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On June 8, 2021, the Colorado legislature approved 2021 Colo. HB 1327 (HB 1327), which would allow certain pass-through entities (PTEs)¹ (i.e., partnerships, S corporations and LLCs treated as partnerships or S corporations) to elect to pay state income taxes at the entity level. This proposed entity-level tax² is intended to enable most Colorado taxpayers who are PTE owners to deduct, for federal income tax purposes, state and local taxes exceeding the annual $10,000 deduction limitation ($5,000 for married individuals filing separately) imposed by IRC Section 164(b)(6) (the SALT deduction limitation), consistent with IRS Notice 2020-75 (see Tax Alert 2021-0092).

This PTE tax election, if enacted, would be available for tax years beginning on or after January 1, 2022, and would only be available in an income tax year during which the federal SALT deduction limitation applies under IRC Section 164. The federal limitation on the SALT deduction is scheduled to expire for tax years beginning after December 31, 2025, unless otherwise extended by federal law.

Election, imposition of tax at entity level, and owner exclusion of pass-through entity income

Section 1 of HB 1327 would add Colo. Rev. Stat. 39-22-343, which would allow an "electing pass-through entity" (electing PTE), to annually elect to pay tax at the entity level for the tax year. The election would be made on the return filed by the electing PTE and would be binding on all the electing PTE's owners.

HB 1327 would also add Colo. Rev. Stat. 39-22-344(1), which would subject an electing PTE to a tax rate of 4.55%. A special tax base would be constructed for computing the elective PTE tax by adding (1) each electing PTE owner's³ distributive or pro rata share of the electing PTE's income attributable to Colorado and (2) each resident electing PTE owner's distributive or pro rata share of the electing PTE's income not attributable to Colorado.

Any credit allowed under Colorado law that is attributable to the electing PTE's activities could be claimed by the electing PTE and not passed through to the electing PTE's owners. Colo. Rev. Stat. 39-22-346, as added by HB 1327, would entitle an electing PTE to the credit, which would otherwise be available to the electing PTE's owner for taxes paid to other states.⁴

Notwithstanding any contrary provision in Colorado law, any excess income tax credit, net operating loss or other modification may be carried forward on the electing PTE's return but may only be utilized in a year in which the election was made. Any limitations that would otherwise apply to the income tax credit, net operating loss or other modification would apply to the electing PTE. Colorado's composite return provisions applicable to nonresident PTE owners under Colo. Rev. Stat. 39-22-601(2.5)(d) through (2.5)(i) would not apply to an electing PTE.

Under Colo Rev. Stat. 39-22-345(1), electing PTE owners would not be liable for the tax or the alternative minimum tax, and the electing PTE's income would be excluded from those owners' Colorado individual income tax computations. Notwithstanding this exclusion, the owner's basis in the electing PTE would be determined under Colo. Rev. Stat. 39-22-345(2) as if the election had not been made. An electing PTE, and not its owners, would be entitled to a credit for taxes paid to other states as defined and limited under Colo. Rev. Stat. 39-22-108.

Other provisions

HB 1327 would add new subdivision (3)(p) to Colo. Rev. Stat. 39-22-104 to allow an individual income tax addition adjustment for the adjustment taken under IRC Section 199A (unless otherwise disallowed under IRC Section 265), to the extent the individual is an electing PTE owner for that tax year. Subdivision (4)(z) would also be added to Colo. Rev. Stat. 39-22-104, allowing an individual income subtraction adjustment for the income that is taxed at the entity level to the electing PTE. Subdivision (1)(a)(IV) would be added to Colo. Rev. Stat. 39-22-601 so a nonresident individual whose only source of Colorado income is income from electing PTEs would not be required to file an individual income tax return.

Implications

In November 2020, the IRS indicated its intention in Notice 2020-75 to issue proposed regulations clarifying that a partnership or S corporation computing non-separately stated taxable income or loss for federal income tax purposes could deduct state and local income taxes imposed on its net income for the tax year at issue without regard to the SALT deduction limitation (see Tax Alert 2020-2690). Those regulations have yet to be proposed. It was widely anticipated that most states would rush to enact an entity-level tax to provide the federal tax benefit to owners of PTEs in their states.⁵ Colorado becomes the latest state to propose a "workaround" to the federal SALT deduction limitation by allowing an election to pay taxes at the entity level.⁶

HB 1327 authorizes the Colorado Department of Revenue to adopt rules governing how to make the election, information reporting requirements and other rules necessary to enforce these provisions. EY will continue to monitor developments in this area.

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ENDNOTES

¹ The definition of PTE, as added by Section 1 of HB 1327, would appear at Colo. Rev. Stat. 39-22-342(1).

² Section 1 of HB 1327 would codify the new PTE tax law at Colo. Rev. Stat. 39-22-340 through 346.

³ For a partnership making the election, the definition of "electing pass-through entity owner," which would be added by HB 1327 and codified at Colo. Rev. Stat. 39-22-342(2), would prohibit a partner from including a C corporation that is unitary with the partnership. Effectively, this provision means that the distributive share of the partnership's income from such a unitary C corporation partner would not be subject to the Colorado elective PTE tax.

⁴ Colorado resident owners of an electing PTE would not be entitled to the Colorado credit for taxes paid to other states on their distributive share of income from an electing PTE.

⁵ States that had already enacted PTE taxes (or PTE tax elections) before IRS Notice 2020-75 was issued were Connecticut, Louisiana, Maryland, New Jersey, Oklahoma, Rhode Island and Wisconsin.

⁶ States that recently enacted similar PTE-level taxes include Alabama, Arkansas, Georgia, Idaho, New York and South Carolina. In addition, a bill to enact a similar elective PTE tax was approved by the Illinois Legislature and similar elective PTE tax bills are being considered in Arizona, California, Massachusetts, Michigan, Minnesota and North Carolina.