Colorado State Auditor: 'Tax Expenditure Evaluation – Previously Taxed Income Deduction for Individuals, Estates, and Trusts'

DENVER, Colorado, April 15 -- The office of the Colorado State Auditor issued the following report (No. 2021-TE9) entitled "Tax Expenditure Evaluation: Previously Taxed Income Deduction for Individuals, Estates, and Trusts":

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Here are excerpts:

KEY CONCLUSION: Eligible taxpayers appear to be aware of and use the deduction, which allows them to avoid paying tax on income that the State has already taxed in previous years.

WHAT DOES THE TAX EXPENDITURE DO?

The Previously Taxed Income Deduction for Individuals, Estates, and Trusts allows individual, estate, and trust taxpayers to deduct any income or gain that was previously taxed by Colorado when calculating Colorado taxable income.

WHAT IS THE PURPOSE OF THE TAX EXPENDITURE?

Statute and the enacting legislation for the Previously Taxed Income Deduction do not explicitly state its purpose; therefore, we could not definitively determine the General Assembly's original intent. Based on the operation of the deduction, the legislative history of the deduction and income taxes in Colorado, and discussions with Department of Revenue staff, we considered a potential purpose: to reconcile differences between state and federal tax law and prevent the State from taxing the same income twice.

WHAT POLICY CONSIDERATIONS DID THE EVALUATION IDENTIFY?

The General Assembly may want to consider:

* Establishing a statutory purpose and performance measures for the deduction.

* Whether taxpayers who claimed a tax credit pursuant to section 1341 of the Internal Revenue Code should be allowed to claim the deduction.

EVALUATION RESULTS

WHAT IS THE TAX EXPENDITURE?

The Previously Taxed Income Deduction for Individuals, Estates, and Trusts [Section 39-22-104(4)(c), C.R.S.] (Previously Taxed Income Deduction) allows taxpayers who file as individuals, estates, or trusts to deduct from their federal taxable income any income or gain that was previously taxed by Colorado when calculating Colorado taxable income. Colorado uses federal taxable income, which is calculated by subtracting federal deductions from gross income, as the starting point for determining Colorado taxable income. Therefore, any income included or deductions allowed in calculating federal taxable income automatically apply in Colorado unless Colorado statutes specifically require taxpayers to add back the amount they claimed for a federal deduction or to subtract certain types of income included in federal taxable income.

Currently, Colorado generally conforms to federal tax treatment of income and gains with regard to when they are taxed. However, in the past, there have been periods in which the tax treatment of deferred compensation, such as certain retirement and pension plans, was different for Colorado and federal income tax purposes. Specifically, employee contributions made to the Public Employee Retirement Association (PERA) from July 1, 1984, to December 31, 1986, and employee contributions made to the Denver Public Schools Retirement System (DPSRS) from January 1, 1986, to December 31, 1986, were taxed by the State when the contributions were made, but the contributions were tax-deferred for federal tax purposes. This discrepancy occurred due to changes in federal law in 1984 (for PERA) and 1986 (for DPSRS) that made those contributions tax-deferred, and there was a delay between the time federal law changed and the General Assembly changed Colorado law to conform to the tax treatment of these retirement contributions. When employees who contributed to PERA or DPSRS during those dates receive their benefits, the pension income is included in federal taxable income. The Previously Taxed Income Deduction allows those employees to deduct the amount of income on which they already paid Colorado income tax. For example, if a state employee contributed $10,000 to PERA in 1986, when that employee retires and begins receiving retirement benefits, they are eligible to deduct $10,000 when calculating their Colorado taxable income, since they paid Colorado income tax when that $10,000 was contributed to PERA. If a taxpayer does not have enough taxable income in the year they retire to claim the entire deduction, they can continue to claim it until they have received the entire deduction amount that they are entitled to claim. It is possible some taxpayers besides PERA and DPSRS members have income previously taxed by the State; however, we spoke with Department of Revenue (Department) staff and a certified public accountant (CPA) in Colorado, and they were not aware of any other reasons to use the deduction.

The Previously Taxed Income Deduction was created in 1964 with House Bill 64-1003, which is the same legislation that established federal income as the starting point for determining Colorado taxable income. The operation of the deduction has remained unchanged since its creation, although it was revised in 1987 with House Bill 87-1331 as part of a revision and reenactment of the income tax section in the Colorado Revised Statutes.

Individuals claim the Previously Taxed Income Deduction on Line 11 (for eligible PERA/DPSRS-related income) or Line 19 (for other previously taxed income) of the Subtractions from Income Schedule (Form DR 0104AD), which gets attached to the Individual Income Tax Return (Form DR 0104). Estates and trusts claim the deduction on Line 5 (subtractions from federal taxable income) of the Fiduciary Income Tax Return (Form DR 0105).

WHO ARE THE INTENDED BENEFICIARIES OF THE TAX EXPENDITURE?

Statute does not directly state the intended beneficiaries of the Previously Taxed Income Deduction. Because the deduction applies to individuals, estates, and trusts who have previously taxed income included in their federal taxable income, we inferred that they are the intended beneficiaries of the deduction. In particular, this tax expenditure appears to benefit PERA and DPSRS members who made contributions in 1984 through 1986, at which time the contributions were taxed by the State, but tax-deferred for federal tax purposes.

According to data from PERA, there were, on average, about 98,000 contributing PERA members each year in 1984 through 1986 and about 6,000 DPSRS members in 1986.

WHAT IS THE PURPOSE OF THE TAX EXPENDITURE?

Statute and the enacting legislation for the Previously Taxed Income Deduction do not state its purpose; therefore, we could not definitively determine the General Assembly's original intent. Based on the operation of the deduction, the legislative history of the deduction and income taxes in Colorado, and discussions with Department staff, we considered a potential purpose: to reconcile differences between state and federal tax law and prevent the State from taxing the same income twice.

IS THE TAX EXPENDITURE MEETING ITS PURPOSE AND WHAT PERFORMANCE MEASURES WERE USED TO MAKE THIS DETERMINATION?

We could not definitively determine whether the Previously Taxed Income Deduction is meeting its purpose because no purpose is provided for it in statute or its enacting legislation. However, we found that it is meeting the potential purpose we considered in order to conduct this evaluation because eligible taxpayers are likely claiming it to reconcile differences between their state and federal taxable income.

Statute does not provide quantifiable performance measures for this deduction. Therefore, we created and applied the following performance measure to determine the extent to which the deduction is meeting its inferred purpose:

PERFORMANCE MEASURE: To what extent are eligible taxpayers using the deduction to prevent double taxation on income that was previously taxed by the State?

RESULT: In Tax Year 2018, which was the most recent year of data available, the Previously Taxed Income Deduction was claimed for PERA and/or DPSRS contributions on just under 2,700 individual income tax returns. Although we lacked data on the total amount of potentially eligible taxpayers (i.e., State and DPS employees who worked in 1984, 1985, or 1986 and who retired in 2018, as well as taxpayers with other previously taxed income), the number of claims in Tax Year 2018 indicates that many eligible taxpayers are aware of and use it.

Additionally, information about this deduction is widely available from several sources, which indicates that eligible taxpayers are likely to learn of the exemption and claim it. Specifically, there is a dedicated line for this deduction for PERA/DPSRS 1984-1986 contributions on the Subtractions from Income Schedule (Form DR 0104AD), which is part of the Individual Income Tax Return (Form DR 0104); the return instructions include information on who is eligible and how to claim the deduction. The Department also has published a taxpayer guide about the deduction that is available on its website. PERA includes information about this deduction in its Taxes on PERA Benefits booklet, which is included in its retirement kit for soon-to-be retirees.

PERA staff indicated that they believe most retirees are aware of the deduction, that retirees can contact PERA to receive a letter that provides them with the amount of contributions made in the eligible years, and that some retirees can access this information on demand through their personalized secure account. TurboTax, a tax preparation software that taxpayers can use to prepare and file their own taxes, also provides information about this deduction. We also consulted with a CPA in Colorado and they were aware of the deduction, and believe professional tax-return preparers in Colorado are aware of it, but that most taxpayers may not be. However, the CPA reported that they believe most eligible taxpayers would already have claimed the deduction.

We lacked information and data on claims of this deduction for previously taxed income other than 1984-1986 PERA or 1986 DPSRS contributions. However, because Colorado generally conforms to federal law regarding the timing of the taxation of income, Department staff reported that claims of this deduction for previously taxed income other than 1984-1986 PERA or 1986 DPSRS contributions would be rare.

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View full report at https://leg.colorado.gov/sites/default/files/2021_te9_previously_taxed_income_deduction_individuals_estates_trusts.pdf