Colorado’s pass-through entity tax now retroactive to 2018

The bill represents the first time a PTET has been effective retroactive to the effective date of the limitation on the federal state and local tax deduction – the SALT cap – enacted by the Tax Cuts and Jobs Act. The SALT cap refers to the $10,000 maximum state tax itemized deduction an individual can claim for federal income tax purposes. Since 2018, 27 states have instituted a pass-through entity-level tax as a workaround to the federal SALT cap. By assessing tax at the pass-through entity level, the entity takes a federal deduction for state tax paid, which is passed through as a reduction in an owner’s ordinary income without limitation.

The bill makes the following additional changes to the Colorado PTET, which also are applied retroactive to Jan. 1, 2018:

• Electing pass-through entity owners will receive a refundable credit equal to the owner’s pro rata share of PTET paid by the entity. As originally enacted, owners deducted their pro rata portion of income taxed at the entity level from Colorado taxable income.
• The PTET rate is changed from a fixed 4.55% to the corporate income tax rate applicable to each particular tax year. For tax years beginning on or after Jan. 1, 2018, and before Jan. 1, 2022, Colorado corporate tax rates are the same as the state’s individual income tax rates.
• Colorado income tax credits allowed by law attributable to electing pass-through entities are passed through and claimed by electing pass-through entity owners.
• The initially enacted provision allowing an electing pass-through entity to carry forward any excess income tax credit, net operating loss, or other modifications has been repealed.

Pass-through entities may elect the retroactive PTET on or after Sept. 1, 2023, and before July 1, 2024. Effectuating the federal benefit will require the following steps to amend pass-through entity and individual Colorado returns for 2018 through 2021:

1. Amend the pass-through entity’s state tax return to make the election and pay the PTET.
2. Amend Colorado owner returns to claim the PTET refundable credit and request a refund of taxes previously paid.

The federal income tax benefit would be realized by individuals as a deduction against ordinary income in the period the electing pass-through entity deducts the PTET for federal purposes.

Generally, assuming the PTET payments by the electing pass-through entities are made with the filing of their amended Colorado tax returns, both cash-basis and accrual-basis taxpayers should be entitled to a federal deduction in the tax year the amended Colorado returns are filed.

The annual election to pay Colorado tax at the entity level is binding on all owners, which could pose challenges for individuals who are not Colorado residents. The main issue is whether a nonresident individual owner’s state of residence will allow a credit for Colorado tax paid at the entity level or a deduction for apportioned pro rata income subject to tax. Pass-through entities and their owners should consult their tax advisers to determine if making this election makes sense.

It should be noted that the prior IRS guidance contained in IRS Notice 2020-75 did not specifically contemplate the effect of a retroactive state PTET, so there is no assurance that the IRS would apply the same principles in the notice to Colorado’s retroactive PTET.