Colorado made a change to its pass-through entity (PTE) tax regime. Taxpayers may now have an opportunity to amend prior year tax returns to take advantage of the Colorado PTE.
BACKGROUND
In 2021, Colorado enacted the SALT Parity Act for income tax years commencing on or after Jan. 1, 2022 that allows PTEs to elect to pay state income tax at the entity level and claim the deduction at the federal level for the taxes paid.
However, later in 2022, SB 22-124 amended the Parity Act to allow PTEs and their owners access to the elective PTE tax regime retroactively for tax years beginning on or after Jan. 1, 2018 through Dec. 31, 2021. The election to file retroactively in Colorado is binding on all electing PTE owners and cannot be reversed.
The Parity Act originally allowed electing PTE owners’ share of income taxed at the entity level to be excluded from their Colorado taxable income. Under SB 22-124, this exclusion is replaced by a refundable credit at the owner level for their share of elective PTE tax paid. SB 22-124 also amended the electing PTE owners to compute their resident credit without regard to the PTE credit.
HOW TO MAKE A RETROACTIVE ELECTION
To make the election on a previously filed return, taxpayers need to file an amended composite tax return on or after Sept. 1, 2023 but before July 1, 2024 pursuant to Colo. Rev. Stat. § 39-22-343.
The forms to make retroactive elections and amend returns for tax years 2018 through 2021 will be released in the fall of 2023. Do not use the form DR 1705 or DR 01016 to make the retroactive elections. The Form DR 1705 or DR 0106 can still be used for 2022 PTE election in 2022.
The Colorado Department of Revenue will not assess any late-filing interest or penalty for filing amended composite returns. The state also waived underpayment of estimated tax penalties for the PTE tax for tax years ending before Jan. 1, 2023.
GHJ’S OBSERVATIONS
If the PTE has sold its assets or is liquidated/dissolved, then the entity may need to keep enough cash in the reserves at the entity level to make the retroactive election. If the PTE owners were to contribute cash to the PTE to pay the entity-level tax to make the retroactive election, the PTE owners may not be able to recoup the cash until the refund is received with the composite return(s).
Before making the PTE election, the taxpayer may need to consider the impact on any non-resident owners. Not all states may give a credit to a taxpayer for any PTE taxes paid to another state relating to retroactive election. It is also unclear whether a Colorado resident investor in a PTE that did not make the Colorado PTE election may claim a resident credit for PTE taxes in another state.
The administrative burden such as audit or state inquiry for the amended composite return filed by the PTE may be a separate challenge since the PTE may need to keep the cash in reserves to conclude such audits even if the entity is dissolved or assets are liquidated. In addition, the retroactive election may extend the statute of limitations for the state to audit and assess a PTE.
The following items have not been clarified; however, we hope to receive the clarification in the subsequent months:
- Notice 2020-75 does not clarify whether the IRS will allow a federal deduction for PTE taxes paid retroactively. It is uncertain how to reflect a federal tax benefit accruing from the retroactive election.
- It is unclear whether the retroactive election is binding for all years or whether the PTE can make an election for selected years.
PTE owners should examine the facts and circumstances to determine whether such an election in Colorado will result in a tax benefit. For further assistance on this procedure, or to learn more about retroactive election, please reach out to GHJ’s State and Local Tax Team.
