b)(II). The reference to the federal economic nexus standard in IRC § 7701(o) is interesting because states recently have been relatively silent on this provision. There is a possibility of a state resurgence on this issue.
20 COLO. REV. STAT. § 39-22-304(1)(b)(I).
21 COLO. REV. STAT. § 39-22-304(3)(j), (q).
22 COLO. REV. STAT. § 39-22-304(2)(j)(I). This provision is expressly repealed effective Dec. 31, 2030, but it is not clear why the repeal date is so far in the future when the addition only applies to tax years beginning in 2022.
23 COLO. REV. STAT. § 39-22-104(3)(o). Under existing law, this provision applied to tax years beginning in 2021 or 2022. An addition equal to the amount of the deduction is required for single filers with adjusted gross income over $500,000 and joint filers with adjusted gross income over $1 million. 
24 COLO. REV. STAT. § 39-22-104(3)(p).
25 COLO. REV. STAT. § 39-22-104(4)(i)(II).
26 COLO. REV. STAT. § 39-22-104(4)(i)(V).
27 COLO. REV. STAT. § 39-22-123.5(2), (2.5), (2.7).
28 COLO. REV. STAT. § 39-22-129(3.5).
29 CARES Act Tax Law Changes & Colorado Impact, Colorado Department of Revenue, revised Aug. 2021.
30 COLO. CODE REGS. § 39-22-103(5.3). This originally was adopted as an emergency regulation, effective June 2, 2020 through Sep. 30, 2020. On July 31, 2020, this regulation was permanently adopted with a Sep. 30, 2020 effective date. For further discussion of this regulation and H.B. 20-1420, see GT SALT Alert: Colorado decouples from some CARES Act provisions.
31 H.B. 21-1002, Laws 2021. For further discussion of this legislation, see GT SALT Alert: Colorado creates CARES Act modifications.
32 P.L. 116-260, § 276.
33 COLO. CODE REGS. § 39-22-103(5.3).
34 H.B. 21-1311, § 1(b). 
35 Direct Marketing Ass’n v. Brohl, 575 U.S. 1 (2015).

 


 

 

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