Colorado Tax Proposal on Phantom Income

Under HB26-1221, Colorado would make two changes that raise additional revenue by taxing income that doesn’t actually exist. The proposed changes to the state’s alternative minimum tax A tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. and net operating loss provisions are designed to overstate income, leading to double taxation Double taxation is when taxes are paid twice on the same dollar of income, regardless of whether that’s corporate or individual income. and distorting taxpayer behavior.

Double Taxation Under the Alternative Minimum Tax

Colorado is one of the few states that still maintains an alternative minimum tax (AMT). The AMT functions as a parallel tax system that denies the benefit of many deductions and credits, ensuring that these tax provisions cannot reduce tax liability below a certain threshold. Most states have repealed their AMTs, since their complexity and compliance costs have become increasingly difficult to justify.

State income taxes tend to feature far fewer deductions and credits than the federal system, meaning that states were already importing a federal solution for a federal “problem” that did not map neatly onto state tax codes. Particularly now that the federal AMT has also been dramatically curtailed, applying to far fewer filers, most states no longer see the need for their own piggyback provision. Colorado, which has unusually tight conformity with the federal tax code, maintains an alternative tax regime that most states have abandoned.

Part of that system—at the federal level and in states with AMTs—is a credit designed to avoid double taxation. The AMT denies a variety of deductions, including those that are largely timing differences rather than permanent exclusions, but it is not intended to tax phantom income, which would happen if the credit were repealed. Consider two examples.

The ordinary tax code allows accelerated depreciation Depreciation is a measurement of the “useful life” of a business asset, such as machinery or a factory, to determine the multiyear period over which the cost of that asset can be deducted from taxable income. Instead of allowing businesses to deduct the cost of investments immediately (i.e., full expensing), depreciation requires deductions to be taken over time, reducing their value and disco of some business investments, and the AMT can add those back. Additionally, some employees receive incentive stock options (ISOs), and the AMT will tax them on the difference between the strike price and the market value when the options are exercised. The existing credit ensures that the business owner still gets those deductions eventually and doesn’t pay income tax on what is actually capital investment. It likewise ensures that employees receiving ISOs aren’t taxed on phantom gains if the stock price later drops before they sell. The credit is a necessary part of the AMT, ensuring that it strips away the benefit of certain provisions (like accelerated depreciation) without permanently taxing income that is not true economic income.

Repealing the AMT credit would take a system meant to prevent tax deductions and credits from eliminating liability and turn it into a permanent surtax A surtax is an additional tax levied on top of an already existing business or individual tax and can have a flat or progressive rate structure. Surtaxes are typically enacted to fund a specific program or initiative, whereas revenue from broader-based taxes, like the individual income tax, typically cover a multitude of programs and services. on timing differences, imposing higher, distortionary tax burdens on business capital investment and taxing paper gains that never amount to real income.

Limiting Net Operating Loss Deductions

Curtailing net operating losses has a similar effect. Corporate income taxes are levied on annual income, but the economic tax base The tax base is the total amount of income, property, assets, consumption, transactions, or other economic activity subject to taxation by a tax authority. A narrow tax base is non-neutral and inefficient. A broad tax base reduces tax administration costs and allows more revenue to be raised at lower rates. is profits over a longer time horizon. Businesses frequently have losses in some years and profits in others, and if the corporate income tax A corporate income tax (CIT) is levied by federal and state governments on business profits. Many companies are not subject to the CIT because they are taxed as pass-through businesses, with income reportable under the individual income tax. were applied only to profitable years, with no offset for losses, it would dramatically overtax overall profitability. To guard against this problem, all state corporate income taxes, as well as the federal tax, permit net operating loss (NOL) carryforwards, permitting businesses to deduct past losses against future taxable income. This allows businesses to smooth their income, making the tax code more neutral over time.

Historically, the federal government allowed net operating losses to be carried forward for 20 years, with no limit on utilization. Since the enactment of the Tax Cuts and Jobs Act (TCJA), losses can be carried forward indefinitely, though they can only reduce taxable income by up to 80 percent in a given year. Some states have followed the federal changes, while others, like Colorado, have maintained the prior 20-year, uncapped-utilization approach.

Under HB 1221, Colorado would limit carryforwards to 10 years and cap the deduction at 70 percent. This proposal is intended to deprive businesses of their ability to fully offset losses, thereby taxing them on an inflated measure of net income. It is particularly punitive for startups, which can often post losses in their first 5-10 years as they develop products or scale their work. A 10-year limit could lead to some losses expiring before the company ever posts a profit, and the 70 percent cap further restricts companies’ ability to offset losses before they expire. For highly cyclical businesses, moreover, the 70 percent cap increases the cost of capital, since recovery of losses no longer provides the same tax buffer during a recovery.

Both the NOL and AMT policies in HB 1221 are attempts to extract additional revenue from individuals and businesses by taxing phantom income, and both would lead to economic distortions. These policies would punish startups, discourage capital investment, and encourage selling stock options early, among other distortions of economic decision-making.

Colorado has long kept its individual and corporate income taxes relatively simple, with broad bases, low rates, and substantial conformity to federal tax policy. That makes these two departures from sound tax policy stand out all the more: both would position Colorado as an extreme outlier. Colorado is hardly the only state where lawmakers are considering higher taxes on businesses or individuals, but proposals so expressly targeted at taxing phantom income are, thankfully, quite rare.

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About the Author

Expert

Jared Walczak

Senior Fellow Jared Walczak is a Senior Fellow at the Tax Foundation, where he spent five years as Vice President of State Projects, and president of Walczak Policy Consulting.