On June 23, 2021, Colorado Governor Jared Polis signed HB 21-1327, enacting an annual elective pass-through entity-level tax, effective for tax years beginning January 1, 2022.
This change allows pass-through entity shareholders to take advantage of the full federal deduction for state income tax paid in Colorado, operating as a workaround for the federal $10,000 state and local tax deduction limitation.
Issues to consider when navigating this tax and how it could impact your business are below.
In 2017, Congress capped the state income tax deduction at $10,000 per individual return.
In Notice 2020-75, the IRS announced that it wouldn’t challenge state income tax deductions taken by pass-through entities, even if the state tax paid is elective, and even if the tax paid by the entity results in a credit or a deduction available to the individual shareholder.
Colorado joins Alabama, Arkansas, Connecticut, Georgia, Idaho, Louisiana, Maryland, New Jersey, New York, Oklahoma, Rhode Island, South Carolina, and Wisconsin in allowing pass-through entities to elect to pay tax at the entity level and take full advantage of the federal state and local tax deduction.
In addition to these 14 states, another 10 states currently have pending legislation to do the same: Arizona, California, Illinois, Massachusetts, Michigan, Minnesota, North Carolina, Ohio, Oregon, and Pennsylvania.
Issues to Consider
Credit vs. Deduction
Some states offset the tax imposed at the entity level with a credit available to the individual shareholders.
Other states, like Colorado, will offset the tax paid at the entity level with a subtraction for the income passed through from the entity.
Colorado allows a shareholder deduction for 100% of the income passed through from the entity. As a result, it disallows the Federal 199A deduction that was allowed at the federal level relative to the income passed through from the entity.
States vary in their treatment of the 199A deduction, but care should be taken to model out any loss of the state benefit of this deduction relative to the benefit of the increase in the federal state and local tax deduction.
Net-Operating Loss Offset
Colorado offers a shareholder deduction rather than a credit for the tax paid by the entity, so making the election at the pass-through entity level of shareholders that have interests in more than one entity may not be beneficial.
Gains from one entity may be offset by losses from another. In states that offer a refundable credit, this counterweight won’t arise. In states like Colorado that offset with a subtraction instead, however, this may need to be evaluated.
Pass-through entities and their owners will need to assess the benefits of making the pass-through entity taxation election.
A tax professional with in-depth expertise in these areas can help your businesses model benefits and costs of the election on a state-by-state basis to determine whether or not to make the election.
We’re Here to Help
To learn more about elective pass-through entity taxes and how they could impact your business, contact your Moss Adams professional.