Colorado just enacted 4 major state tax changes. What do taxpayers need to know?
- Colorado recently enacted a major new state tax law, H.B. 26-1289, that implements mandatory worldwide combined reporting (with a water’s edge exclusion), changes opportunity zone rules for certain taxpayers and repeals a state-level income tax deduction related to federal tax credits.
- A second major tax change, H.B. 26-1223, which makes software subject to Colorado’s sales and use tax, also recently became law.
- Talk with your state and local tax advisor to understand how Colorado’s new tax rules could affect your business or personal finances.
On June 3, 2026, Colorado Gov. Jared Polis signed into law H.B. 26-1289. This bill adopted mandatory worldwide combined reporting under its corporate income tax with a water’s edge election, required certain taxpayers to add back their federal exclusion for Opportunity Zone gains and repealed the state’s deduction for wages made federally nondeductible under Code Sec. 280G.
The next day, on June 4, Gov. Polis signed into law H.B. 26-1223, which dramatically expanded the taxability of software to include nearly all electronically delivered software, such as software-as-a-service (SaaS).
What could these changes mean for Colorado taxpayers? Keep reading to find out.
1. Mandatory worldwide combination with water’s edge election (H.B. 26-1289)
Colorado has required unitary C corporations to file a combined report for many years, but the related rules have changed dramatically in the recent past:
- Through 2025, Colorado defined a unitary business using its unique “three of six” test, which required taxpayers to meet at least three of six criteria for the current and immediately preceding tax years to qualify as a unitary business.
- Starting in 2026, Colorado changed its unitary business definition to the traditional “flow of value” test used by most states.
- Under both regimes above, Colorado required the combined group to include affiliated C corporations that were formed under the laws of a country that Colorado deemed to be a tax haven, using a “listed jurisdiction” or “blacklist” method.
What is Colorado’s new water’s edge election?
Effective for tax years beginning on or after Jan. 1, 2027, Colorado will default to a worldwide combined reporting system. This includes the option to make a water’s edge election, which allows corporations to exclude foreign income from state tax filings:
- The water's edge election may be made on an original, timely-filed return. Thus, if any member of a worldwide group has nexus in Colorado for a particular tax year but fails to timely file a return for that year, it is prohibited from making a water’s edge election for that year even if it later files an original return for that year.
- Once made, Colorado water’s edge elections are binding for the current and consecutive nine tax years, and they automatically renew for additional ten-year periods unless revoked by the taxpayer.
- The water’s edge group will fully include all unitary affiliates that are domestic (U.S.) corporations, foreign corporations with at least 20% of their average property and payroll in the U.S., DISCs (Sec. 991-994), export trade corporations (Sec. 970-971) and corporations formed under the laws of a “tax haven” country.
The water’s edge group will partially include C Corporations addressed above, to the extent that their income is effectively connected with the conduct of a U.S. trade or business.
2. Income tax addback for gains invested in an opportunity zone (H.B. 26-1289)
In prior years, Colorado has fully conformed to the federal income tax deferral of gain that is reinvested in a Qualified Opportunity Zone Fund (QOF), regardless of whether the fund’s property was located in Colorado.
Effective for tax years beginning on or after Jan. 1, 2027, Colorado taxpayers must add back, to Colorado taxable income, any gain that is excluded from their federal taxable income under Code Sec. 1400Z-2 unless the gain is attributable to an investment in a “Colorado Qualified Opportunity Fund”. To qualify for this treatment, the fund must hold at least 90% of its assets in QOZ property that is located in Colorado.
3. Repeal of income tax deduction for wages claimed under certain federal tax credits (H.B. 26-1289)
Under Code Sec. 280C, taxpayers may not deduct any wages that they also claim under various credits, such as the Work Opportunity Tax Credit (WOTC), to avoid so-called “double dipping” of those expenses.
In the past, Colorado has permitted a state-level deduction for wage expenses that are federally nondeductible under Code Sec. 280C, likely on the ground that the lack of a state-level WOTC eliminates any potential for double-dipping in Colorado.
Effective for tax years beginning on or after Jan. 1, 2027, this state-level deduction is repealed.
4. Expanded taxability of software (H.B. 26-1223)
Effective Jan. 1, 2027, all computer software (including downloaded software, software-as-a-service (SaaS) and mobile applications) becomes subject to Colorado sales and use tax. Between now and then, the only kind of software subject to Colorado sales and use tax is prewritten software that is delivered on a tangible medium (e.g., disk, CD, USB drive).
The new law will maintain the state’s existing, narrow exemption for custom software or software governed by a truly negotiated license agreement (i.e., one that is “individually bargained” and executed by authorized representatives of each party). Software licensed under a click-through, browse-wrap, click-wrap or other automated agreement does not qualify for this exemption.
Note: Home-rule jurisdictions in Colorado may tax software differently, before and after the law change, so it is important to review those jurisdictions’ treatment of software separately to determine the correct taxability.
What should Colorado taxpayers do now?
To understand how the recent changes to Colorado state tax rules could affect you, talk with your state and local tax advisor. Your tax advisor can assess any impact on your business or personal finances, as well as help you determine whether you have new opportunities available to you as a result of H.B. 26-1289 and H.B. 26-1223.
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