06 Jun Colorado’s SALT Parity Act
This new law concerns the authority of a pass-through business entity to elect to pay state income taxes at the entity level, known euphemistically as Colorado’s SALT Parity Act.
It was first enacted in 2021 and amended in May 2022 & is effective January 1, 2022. Also unique to Colorado it is retroactive to January 1, 2018.
- SALT Parity works as a refundable tax credit at the owner level and is intended to both keep Colorado revenue neutral & avoid double taxation on the owners.
- Shareholders/Partners of pass-through entities (PTEs) have the option to pay state tax at the entity level, rather than passing liability on to themselves as individual taxpayers.
- Since the entity would be paying the state tax, there would be no limitation on the SALT deduction.
- To make the election for the 2022 or future tax years, PTEs would make a check-the-box election on the annual state income tax return.
- It’s an annual election that applies to all owners for each tax year elected.
- PTEs would need to provide information on the return to identify all owners.
- SB22-124 & HB21-1327 authored by Representative Ortiz & Van Winkle and Senators Kolker and Woodward among other things added Sections 39-22-340 to 39-22-346 to our Colorado Revised Statutes addressed below.
- The 2017 federal “Tax Cuts and Jobs Act” placed a cap of $10,000 on the amount of state and local taxes paid that an individual may deduct on their federal taxes as an itemized deduction on Schedule A.
- Unfairly this limitation did not apply to C corporations.
- Consequently, businesses organized as pass-through entities like S corporations and partnerships were disadvantaged by being obligated to pay increased taxes on business profits compared to C corporations.
Remember pass-through entities pay taxes on business profits at the individual (partner or shareholder) level.
- Starting in 2022 and as long as the SALT caps of the 2017 Tax Cut & Jobs Act remain in effect (IRC 164), pass-through entities may elect to pay their state income tax at the entity level so that the pass-through entity can claim an unlimited deduction at the federal level of state and local taxes paid.
Remember the Tax Cut & Jobs Act provisions sunset in 2026, including the cap on state and local tax (SALT) deductions.
Meaning this new Colorado statutes may be short lived IF not extended.
According to the Colorado Department of Revenue
- The ANNUAL election can be made in advance using form DR 1705
- The ANNUAL election can also be made on the DR 0106 form – with a 2022 new release forthcoming as of posting
- Shareholders and partners of ELECTING Pass Through Entities (PTE) make quarterly estimated payments 2 ways: DR 0106EP & EFT
- There are some special instructions regarding estimated payments on the Tax Division website.
- All Colorado tax credits pass through proportionally to the owners of the entity.
- PTEs can file amended returns for 2018 through 2021 between September 1, 2023, and July 1, 2024.
- PTEs will not be assessed late filing penalties or interest if they choose to make a retroactive election.
- Once a PTE makes an election under the Colorado SALT Parity Act, its Owners are no longer required to remit their own separate estimated taxes for their proportionate share of PTE taxable income.
Factors That May Affect Colorado Tax Planning
Even though the SALT Parity Act can save on taxes, some considerations may affect a PTE’s tax planning
- Once the election is made, it applies to all resident and non-resident Owners for the tax year.
- This can benefit nonresidents since the state tax liability would be taken care of at the PTE level.
- The requirement of Colorado non-residents to file a Colorado tax return is eliminated if the only source of Colorado income is through the PTE.
- Paying the tax at the PTE level will reduce the profits flowing to Owners for federal income tax.
- The benefit is that Owners’ federal tax liability is lowered.
PTEs may not wish to make the election due to Owners’ unique circumstances or tax liabilities
- Careful planning in consultation with all Owners and PTE managers is necessary to ensure maximum benefit to owners.
- PTEs with multiple owners may also find it too labor-intensive and costly to remit the tax due and prepare amended returns for the PTE and owners for past years.
- The Colorado tax rates in 2018 and 2019 were higher, which may impact planning.
There is also a consideration for federal taxable income
- Even with the SALT Parity Act, state income tax paid by the PTE and the Section 199A pass-through business deduction must still be added back to the PTE’s state taxable income for the federal return.
- Sole proprietors may still include their Sec. 199A deduction on the federal return.
How the ‘workaround’ works
- If the election is made, the PTE, itself would be subject to a tax rate of 4.5% -> going to -> 4.4% in future years = to individual Colorado taxpayers’ flat rate.
- The tax would be applied to each owner’s distributive share of entity income attributable to Colorado.
- A Colorado resident owner’s entire distributive share of income from the PTE is subject to the tax, including non-Colorado source income
- Conversely a non-resident owner’s share of income is subject to the tax is only the Colorado source income.
- Owners would still have to make estimated tax payments throughout the year for other Colorado sourced income not subject to withholding.
- Excess credits can be carried forward but only claimed at the entity level in the same year as the workaround is elected.
Limitations – Basically more things for partners to fight over
- If an owner of a PTE has multiple business interests in Colorado entities, he or she may not want the PTE to make the election if one business generates income, but the other has a net loss.
- As losses from one PTE cannot offset income from another PTE at the entity level, the business with income would be subject to tax currently, while the net loss from the second business would carry forward to the next tax year.
- PTEs that plan to utilize the SALT cap workaround cannot claim the Section 199A deduction in determining its Colorado source income subject to tax.
- Now that the workaround is in place, affected entities should model different scenarios to weigh the pros and cons of taking either the Section 199A deduction at the individual level or electing the entity level tax.
- Resident owners do not receive a credit for taxes paid to other states, though this credit would be available at the entity level.
- The ‘workaround’ may not be suitable for every shareholder or owner. It should be a year by year determination.
- If the federal TCJA $10,000 SALT cap expires at the end of 2025, Colorado’s SALT Parity Act will be disallowed, and Owners will resume paying tax as profits flow through from the PTE.
- There are still several tax years were making the SALT Parity Act election could be extremely beneficial and help Owners manage their state tax liability.
- It’s also possible the $10,000 SALT cap could be extended, in which case, the SALT Parity Act could significantly help Colorado PTEs.
Colorado Revised Statues Drill Down
- Provided SALT deductions remain limited by IRC 164 – presently through tax year 2025 – an S corporation or partnership may annually elect to be subject to income tax at the entity level.
- The election as we presently understand will be made on the income tax return filed by such S corporations or partnerships, under section 39-22-601.
- The annual election is binding on all electing pass-through entity owners each tax year.
- An electing pass-through entity is subject to tax = 4.5% of the sum of each owner’s pro rata or distributive share of the entity’s TOTAL pass-through income
- BOTH attributed to Colorado & NOT attributed to Colorado.
- Any Colorado tax credits in the election year shall be claimed by the entity and NOT passed through to the entity owner.
- Any excess income tax credit, net operating loss, or other modification may be carried forward on the electing pass-through entity’s income tax return but may only be recognized in an election year.
- Electing pass-through entity owners shall not be liable for the tax nor the Alternative Minimum Tax in their separate or individual capacities.
- The basis in the hands of the owner’s interest is determined as if the election had not been made.
- An electing pass-through entity is entitled to a Colorado tax credit subject to limitations (CRS 39-22-108) for taxes paid to other states for income not attributable to Colorado (CRS 39-22-344) whether the tax was paid by the electing pass-through entity itself or by its owners.
- Owners of the resident electing pass-through entity are not entitled to any credit with respect to income of the electing pass-through entity.
- A Colorado NONRESIDENT INDIVIDUAL whose only source of income from Colorado is income from the electing pass-through entity need not file a Colorado income tax return (DR 0104).