This summer, as part of a larger state tax overhaul, Colorado joined a growing number of other states to enact workarounds for owners of pass-through entities (PTEs) to avoid the $10,000 state and local tax (SALT) federal itemized deduction limit. The $10,000 SALT cap, which was a product of 2017’s Tax Cuts and Jobs Act, has put PTE owners at a relative disadvantage compared to C-corporations. And while the SALT cap has affected taxpayers more in higher-tax states, a workaround may help Colorado partnerships, and S-corporations save on taxes. On June 23, 2021, Governor Polis signed the Colorado SALT Parity Act into law officially providing a SALT Cap workaround to help impacted Colorado businesses. To help clients, prospects, and others, Hanson&Co has provided a summary of the key details below.
Colorado’s SALT Cap Workaround
The new law allows PTEs to pay Colorado income tax at the entity level, allowing an entity-level business income tax deduction. It’s an annual election that can be taken made for tax years beginning on or after January 1, 2022, and would apply to all pass-through owners of an entity, with the exception of a C-corporation partner that is unitary with the partnership.
If the election is made, the entity, itself would be subject to a tax rate of 4.55%, which is equal to individual taxpayers’ flat rate. The tax would be applied to each owner’s distributive share of entity income attributable to Colorado. It is important to note that a Colorado resident owner’s entire distributive share of income from the PTE is subject to the tax, including non-Colorado source income, whereas a non-resident owner’s share of income is subject to the tax is only the Colorado source income. The individual PTE owners then exclude their share of distributive income from their Colorado income tax returns so that the income is not subject to tax twice.
Non-resident owners get another benefit. If the PTE income is their only connection to Colorado, they would not be required to file a Colorado state income tax return.
Alternative minimum tax treatment would not apply to any income related to the electing PTE. Owners would still have to make estimated tax payments throughout the year. Finally, excess credits can be carried forward but only claimed at the entity level in the same year as the workaround is elected.
Colorado’s SALT Parity Act Limitations
There are limitations and other considerations that PTEs should be aware of. 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.
Also, 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. Another factor to consider is that resident owners would not receive a credit for taxes paid to other states, though this credit would be available at the entity level. This is another reason why the workaround may not be suitable for every shareholder or owner.
If the SALT cap were to be repealed at the Federal level, the Colorado entity-level tax would not be available, as the new law indicates that the election can only be made in a tax year where the Federal SALT deduction limit is in place. The SALT cap has received renewed attention in recent months as President Biden circulates various pieces of legislation; it is set to expire at the end of 2025, without further Congressional intervention.
Governor Polis signed two other substantial tax bills into law at the same time as the SALT Parity Act. These provisions will affect corporations, individuals, trusts, estates, small businesses, and captive insurance companies in some way. Revisions to sales, insurance premiums, property, and severance taxes were also made.
Denver Pass-Through Entity business owners have been waiting for the state to follow suit with others and adopt a workaround process. However, depending on certain circumstances it may not make sense to take advantage of the new changes. If you have questions about the information outlined above or need assistance with a tax planning or compliance need, Hanson&Co can help. For additional information call us at 303-388-1010 or click here to contact us. We look forward to speaking with you soon.