The Arizona Middle Class Tax Cuts Package: Operational Considerations for the 2025 Filing Season

Governor Katie Hobbs issued Executive Order 2025-15 on November 20, 2025, titled “Cutting Taxes for Hard-Working Arizonans”. This action initiates a series of prospective changes to the Arizona state income tax structure, primarily aimed at middle-class taxpayers. Given that the Executive Order (EO) directs the Arizona Department of Revenue (ADOR) to update state tax forms for the 2025 tax year, tax professionals must understand the technical directives of the order and the subsequent legislative action required to ensure the validity of these planned benefits.

Executive Order 2025-15: Directives and Scope

The core function of Executive Order 2025-15 is to mandate that ADOR update the State of Arizona tax forms to enable taxpayers to utilize the proposed Middle Class Tax Cuts Package when filing their 2025 tax returns.

The EO directs ADOR to implement two distinct categories of adjustments:

  1. Standard Deduction Update: The tax forms will be updated to include the higher standard deduction passed into law by H.R. 1. This brings Arizona tax forms into conformity with portions of H.R. 1 that benefit middle-class Arizonans. Specifically, the state standard deduction is set to increase from the previous $15,000 amount to $15,750 for single filers and $31,500 for joint filers.
  2. Prospective Instructions for Legislative Subtractions: The ADOR is also directed to include prospective instructions for Arizonans to take advantage of several new deductions. These instructions are included in anticipation of the legislature subsequently codifying these proposed measures into law.

It is important to note that any further tax conformity provisions, particularly those affecting corporations and high earners, are intended to be negotiated separately in the FY27 budget, consistent with the standard procedure for legislation that carries fiscal impacts.

Specific Proposed Subtractions and Deductions

The Middle Class Tax Cuts Package introduces several specific income subtractions designed to reduce Arizona taxable income:

  • Senior Deduction: An additional deduction of $6,000 for Arizonans over the age of 65.
  • Tipped Income Subtraction: Arizonans will be allowed to deduct tipped income from their state taxes. For instance, a hypothetical taxpayer’s return showed a $5,000 subtraction for tip income.
  • Overtime Income Subtraction: Arizonans will be allowed to deduct eligible overtime income from their state taxes. A hypothetical example illustrated a $3,000 subtraction for overtime wages.
  • Car Loan Interest Subtraction: Arizonans will be allowed to deduct interest for car loans on new, American-made vehicles from their taxes. A hypothetical taxpayer was shown benefiting from a $4,000 subtraction for car interest.

These combined subtractions and the increased standard deduction significantly impact the calculation of Arizona Taxable Income. In a modeled scenario, a 68-year-old single filer with a Federal Adjusted Gross Income (AGI) of $75,000 saw their Arizona Taxable Income drop from $60,000 (using the $15,000 standard deduction) to $41,250 (using the $15,750 standard deduction and $18,000 in additional subtractions).

Implications for Arizona 2025 Income Tax Returns

The Executive Order places ADOR in the position of issuing tax forms that incorporate subtractions that have not yet been statutorily enacted.

For tax professionals preparing 2025 returns, the primary operational challenge lies in the distinction between the standard deduction increase and the new subtractions:

  1. Standard Deduction: The increased standard deduction ($15,750 single / $31,500 joint) is included in the updated forms because it was “passed into law by H.R. 1”.
  2. Middle Class Subtractions: The deductions for tipped income, overtime, senior status, and car interest are based on “prospective instructions”. This means that while ADOR has been directed to enable these subtractions on the forms, their legal efficacy depends entirely upon the subsequent legislative action.

If the legislature fails to codify the Middle Class Tax Cuts Package, taxpayers who rely on the deductions specified in the ADOR’s prospective instructions could face deficiency assessments, as the subtractions would lack statutory authority.

The Urgency of Legislative Codification

Governor Hobbs has called upon the state legislature to immediately pass the Middle Class Tax Cuts Package at the beginning of the session. This urgency stems from the need to provide tax certainty to everyday Arizonans.

Crucially, the vast majority of taxpayers will file their 2025 returns prior to the anticipated completion of the FY27 budget. If the legislature delays the codification of the tips, overtime, senior, and car interest subtractions until the budget process concludes, those taxpayers who file early and claim these deductions, based on ADOR’s instructions, risk filing an erroneous return if the provisions are altered or rejected.

Therefore, for CPAs and EAs seeking to ensure clients maximize benefits without incurring future amendment requirements, the prompt codification of the Middle Class Tax Cuts Package into state law by the legislature is essential. Codification at the start of the session would retroactively grant the necessary statutory authority to the subtractions, aligning the law with the tax forms ADOR has been directed to issue under EO 2025-15.

The filing certainty for Arizona taxpayers regarding these proposed subtractions is currently akin to building a bridge that is authorized but not yet anchored; while the path forward is visible on the forms, its structural integrity relies entirely on the timely arrival of statutory legislative support.

Prepared with assistance from NotebookLM.

Sometimes Memorization Just Ain’t Enough (With Apologies to Patty Smyth for Borrowing Her Title)

In a recent article published by Futurism, Jad Tarifi, the founder of Google’s inaugural generative AI team, posited a cautionary stance regarding careers in law and medicine, asserting that these professions primarily entail the memorization of information. This assertion prompted a critical examination of prevalent misconceptions concerning the true nature of knowledge and skill acquisition within these domains.

A compelling illustration of this misunderstanding is evidenced by the consistent erroneous responses from three distinct AI large language models (LLMs) when queried about specific provisions within the One Big, Beautiful Bill Act (OBBBA) designed to reduce an individual’s adjusted gross income. As I documented in a prior blog entry, I, a certified public accountant (CPA) without additional legal training, and certainly not possessing comprehensive recall of the entire OBBBA, was immediately able to identify the flaw in the models’ conclusions. This occurred despite the theoretical premise that these models “knew” the entirety of the Internal Revenue Code (IRC), along with all pertinent binding guidance, and had unfettered access to the complete legislative text that modified the aforementioned law.

Within tax law, rote memorization has never been, nor will it ever be, the sole method for ascertaining legal principles and their application. Instead, a meticulous reading of the law is imperative, necessitating careful attention to its enumerated items, cross-references, and the subsequent tracing of those references (which may lead to further cross-references) to construct a comprehensive understanding of the statute. Furthermore, the process involves distinguishing unambiguous statutory provisions, which dictate a singular interpretation, from those exhibiting ambiguity, which require interpretation. This interpretive process relies upon established canons of statutory construction developed over time.

Subsequent to this initial statutory analysis, the practitioner must then explore other existing interpretive binding official guidance, assess whether the law has undergone changes since such guidance was issued, and finally, consult expert discussions from third-party sources and non-binding official guidance. This comprehensive approach yields potentially supportable interpretations of the matter at hand, alongside an assessment of the likelihood that any given interpretation would ultimately be accepted by an IRS agent, an appellate conferee, or the highest court to which the case might escalate.

The fundamental flaw in the analyses provided by ChatGPT, Gemini, and BlueJ in this instance was their failure to commence with an isolated examination of the law. Instead, they prematurely resorted to other sources, neglecting to analyze the memorized legal text and the legislative amendments in isolation. Moreover, it remains unclear whether such isolated analysis is truly feasible for these models given their operational paradigms.

As previously detailed, the OBBBA provisions concerning the exemption of tips, overtime pay, and car loan interest from taxation were appended as deductions to Section 63 of the IRC. This classification renders them deductions taken along with either the standard deduction or itemized deductions in computing taxable income, rather than deductions that reduce adjusted gross income. As elaborated upon in the earlier article, deductions utilized in the computation of adjusted gross income would be allocated to Section 62.

While the models had purportedly memorized the entire structure of the IRC, theoretically imparting this knowledge, they failed to undertake the crucial step that tax CPAs and attorneys should perform at this juncture: consulting the statutory text and following cross-references to gain an initial understanding of the IRC’s provisions as amended pertaining to this issue. Instead, they were diverted by other related information contained within their models and acquired from the web during data updates to fill in for developments taking place after the end of time covered by their training. This data included articles quoting Congressional sources that correctly noted these items were deductible regardless of whether a taxpayer itemized deductions. Furthermore, the training data encompassed years of articles that referred to various prior specific items deductible irrespective of itemization as “above the line” deductions. Their data also indicated that “above the line” signified a deduction used in computing adjusted gross income. None of this memorized data was factually incorrect, though much of it proved irrelevant in this specific context.

Consequently, the models quickly identified a high correlation between the terms “deductible even if the taxpayer does not itemize deductions” and a deduction being categorized as “above the line,” as well as a nearly one-to-one correlation between a deduction being referred to as “above the line” and its use in computing adjusted gross income. Again, all of this derived from the memorized information was accurate.

However, at this juncture, the analysis fell apart due to an incorrect inference. The models utilized all data indicating these deductions were available to both itemizing and non-itemizing taxpayers (which was entirely correct) to infer that these deductions were “above the line” and utilized in computing adjusted gross income (absolutely not correct). This inference was reinforced by the historical commentary present within their vast memorized data. Nevertheless, it was an inference that proved completely erroneous.

The question then arises: why did the models’ access to more current sources not challenge their conclusions? This highlights the fallibility of many human authors who were expeditiously producing commentary on the bill. Numerous such articles, some originating from highly reputable sources, incorrectly labeled these provisions as “above the line” deductions.

While the precise reasons for these authors’ misclassification remain speculative, it appears evident that they did not base their initial articles on a direct analysis of the bill itself and the Internal Revenue Code for this issue. It is plausible that many made the same inference that the LLMs derived from their extensive memorized data—namely, that historically, Congress had enacted provisions for items deductible even without itemization as deductions used to compute adjusted gross income. Others, encountering previously published articles making the claim that these deductions reduced adjusted gross income, simply relied upon those sources. Furthermore, I suspect that some authors, operating under time constraints, posed the question to LLMs, which, based on their initial model assumptions, provided the erroneous result.

In any event, the articles discovered by the LLMs analyzing the law served to corroborate their models’ initial assumptions, which were rooted in their extensive memorized data, thereby creating a significant feedback loop.

My approach to the new legislation mirrored that of previous laws, with the notable addition of Google’s NotebookLM, an AI application primarily reliant on user-provided sources. The notebook I established contained exclusively the tax provisions of the statute. As I systematically reviewed each section of the bill, I utilized NotebookLM to generate summaries of the respective sections, while simultaneously conducting my own independent review to ensure comprehensive understanding and prevent oversight during rapid analysis of the law.

NotebookLM’s analysis was largely confined to the provided document, offering little beyond the assertion that each provision modified Section 63 since that was all that was available to the application. Consequently, I cross-referenced Section 63 to ascertain the specific implications of such modifications. As I knew Congress had, on a rare occasion, introduced an additional “below the line” deduction by placing it in this Section, accessible regardless of whether a taxpayer itemized deductions. They had decided to do this multiple times in the new bill.

A precedent for such a deduction can be found in the Qualified Business Income (QBI) Deduction under IRC §199A, enacted by the Tax Cuts and Jobs Act of 2017. This provision has remained in effect and its application was extended as part of the OBBBA.

Posing inquiries to the models regarding the placement of these deductions within Section 63, akin to the QBI deduction in 2017, frequently resolved the models’ prior limitations. This shift in focus directed their attention to articles detailing that specific deduction and highlighting the impact of its placement in Section 63 rather than Section 62. The models subsequently confirmed that the bill text indeed added these deductions to Section 63 and, likely drawing from the newly focused articles, concluded that these deductions do not reduce adjusted gross income.

Even if their approach remained flawed, they did finally arrive at a correct solution.

I am not an attorney and do not claim to be one. However, I would be astonished if similar problems didn’t frequently emerge when parties depend on LLMs for tasks typically handled by law students who would become attorneys, whom Mr. Tarifi suggests should discontinue their legal studies.

Mr. Tarifi undoubtedly possesses far greater knowledge of LLMs and AI than I ever will. Yet, I question whether proponents of AI solutions truly grasp the issues they aim to resolve, or if they merely presume to understand them. The immediate availability of the entire IRC and all supporting documentation within an LLM’s model is genuinely incredibly useful and will revolutionize our approach to tax research and analysis. Nevertheless, I hope I have demonstrated how mere rote memorization is insufficient to perform the job being done today—nor do I observe signs that newer models are progressing beyond memorization to conduct a comprehensive analysis of new laws and developments.

Large Language Models (LLMs) represent a significant advancement that professionals in tax practice must comprehend to maintain relevance. However, similar to the introduction of computers in the 1960s and 1970s and subsequent machine learning enhancements beyond initial automation of routine preparation tasks, LLMs are not anticipated to be the technology that renders tax professionals obsolete.

An Interesting Error from LLMs in Tax Research That Does Not Seem to Be a Hallucination

I was experimenting with three LLMs on a tax research issue recently. I asked them to identify deductions newly available to individuals without a business or rental activity that are deductible in computing adjusted gross income (AGI).

ChatGPT, Gemini, and BlueJ (a paid service for tax professionals) all identified the following:

  • No tax on tips
  • No tax on overtime
  • No tax on interest on car loans

As I’ll show, this answer is wrong. But first, consider this: they all arrived at the same incorrect answer. While we know that LLMs can hallucinate, this isn’t likely a hallucination (an answer created from thin air). If all three models were hallucinating, they would be highly unlikely to invent the exact same error.

The key to the error lies in the distinction between IRC §62 and §63. If you’ve taken my course on the OBBBA, you’ll recall I noted that these specific deductions are routed through §63 (computation of taxable income), not §62 (computation of adjusted gross income). The most well-known §63 deduction is the QBI deduction under §199A-it reduces taxable income on Form 1040 but does not reduce AGI. Because it doesn’t reduce federal AGI, it also doesn’t reduce Arizona taxable income, a crucial point for us here in Arizona.

So, how did all three AIs get the same wrong answer? It’s simple: a large number of human authors, whose material was used in the models’ training data or accessed via web searches, made the same mistake. Because these new deductions were touted as being available even to non-itemizers, many authors assumed they were “above-the-line” deductions and described them as such. However, a review of the statute makes it clear: the OBBBA added these provisions to §63 but made no change to §62.

It’s true that the LLMs didn’t consult the text of the law; they don’t perform legal analysis. Rather, they synthesize the analysis that others have prepared and published, giving extra weight to “high-quality” sources. In this case, a large percentage of human analysts made the same mistake.

There are understandable reasons for this. Bill proponents repeatedly noted the deductions were available even if a taxpayer did not itemize. Many general-purpose financial publications quickly released articles stating these deductions were “above the line.” They presumably equated being able to take a deduction without itemizing with it being an “above-the-line” deduction-an association that was generally, but not always, true before the TCJA and OBBBA.

From personal experience, I know producing an analysis of a new tax bill is done under extreme pressure. Reading federal legislation is messy; the bill only shows the amendments, not the law in its final, consolidated form. It’s easy to miss the significance of a deduction being added to §63 instead of §62.

This distinction is critical because AGI impacts numerous calculations. For states like Arizona that start with federal AGI, these deductions won’t reduce state taxable income. Furthermore, AGI affects tax thresholds (like phase-outs and deduction floors) and even non-tax items like the IRMAA calculation for Medicare premiums.

The takeaway is that relying on a human-written analysis is no guarantee of correctness, either. I have sat through continuing education webinars on the OBBBA that contained this exact error. At this point, the error is so common that it has likely “infected” other human authors, who repeat it after hearing it from multiple sources.

I fully understand how this error was made and could easily have made the same mistake myself (and have likely made other mistakes).  But unless you are working directly from source materials you have to always remember that there could be flaws in the analysis you are reading-and sometimes these errors become self-reinforcing when authors have seen or read previous analyses.

Gemini “Thought” Process for Deep Research – How It Produced the Correct Analysis While Continue to “Think” It Was Dealing with Fabricated Detail for a Non-Existent Law

I have been looking at various AI sources for dealing with tax updates, including new law such as the One Big Beautiful Bill that was enacted on July 4, 2025 (I did mistakenly refer to the signed into law date in my prompt as July 1, 2025 but that did not cause the issue, though you will notice that date in Gemini’s response to my query). And I noticed one thing about Gemini when I asked about the Trump Accounts in it, something I knew had changed dramatically in various versions of the bill. When I told Pro 2.5 to give me information about the bill signed into law on July 4, 2025 it replied that no such bill exists. That didn’t surprise me, as I didn’t expect it training to be that up to date.

So I next turned to Deep Research. The report it generated was the best one I’ve gotten from any AI system (including BlueJ, a commercial tax professional product) but in looking at its “thoughts” I found it initially concluded that the bill did not exist, then did its web search, found a lot of high quality sources that did talk about it, but it continued to refer to this information as fabricated in the thought process (the bill didn’t exist). Nevertheless, it produced summary that the thought history shows it believes was fabricated, but which never is labeled as such in the output.

So I decided to pose the question to Gemini 2.5 Pro about why that had happened, and it’s explanation, reproduced below, is an interesting look at how that system works. And why the “thoughts” are more of a look at the internals and not necessarily reflecting a “belief” in any way you might interpret that word.

Gemini’s Response Follows:

That is an excellent and highly insightful question. Your observation gets to the very heart of how advanced AI systems like Gemini, particularly with features like Deep Research, function. You are correct in your core assumption, but there’s a fascinating nuance to why you see that “cognitive dissonance” in the process.

Here’s a breakdown of what’s happening, addressing your specific question about why the model seems to maintain its initial belief in the “Thoughts” while producing a correct final output.

The Two “Minds” of the Operation: Base Model vs. Research Agent

Think of the process not as a single mind that changes its opinion, but as a multi-step workflow involving different specialized components or “agents.”

  1. The Planner (Based on Gemini 1.5 Pro’s Static Knowledge):
    When you initiate Deep Research, the first step is for the base model (Gemini 1.5 Pro) to understand your request and formulate a research plan.
    • Initial Check: The model’s first instinct is to check its own internal, static knowledge base. In your scenario, its training data cuts off before July 2025.
    • The First “Thought”: When it checks for “HR1 signed into law on July 1, 2025,” its internal knowledge returns a definitive “no match found.” This is a factual statement based on its training data. This is where the thought you observed—“the bill does not exist”—originates.
    • The Plan: Crucially, the model doesn’t stop there. It recognizes that its knowledge is limited by time. The plan it generates will involve steps to overcome this, such as:
      • Search for information about a bill designated HR1 in 2025.
      • Verify if HR1 was signed into law in July 2025.
      • Find authoritative sources like congress.gov, news reports, and legal analyses for this bill.
      • Synthesize the findings into a comprehensive analysis.
  2. The Researcher (The Tool-Using Agent):
    This is the part of the process that executes the plan. It autonomously runs Google searches, reads the results from the credible sources it finds, and gathers the raw data.
    • Finding New Evidence: In your hypothetical scenario, this agent finds a wealth of information about your fictional HR1 from authoritative sources published after its knowledge cutoff. It discovers the bill’s text, news reports on its signing, and analyses from think tanks.
    • Data Collection: This new, contradictory information is collected. The system notes the sources and the content. This is the second part of the “Thoughts” you see, where it lists the sources it found and the information it extracted.
  3. The Synthesizer (The Final Report Generator):
    This is the final and most important step. The system now has two conflicting sets of information:
    • Internal Knowledge (from the Planner): “This bill doesn’t exist.”
    • External Knowledge (from the Researcher): “Multiple, fresh, authoritative sources confirm this bill exists and here are its complete details.”

This is the key to your question: The system is not designed to “believe” one thing over the other in a human sense. It is designed to **fulfill the user’s request using the best available information.**The ultimate goal is to provide an analysis of the bill. The information retrieved from the live searches is infinitely more relevant, current, and useful for that task than its own outdated internal knowledge. Therefore, the synthesis process is architected to prioritize and build the final report based on the fresh data gathered by the Researcher. The initial (and now invalidated) thought from the Planner is correctly discarded as an artifact of the research process, not a fact to be included in the final product.

Why Does the “Thought” Linger?

The “Thoughts” section is a transparent log of the agent’s work process. It’s showing you its homework.

  • It shows the initial state (Premise: Check for HR1. Result: Not found in my knowledge base.).
  • It shows the actions taken (Action: Search Google. Results: Found 10 credible sources…).
  • The log isn’t a “stream of consciousness” that constantly edits itself. It’s a record. So, the initial premise remains logged even after it has been superseded by new evidence.

You are essentially seeing the “ghost in the machine”—the base model’s initial, correct-but-outdated assessment—before the research agent provides new, more relevant data for the final output.

Analogy: The Diligent Librarian

Imagine you ask a librarian (with a perfect memory up to 2024) for a book published yesterday.

  1. Initial Thought: The librarian thinks, “I have memorized every book in this library’s catalog. That book is not in my memory. Therefore, it does not exist in my catalog.”
  2. Action: However, they are a diligent librarian. They don’t stop there. They say, “Let me check the ‘New Arrivals’ cart from today’s delivery.”
  3. Discovery: They walk over to the cart, find the book, and read its back cover and table of contents.
  4. Final Answer: They walk back to you and give you a perfect summary of the new book. They don’t start by saying, “Well, I first thought this book didn’t exist…” They give you the answer you asked for, based on the new information they actively sought.

The “Thoughts” in Deep Research let you watch the librarian walk to the cart. The final output is the summary they give you at the end. Your observation is so keen because you noticed the librarian’s initial, momentary flicker of doubt before they completed their process.

Senate Finance Committee Initial Draft of Reconciliation Bill Tax Provisions

I’ve uploaded a (primarily) NotebookLM section by section summary of tax related provisions found in the Senate Finance Committee draft issued on June 16, 2025, using the law text and the committee’s section by section summaries as inputs. While I’ve roughly reviewed each section’s explanation, I have not done a deep dive on confirming treatments since this clearly won’t be the final bill.

For those note aware, NotebookLM is a Google notes/study web application that uses specific sources uploaded to each notebook as the inputs to answer questions, generate summaries, FAQs and study materials on the provided items. The inputs given were:

Finance Committee Proposed Legislative Text

Section by Section Details in Summary Form

My document was generated by making a standard inquiry of NotebookLM on a bill section by section basis. That helps focus the program on the items in that section and reduces (but does not eliminate) the risk that it will find and misinterpret irrelevant items in the texts about each section.

Here is the query I used, changing the section number for each run.

Please write a summary of Section 71304 of the proposed legislation.  Outline the provisions found in current law, how the bill would change the law going forward, and any Internal Revenue Code provisions impacted by the law change.  You are a CPA experienced in tax matters writing an article to explain this provision to other experienced tax professionals.  Try to maintain a neutral position on any policy related matters, concentrating primarily on the mechanics of the operation of the old and new law.  Do not discuss IRC Section 15 revisions in this article. Just include the article, with no text before or after the article you generate. The title of the article should only be the word “Section” followed by the section number and then the formal title of the section.

A couple of notes on the last few sentences. The Section 15 discussion in both the bill and the summary applies generally to the bill, so NotebookLM wanted to keep bringing it up every time even though it really only impacts a few provision. I kept it in the first section discussion on rates, but then suppressed it. I also didn’t really want the “chatty” description of what I had asked (so thus the suppress text before and after the article) and the last couple of sentences just helped to get more consistent headers and titles.

Here is the entire document that was created on this bill. Again, use this as a rough guide and it some issue is crucial for your client, please go directly to the sources noted above. Any time something is “summarized” by definition some things get left out, and sometimes those details are important in your client’s situation. As well, errors do creep in for various reasons, so confirming any editorial source (including CCH and RIA’s) is an important step before relying on any analysis.

Senate Finance Commmittee Tax Bill NotebookLM DocumentDownload

The One, Big, Beautiful Bill Title XI Tax Provisions as Passed by the Ways & Means Committee

I decided to post the following for various reasons at this point. First, since the One, Big, Beautiful Bill has already had some amendments made to Title XI by the House Rules Committee (though the full updated bill text is not available as of the morning of May 24) there’s little reason to refine this document. Second, I have found it useful as a starting point for answering questions about the bill (being able to find relevant items in the bill text and JCT report). And, third, it does demonstrate the usefulness of NotebookLM for getting on top of these sorts of things, as well as gave me a good learning experience in how to deal with new law text (the JCT report was really useful in being able to handle the bill, since the latter only comes with the changes to the IRC, not the full revised IRC provision in context which is often needed to understand what Congress is doing).

So I am posting the analysis I compiled of the bill using NotebookLM, the bill text that was approved by the Ways & Means Committee, and the JCT report on the various provisions in that bill. I added a section on the proposed changes to PL 86-272 as well though that was added by a different committee and is not part of Title XI.

The way I handled it was to craft a prompt to ask for an analysis dealing with specific areas of each section in the bill, working from the section list in the Ways & Means Committee summary. Giving NotebookLM “bite sized” items to analyze proved a much more accurate way to get it to focus on the proper items than trying to pick off multiple provisions at once. And I did scan the output to make sure I didn’t see any obvious issues, following up on a few things where I was surprised though most often discovering that “yeah, that’s how it was written” when I was done reviewing the appropriate sections of each document.

You can download that analysis below. There’s little reason for me to refine it more at this point since the final bill will require a “start over” (you never know what change will sneak in as a bill moves through the process) but, as I noted, with the caveat that you don’t assume it’s 100% accurate (which you shouldn’t do for any analysis–the law is what matters), I do find it useful.

Tax Provisions of The One, Big, Beautiful Bill, Title IX – Ways & Means Committee Tax ProvisionsDownload

If you haven’t used it, you might want to go look at NotebookLM. Even with a free account you can do a decent analysis (just not a huge number of them).

Arizona Tax Provisions in the Budget

The end of the Legislature’s regular session typically results in the introduction of budget bills, which may include tax-related provisions. In 2023, SB 1734 was introduced and contained three significant provisions related to taxation.

However, only one of these provisions was incorporated into the Arizona Revised Statutes, while the other two exist solely as part of the session law. This means that if you want to reference those two provisions, you will need to refer back to the original bill that was signed by the Governor (presuming the Governor signs the bill, as expected).

The bill passed both chambers of the Arizona Legislature on May 10, 2023 and is expected to be signed by the Governor.

Partnership Income Subject to the Pass-Through Tax Broadened

One significant limitation that many CPAs encountered when working with Arizona’s passthrough entity tax for 2022 tax returns was that only a narrow range of partnership income was subject to the tax. Specifically, the tax was only levied on the non-separately stated income of the partnership, while any separately stated items of income and deduction were disregarded. Despite this, the non-separately stated income was still subject to all of the Arizona additions and subtractions to partnership income that were detailed in the statute.

By contrast, S corporations were subject to the passthrough entity tax on all of their passthrough income. Given that the primary purpose of the tax was to pay Arizona tax at the entity level, rather than the individual level, most CPAs and their clients preferred the more comprehensive taxation of S corporations over the limited taxation of partnerships.

However, effective for tax years starting on or after December 31, 2022 (essentially, 2023 and beyond), the law has been modified to change the way that the income of a partnership is calculated for tax purposes. Specifically, the calculation of partnership income will now encompass a broader range of income, including separately stated items of income and deduction.  The new definition reads:

(ii) for taxable years beginning from and after December 31, 2022, the Arizona taxable income determined under chapter 14 of this title, including the items that require separate computation under section 43-1412, paragraphs 1 through 16.[1]

It’s worth noting that the previous calculation method for partnership income, which limited the taxable income to only the non-separately stated income of the partnership, will continue to apply for the 2022 tax returns. This calculation method is explicitly retained in ARS §43-1014.B.1.(a)(i).:

(i) for taxable years through December 31, 2022, the Arizona taxable income determined under chapter 14 of this title.

The definitions provision of Chapter 14 of Title 43 of the Arizona revised statutes contains the following definitions of Arizona gross income and Arizona taxable income:

43-1401. Definitions

In this chapter, unless the context otherwise requires:

1. “Arizona gross income” of a partnership means its taxable income for the year, computed according to subtitle A, chapter 1, subchapter K of the internal revenue code, exclusive of items requiring separate computation under section 43-1412, paragraphs 1 through 16. (emphasis added) For purposes of this title the provisions relating to interest on investment indebtedness contained in section 163(d) of the internal revenue code shall not apply.

2. “Arizona taxable income” of a partnership means its Arizona gross income adjusted by the modifications specified in sections 43-1021 and 43-1022 and section 43-1414, subsection A.

The Arizona Department of Revenue had interpreted that reference to exclude from the calculation all non-separately stated items of income and deduction.  The new law seeks to explicitly have those items included in the calculation.

Example

Below is the computation of an example partnership’s income subject to the PTE tax under both the 2022 and the 2023 provisions.

Under the prior law that applied in 2022:

  • Ordinary business income or loss: $500,000
  • Section 1231 gain: $1,000,000 (not included)
  • Interest income: $1,000 (not included)
  • Dividend income: $2,000 (not included)
  • Charitable contributions: $25,000 (not deducted)
  • Section 179 expense: $200,000 (not deducted)

Income subject to Arizona passthrough entity tax under 2022 law: $500,000

Under the law applicable to 2023 and later years:

  • Ordinary business income or loss: $500,000
  • Section 1231 gain: $1,000,000 (included)
  • Interest income: $1,000 (included)
  • Dividend income: $2,000 (included)
  • Charitable contributions: $25,000 (deducted)
  • Section 179 expense: $200,000 (deducted)

Income subject to Arizona passthrough entity tax: $1,278,000

Temporary Increase in Adoption Expense Subtraction to $40,000 (2023-2025)

Under Arizona’s income tax law, taxpayers are permitted to take a subtraction for adoption expenses up to a maximum of $3,000 in the year when the adoption is finalized. This provision is outlined in ARS §1022.12:

12. The amount of unreimbursed medical and hospital costs, adoption counseling, legal and agency fees and other nonrecurring costs of adoption not to exceed $3,000.  In the case of a husband and wife who file separate returns, the subtraction may be taken by either taxpayer or may be divided between them, but the total subtractions allowed both husband and wife may not exceed $3,000.  The subtraction under this paragraph may be taken for the costs that are described in this paragraph and that are incurred in prior years, but the subtraction may be taken only in the year during which the final adoption order is granted.

In a provision retained solely as session law (thus not incorporated into ARS §1022), the subtraction is revised for years 2023-2025 as follows to increase the subtraction to $40,000:

A. Notwithstanding any other law, for taxable years beginning from and after December 31, 2022 through December 31, 2025, the subtraction amount allowed under section 43-1022, paragraph 12, Arizona Revised Statutes, is the amount of unreimbursed medical and hospital costs, adoption counseling, legal and agency fees and other nonrecurring costs of adoption not to exceed $40,000. For a married couple filing separate returns, the subtraction may be taken by either taxpayer or may be divided between them, but the total subtractions allowed to each spouse may not exceed $40,000. The subtraction may be taken for the costs that are described in this subsection and that are incurred in prior years, but the subtraction may be taken only in the year during which the final adoption order is granted.[2]

Below is an example of applying the revised limit on the adoption expense deduction

Example

Assume that John and Jane, a married couple, began the process of adopting a child in 2022. They incurred adoption expenses as follows:

  • Unreimbursed medical and hospital costs: $10,000
  • Adoption counseling fees: $2,500
  • Legal fees: $15,000
  • Agency fees: $12,000

Their adoption was finalized in 2023. Under the revised law, they may take a subtraction for adoption expenses on their 2023 Arizona income tax return. The maximum subtraction amount is $40,000.

Since their total adoption expenses ($39,500) do not exceed the maximum allowed amount, they can take the full $39,500 as a subtraction on their 2023 tax return. The subtraction will reduce their Arizona taxable income for the year, likely resulting in a lower tax liability.

If John and Jane had incurred more than $40,000 in adoption expenses, they would only be able to take the maximum allowed amount of $40,000 as a subtraction on their tax return.

It’s worth noting that this subtraction may also be taken for adoption expenses that were incurred in prior years, but only in the year in which the final adoption order is granted.

Had their adoption been finalized in 2022, their deduction would have been limited to $3,000.

Individual Income Tax General Welfare Rebate (Arizona Families Tax Rebate)

Arizona will paying a onetime individual income tax general welfare rebate (referred to as the Arizona Families Tax Rebate) to taxpayers who filed a 2021 full-year resident return, claimed a dependent credit on that return and meets one of the following qualifications:

  • Had a tax liability of at least $1 on the filed full-year resident tax return for taxable year 2021.
  • If the taxpayer does not meet the tax liability requirement for taxable year 2021, filed a full-year resident tax return for taxable year 2020 under the identical filing status used on the taxpayer’s taxable year 2021 full-year resident tax return and had a tax liability of at least $1 on the full-year resident tax return for taxable year 2020.
  • If the taxpayer does not meet the tax liability requirement for taxable years 2021 or 2020, filed a full-year resident tax return for taxable year 2019 under the identical filing status used on the taxpayer’s full-year resident tax returns for taxable years 2020 and 2021 and had a tax liability of at least $1 on the full-year resident tax return for taxable year 2019.[3]

The rebate is calculated using the following rules:

  • The Department of Revenue shall issue to a qualifying taxpayer a rebate of $250 for each dependent tax credit claimed on the taxpayer’s full-year resident tax return for taxable year 2021 who was under seventeen years of age at the end of taxable year 2021 and $100 for each dependent who was at least seventeen years of age at the end of taxable year 2021.
  • The Department of Revenue shall issue a rebate for a maximum of three dependents for a qualifying taxpayer under this section. For a taxpayer who claimed more than three dependents on the taxpayer’s full-year resident tax return for taxable year 2021, the rebate will be calculated by first counting the dependents who were under seventeen years of age at the end of taxable year 2021 and then, if additional dependents may be claimed to meet the maximum number, the dependents who were at least seventeen years of age at the end of taxable year 2021.[4]

Below is an example of applying these rebate rules:

Example 1

Assume that John is a full-year Arizona resident who filed a tax return for taxable year 2021 and claimed four dependent credits on that return. Two of his dependents were under seventeen years of age at the end of taxable year 2021, and two were at least seventeen years of age at the end of taxable year 2021.

Under the newly enacted law, John qualifies for the one-time individual income tax general welfare rebate since he filed a 2021 full-year resident return, claimed a dependent credit on that return, and had a tax liability of at least $1 on that return.

Since John claimed four dependent credits on his 2021 full-year resident tax return, he is eligible to receive a tentative rebate of $700 (before applying the maximum credit limitations). Here’s how the tentative rebate amount is calculated:

  • $250 for each dependent under seventeen years of age: $500 ($250 x 2)
  • $100 for each dependent at least seventeen years of age: $200 ($100 x 2)
  • Tentative rebate amount before limitation: $700

Since John claimed four dependents on his 2021 full-year resident tax return, the maximum number of dependents for which he can claim a rebate is three. However, since two of his dependents were under seventeen years of age, the rebate will be calculated based on those two dependents and only one of the older dependents. Therefore, John is eligible for a rebate of $600 ($250 x 2 plus $100 x 1) for his two dependents who were under seventeen years of age and one additional dependent.

If John had claimed three or fewer dependents on his 2021 full-year resident tax return, the rebate amount would have been calculated based on the actual number of dependents claimed.

Example 2

Now let’s consider another scenario. Assume that Jane is also a full-year Arizona resident who filed a tax return for taxable year 2021 and claimed a dependent credit on that return. However, Jane had no tax liability on her 2021 full-year resident tax return.

Since Jane does not meet the tax liability requirement for taxable year 2021, she must look back to her 2020 full-year resident tax return. If Jane had a tax liability of at least $1 on her 2020 full-year resident tax return, she would qualify for the rebate. However, if she did not have a tax liability on her 2020 full-year resident tax return either, she must look back further to her 2019 full-year resident tax return.

If Jane had a tax liability of at least $1 on her 2019 full-year resident tax return, she would qualify for the rebate. Assuming that the rebate amount is $600 (like John she had two dependents under age 17 and two over), Jane would receive a rebate of $600 from the state of Arizona.

If Jane did not have a tax liability for 2019 then she would not qualify to receive a rebate.

A key issue is what is considered a “tax liability” under this provision. SB1734 Section 4.N.4 provides:

4. “Tax liability” means the taxpayer’s taxable income multiplied by the taxpayer’s applicable tax rate as prescribed in section 43-1011, Arizona Revised Statutes, plus any amount of recaptured income tax credits and the taxpayer’s Arizona small business tax liability, if any, minus the sum of nonrefundable and refundable income tax credits claimed by the taxpayer under title 43, chapter 10, article 5, Arizona Revised Statutes.

Below is an example of applying the tax calculation.

Example 1:

Assume that Neal had $2,000 of Arizona tax for 2021 and had claimed an Arizona tax credit of $2,000 for contributions to a Private School Tuition Organization during the year. Under the definition of a tax liability, the calculation would be as follows:

  • Neal’s Arizona tax: $2,000
  • Nonrefundable income tax credits: $2,000
  • Refundable income tax credits: $0

Therefore, according to the definition of a tax liability, Neal’s tax liability for 2021 is $0. Although Neal had $2,000 of Arizona tax for the year, the full amount was offset by the Arizona tax credit he claimed. Since his tax liability is $0, he would not be eligible for the Arizona income tax general welfare rebate unless he can qualify based on having a tax liability in 2020 or 2019.

Example 2:

Assume that the facts are the same as in Example 1, except that Neal was only eligible to claim $1,999 in credits in 2021. Under the definition of a tax liability, the calculation would be as follows:

  • Neal’s Arizona income tax: $2,000
  • Nonrefundable income tax credits: $1,999
  • Refundable income tax credits: $0

Therefore, according to the definition of a tax liability, Neal’s tax liability for 2021 is $1. Although he had $2,000 of Arizona tax for the year, his tax liability is reduced to $1 due to the Arizona tax credit he claimed. Since his tax liability is (barely) greater than $0, Neal would be eligible for the Arizona income tax general welfare rebate, assuming he meets the other qualifications under the law.

The primary taxpayer’s identification number reported on the 2021 return shall be used as needed for matching and verification purposes.[5]

The bill provides that if the taxpayer is deceased, the taxpayer’s surviving spouse, personal representative or executor or another official representative of the estate designated pursuant to applicable state law may receive the rebate for the deceased taxpayer.[6]

The Department of Revenue (ADOR) is directed to pay all rebates issued pursuant to this section on or after October 15, 2023, and on or before November 15, 2023.[7]

ADOR shall attempt to pay a qualifying taxpayer’s rebate by electronic funds transfer using the routing and account information provided by the taxpayer on the taxpayer’s full-year resident tax return for taxable year 2021 or more recent routing and account information provided by the taxpayer.[8] We will have to wait to see if the Department offers a way for taxpayers to update that information easily, or if the Department will only consult any changes that may have been made when filing the taxpayer’s 2022 returns.

If the attempt to electronically deposit the funds fails, or if the taxpayer did not provide such routing and account information, ADOR is directed to issue the rebate check by mail to the most recent home address provided by the taxpayer.[9]

A taxpayer who does not receive his or her rebate will be able to file a separate refund claim—but the taxpayer will have to wait until November 15, 2024 to do so.  Section 4.H of the bill provides:

A taxpayer who does not receive the rebate issued pursuant to this section on or before November 15, 2024 may claim the rebate by filing a claim application online in the form and manner prescribed by the department of revenue. The claim application must include the claimant’s name, address, taxpayer identification number and individual income tax filing status. The department shall review each claim application and verify the information provided. The department may request that a claimant provide evidence to verify the claimant’s eligibility for the rebate.

Given that the Legislature calls this a “general welfare” rebate, it appears they are asking the IRS to treat these payments as excludable from income under the general welfare exception.  While it likely the IRS will treat them that way, just in case the agency doesn’t the bill provides that any amount of the rebate included in federal income will be subtracted from the taxpayer’s Arizona gross income.[10]

A floor amendment adopted prior to vote on the bill in the Senate added the following provisions regarding communications from the Department of Revenue and the Governor’s office regarding this rebate:

Any notification from the department that relates to the rebate issued under this section shall state the following: “This rebate is being issued pursuant to Senate Bill 1734, as passed by the fifty-sixth legislature, first regular session, and signed into law by the governor.” No letter relating to the Arizona families tax rebate issued under this section shall be sent from the governor’s office, be sent on the governor’s letterhead or reference the governor’s office.[11]

[1] ARS §43-1014.B.1.(a)(ii)

[2] SB1734, Fifty-sixth Legislature, First Regular Session, Section 2.A

[3] SB1734, Fifty-sixth Legislature, First Regular Session, Section 3.A

[4] SB1734, Fifty-sixth Legislature, First Regular Session, Section D and E

[5] SB1734, Fifty-sixth Legislature, First Regular Session, Section C

[6] SB1734, Fifty-sixth Legislature, First Regular Session, Section F

[7] SB1734, Fifty-sixth Legislature, First Regular Session, Section G

[8] SB1734, Fifty-sixth Legislature, First Regular Session, Section G

[9] SB1734, Fifty-sixth Legislature, First Regular Session, Section G

[10] SB1734, Fifty-sixth Legislature, First Regular Session, Section H

[11] SB1734, Fifty-sixth Legislature, First Regular Session, Section G

Arizona Individual Tax Rate to Be a Flat 2.5% Rate for 2023

On September 29, 2022, Governor Ducey sent a letter to Robert Woods, Director of the Arizona Department of Revenue,[1] reporting that the Joint Legislative Budget Committee and the Governor’s Office of Strategic Planning and Budgeting had issued a joint memo certifying that General Fund revenues in Fiscal Year 2022 were $16.7 billion, exceeding the thresholds in the statute that would allow the 2.5% flat tax rate to apply for tax years beginning in 2023.

ARS §43-1011.A.8 and 9 provide:

8. Subject to subsections E and F of this section, for taxable years beginning from and after December 31 of the year in which notice is provided to the department pursuant to section 43-243, subsection A or subsection B, paragraph 1 through December 31 of the year in which notice is provided to the department pursuant to section 43-243, subsection B, paragraph 2:

(a) In the case of a single person or a married person filing separately:

If taxable income is: The tax is:

$0 — $27,272 2.53% of taxable income

$27,273 and over $690, plus 2.75% of the amount over $27,272

(b) In the case of a married couple filing a joint return or a single person who is a head of a household:

If taxable income is: The tax is:

$0 — $54,544 2.53% of taxable income

$54,545 and over $1,380, plus 2.75% of the amount over $54,544

9. Subject to subsection F of this section, for taxable years beginning from and after December 31 of the year in which notice is provided to the department pursuant to section 43-243, subsection B, paragraph 2, the tax is 2.5% of taxable income.

ARS §43-1011.A.8 and 9

The tax rate triggers were found at ARS §43-243.A and B which provided:

A. On or before September 30, 2022, the director of the joint legislative budget committee and the director of the governor’s office of strategic planning and budgeting shall jointly notify the department whether the fiscal year 2021-2022 state general fund revenue, excluding the beginning balance, was $12,782,800,000 or more.

B. On or before September 30, 2023 and on or before September 30 of each year until the notice is provided as prescribed in subsection A of this section or paragraph 1 of this subsection, and paragraph 2 of this subsection, the director of the joint legislative budget committee and the director of the governor’s office of strategic planning and budgeting shall jointly notify the department whether the previous fiscal year state general fund revenue, excluding the beginning balance, was either of the following amounts:

1. More than $12,782,800,000 but less than $12,976,300,000.  The notice required pursuant to this paragraph is not required if the notice required pursuant to subsection A of this section was provided on or before September 30, 2022.

2. $12,976,300,000 or more.

ARS §43-243.A and B

Note that while ARS §43-243.B, which would trigger the first year Arizona would have a single 2.5% tax bracket found at ARS §43-1011.A.9, did not require a notification of meeting its target until September 30, 2023, at which point it would have measured the 2023 fiscal year and first impacted 2024 tax rates, nothing in the law prevented the certification being made earlier than that date.

Thus the rates found at ARS §43-1011.A.8 will never apply to any Arizona individual income tax year, but rather they will be bypassed for the lower rate at ARS §43-1011.A.9 in 2023 and later years.

This change in rate will also affect Arizona’s passthrough entity tax rate.  Under ARS §43-1014 the entity-level tax rate is the “same as the tax rate prescribed by section 43-1011” which means that rate will also drop to 2.5% for 2023 tax years.

[1] Governor Douglas A. Ducey, Letter to Robert Woods, Arizona Department of Revenue, “RE: Accelerated Tax Relief for Families,” September 29, 2022, https://azgovernor.gov/sites/default/files/accelerated_tax_relief_for_arizona_families_letter.pdf