Colorado allows entities treated as S corporations and partnerships (collectively, PTEs) for federal income tax purposes to elect to pay income tax earned on behalf of qualifying owners (the “PTET election”). The intention of this election is to allow owners of pass-through entities to claim a federal deduction for state income taxes on income earned from a PTE without being subject to the federal state and local tax limitation established under the Tax Cuts and Jobs Act and later updated by the One, Big, Beautiful Bill Act. In November 2020, the IRS released Notice 2020-75, allowing a federal deduction for PTE taxes when a state’s tax laws conform to the guidance outlined in the notice. Colorado’s PTET regime follows these provisions.
Colorado pass-through entity tax: A summary
Key provisions of the Colorado PTET include the following:
- The election is made annually, which allows PTEs to elect for tax years when the PTET is beneficial.
- A PTET election requires all qualifying owners of a PTE to participate. Qualifying owners are generally any type of partner, except C corporate partners that are unitary with the PTE. This may require the PTE to confirm with C corporate partners whether they have a unitary relationship with the PTE.
- PTEs are eligible to make PTET elections, unless the federal government rescinds the current limitation for deducting state taxes. Thus, unlike some states that have a fixed date that their PTET election ends, Colorado’s PTET election is applicable until the state and local tax cap is lifted.
- Colorado individual income tax residents are subject to tax on 100% of their share of the PTE’s income, while all other owners’ tax is determined on an apportioned basis.
- PTE owners will receive a refundable credit that they can apply on their Colorado income tax returns.
- Quarterly estimated tax payments are required; underpayments may result in assessments of interest and penalties.
- Nonresident individual PTE owners aren’t required to file a Colorado income tax return if their only source of income from Colorado is from a PTE that made a PTET election. Other types of partners are required to file a Colorado income tax return.
Colorado PTET election process
A Colorado PTET election can be made on a timely filed DR 0106, including extensions. Alternatively, a PTET election can be made on Form DR 1705 during the tax year, or by marking the SALT Parity Act election box on form DR 0106EP filed with an estimated tax payment. Depending on the PTE’s facts and circumstances, the difference between waiting to make Colorado’s PTET election on the return versus making the election during the year via Form DR 1705 or DR 0106EP could be the timing of the federal deduction — current year or subsequent year.
Pitfalls under PTE tax regimes
While PTE taxes in general can be immensely beneficial for PTE owners in terms of tax savings, there are situations where taxpayers may end up paying more income tax under a PTE tax regime.
As an example, individual owners of PTEs should ensure a credit for PTET paid to other states is allowed in their state of residency. Otherwise, the individual may end up paying tax on the same income twice and receiving only a partial benefit for the federal income tax deduction. Note that Colorado residents are allowed a credit for taxes paid for PTE taxes paid to other states.
Another example is where an owner’s PTET is not refundable in a state, but rather carried forward for a set number of years before expiring. If the PTE owner isn’t able to use the credit for a period of years, or, worse case, the credit expires, then the PTET election results in a detriment.
Research and modeling are highly recommended before making an election or payment. Taxpayers should weigh the benefits of the PTET election against the cost of compliance required to ensure pitfalls are avoided.
How we can help with Colorado’s PTET
If you have questions about the impact of a PTET election in Colorado or any other state, please contact your Plante Moran advisor or one of the authors to discuss the specific facts and circumstances of your situation.
