Included in one of the budget bills that passed the Arizona Legislature on June 23, 2022 is a revision to the Arizona elective passthrough entity tax (PTET) that reduces the rate from its previous 4.5% to one tied to rates found in ARS §43-1011 that apply for Arizona individual income taxes.
The revised ARS §43-1014.A reads as follows:
A. For taxable years beginning from and after December 31, 2021, the partners or shareholders of a business that is treated as a partnership or S corporation for federal income tax purposes may consent to be taxed at the entity level at a tax rate that is the same as the tax rate prescribed by section 43-1011 applicable to the entire portion of its taxable income that is attributable to its resident partners or shareholders and the portion of its taxable income derived from sources within this state that is attributable to its nonresident partners or shareholders for that taxable year. The election under this subsection must be made on or before the due date or extended due date of the business’s return under this title.
Unfortunately, there is a bit of ambiguity in that reference, as ARS §43-1011 for the current taxable year provides two different rates, one for each of two brackets that apply for each filing status. ARS §43-1011.A.7 provides that:
Subject to subsections E and F of this section, For taxable years beginning from and after December 31, 2021 through 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:
(a) In the case of a single person or a married person filing separately:
If taxable income is: The tax is:
$0 – $27,272 2.55% of taxable income
$27,273 and over $695, plus 2.98% 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 2.55% of taxable income
$54,545 and over $1,391, plus 2.98% of the amount over $54,544
Presumably the intent is to set the rate at the highest marginal tax rate (2.98%) under ARS §43-1011 for the year in question, but either the Legislature will need to adopt a clarification (likely in the first session of the new legislature in 2023) and/or (more likely due to timing) the Department of Revenue will need to issue guidance clarifying the proper rate to be used.
But no matter whether the rate used is 2.55% or 2.98%, the lower rate makes it far less likely that a taxpayer’s credit for the passthrough entity tax under ARS §43-1075 will exceed the taxpayer’s Arizona income tax for 2022 or later years, something that could easily happen when the PTET rate was well above the maximum individual income tax rates that would apply for those years.
Currently the bill is on the Governor’s desk awaiting is signature. Presumably he plans to sign this bill before the state’s fiscal year ends on June 30, 2022 and the state’s authority to spend funds ends.
 HB 2871, Fifty-fifth Legislature Second Regular Session 2022, Section 15, June 23, 2022
The Arizona Supreme Court has issued an order blocking the referendum on 2021’s SB1828 from going to a vote this November and instead is now treated as enacted and effective. While the Court has not issued its opinion (that has been promised to come later), the Order stated:
The Court en banc has considered the briefs, authorities, and arguments in this appeal. The Court finds that §§ 13 and 15 of S.B. 1828 do fall within the support and maintenance exception to the Arizona Constitution, and thus may not be referred to the voters.
Impact on 2022 Tax Rates – Regular Income Tax
The most immediate impact of the decision is that now the rates are set for the 2022 income tax returns. Under SB1838, Arizona’s regular income rates for 2022 will be as follows:
Single Person or Married Filing Separately
A rate of 2.55% will apply on taxable income up to $27,272, with a rate of 2.98% that applies to taxable income in excess of that amount.
Married Couple Filing a Joint Return or Head of Household
A rate of 2.55% will apply on taxable income up to $54,544, with a rate of 2.98% that applies to taxable income in excess of that amount.
In the future the rates will drop depending on the meeting revenue targets in the bill, with the top rate dropping first to 2.75% and then to a pure flat rate of 2.5%
Impact on the Arizona Small Business Income Tax
With the maximum rate of 2.98% applying for 2022, the Arizona Small Business Income Tax now becomes a virtually irrelevant tax for 2022 as it will apply a flat rate of 3.0% to Small Business Income which is 0.02% higher than the top rate applicable under the regular tax. Thus, there is no reason to elect to pay tax at 3.0% with very limited deductions when, if the election is not made, the highest possible rate is 2.98% for a tax that comes with many more deductions.
And the situation does not improve in the future. For 2023 and 2024 the SBI rate drops to 2.8%, but it’s very likely the regular rate will fall to 2.75% for that year and then 2.5% for 2024. Finally, in 2025 the Small Business Income Tax will fall to a 2.5% rate, but that will simply make the rate equivalent to the regular rate and the SBI tax still does not allow nearly as many deductions as the regular tax.
Arizona Passthrough Entity Tax
The flat tax’s lower rate will also impact the elective Arizona Passthrough Entity Tax. The passthrough entity tax is applied at a rate of 4.5% of taxable income attributable to eligible and electing partners. As should be clear, that rate is over 50% higher than the maximum rate that will apply in 2022, and the rates are scheduled to go lower over time.
But Arizona’s version of the passthrough entity tax has another “feature” that will make this problem far worse for most partners and S corporation shareholders. Unlike most states that use the tax credit structure to give the partners and shareholders a reduced tax burden to compensate for the tax paid at the entity level, Arizona’s credit is not refundable.
Rather the taxpayer must carry any amount of this credit in excess of the tax due on the regular tax return forward for up to five years. If the taxpayer is unable to absorb the credit over that five year period, the taxpayer will have paid more in tax to the state of Arizona than would otherwise be due. And even if it can be absorbed, there are time value of money issues that also must be considered.
The nonrefundable nature of the credit also poses problems for taxpayers that regularly have wiped out most or even all of their Arizona tax liabilities by claiming the various Arizona charitable tax credits.
For taxpayers with large amounts of passthrough income compared to their taxable income, the only realistic option to use up the credit may be to skip the federal benefit of the passthrough entity tax in certain years, or hope the federal benefit of the above the line deduction for the entity level tax will be higher than the extra cash sent to the state of Arizona.
The Arizona Department of Revenue announced that it would waive penalties on the first two estimated tax payments due for the 2022 Arizona elective passthrough income tax. The agency is not yet able to accept electronic payments for this tax but expects to be able to receive such payments by September 15, 2022, the date the third estimated payment is due.
The Arizona elective passthrough entity tax is Arizona’s version of the state and local tax (SALT) workaround that the IRS blessed in Notice 2020-75 in November 2020. The passthrough entity elects to pay a tax at the entity level on all or a portion of the entity’s income, which results in a non-separately stated deduction that passes out to the shareholders on Schedule K-1 as a reduction of non-separately stated income, effectively deducting these taxes in full in computing the equity holder’s adjusted gross income.
The equity holder then gets a dollar for dollar credit against his/her Arizona income taxes, so no extra tax would be paid in the best case. Arizona’s version of the tax first applies for 2022.
The announcement begins by indicating the relief being granted:
First and second quarter Arizona estimated tax payments are not required in 2022 for partnerships or S corporations making the pass-through entity election under A.R.S. § 43-1014.
The page notes that, generally, estimated tax payments are due under the law for partnerships and S corporations making the passthrough entity tax election whose taxable income for a year exceeds $150,000:
A.R.S. § 43-1014(B)(3) requires partnerships and S corporations to pay estimated tax pursuant to A.R.S. § 43-581. A.R.S. § 43-581(C) provides that, for taxable years beginning from and after December 31, 2021, an entity that is treated as a partnership or S corporation for federal income tax purposes that elects to pay the tax under A.R.S. § 43-1014 and whose taxable income for the taxable year exceeds $150,000 in the preceding taxable year must make estimated tax payments during the taxable year in a manner consistent with how estimated individual income tax payments are made. Individuals subject to estimated tax payments in Arizona must make quarterly payments by April 15, June 15, and September 15 of the current year and January 15 of the following year.
But the page notes that the Department itself does not expect to be able to accept these estimated tax payments in time for taxpayers to make those timely first two estimated tax payments:
Because ADOR is currently unable to process electronic estimated tax payments for the new pass-through entity tax, the first two estimated tax payments of 2022 due in April and June will be waived for partnerships and S corporations subject to estimated tax payments under A.R.S. § 43-581(C). Partnership and S corporations that do not make the April and June estimated tax payments will not incur a penalty under A.R.S. § 43-1125(Q): ADOR will notify affected taxpayers of any required action needed to request abatement.
The page concludes by noting that for the third payment in September, taxpayers are only going to be required to pay 25% of their proper estimate for the year (that is, the agency is not asking taxpayers to catch up at that time):
ADOR anticipates being able to accept electronic estimated payments in time for the third quarter payment due on September 15, 2022, at which time a minimum payment of 25% of the entity’s estimated tax for the 2022 tax year will be due.
Presumably taxpayers could wait and pay the amounts that would have been due for the first two estimates with their tax returns in March of 2023 without facing a penalty from the state of Arizona. However, that may not be a smart move under federal law. Under Notice 2020-75, the above the line deduction for these entity level taxes is only allowed for taxes paid during the year in question.
 There are issues with how Arizona handles this tax and credit that raises a real risk that some or all equity holders may find that the system doesn’t actually work to achieve this break-even result. But that is a topic for another day.
 “Arizona Estimated Tax Notice for Partnerships and S Corporations Making the Pass-Through Entity Tax Election,” Arizona Department of Revenue website, March 2, 2022
 “Arizona Estimated Tax Notice for Partnerships and S Corporations Making the Pass-Through Entity Tax Election,” Arizona Department of Revenue website, March 2, 2022
 “Arizona Estimated Tax Notice for Partnerships and S Corporations Making the Pass-Through Entity Tax Election,” Arizona Department of Revenue website, March 2, 2022
 “Arizona Estimated Tax Notice for Partnerships and S Corporations Making the Pass-Through Entity Tax Election,” Arizona Department of Revenue website, March 2, 2022
In the Tax Cuts and Jobs Act (TCJA) Congress imposed a $10,000 cap for deductions of state and local taxes not related to a trade or business or a §212 activity on Schedule A. Effective in 2022 the state of Arizona will allow partnerships and S corporations to elect to pay an entity level tax for which each partner or S corporation shareholder will receive a credit against their Arizona taxes. The entity level tax was first enacted as a SALT cap workaround by the state of Connecticut shortly after the passage of the TCJA. Despite initial statements from the IRS that they agency would issue guidance rendering the workaround ineffective, the agency issued no such guidance and, in fact, in late 2020 announced Treasury would be issuing regulations that would recognize these workarounds as effective.
Arizona Entity Level Tax (ARS §43-1014)
In House Bill 2832, Chapter 425, July 9, 2021 the Arizona Legislature adopted its version of the passthrough entity tax described in Notice 2020-50. The bill takes effect from and after December 31, 2021.
Computation of the Tax
The law provides that “the partners or shareholders of a business that is treated as a partnership or S corporation for federal income tax purposes may consent to be taxed at the entity level” for the tax described at ARS §43-1014.
The tax is imposed at a 4.5% rate on:
The entire taxable income for the year that is attributable to its Arizona resident partners or shareholders and
The portion of its taxable income for the year derived from sources within Arizona that is attributable to its Arizona nonresident partners or shareholders.
ABC is an S corporation that is filing an Arizona S corporation income tax return. ABC has $100,000 of income in 2022, $75,000 of which is from Arizona sources and $25,000 of which is not Arizona source.
There are two shareholders of ABC – Al, who is an Arizona resident holding 75% of the stock and Wilma who is not an Arizona resident and holds the other 25% of the stock.
The shareholder consent and ABC elects to pay the Arizona entity-level tax for 2022. The total income ABC will pay the entity level tax on is computed as follows:
100% of income allocated to Al, Arizona resident (75% of 100,000) or $ 75,000
25% of Arizona source income allocated to Wilma, non-resident (25% of $25,000) or $18,750
Total taxable income for Arizona entity-level income tax is therefore $ 93,750
ABC’s Arizona entity-level income tax is 4.5% of $93,750, or $ 4,219.
If the election described in the next section is made, the taxable income of the entity is calculated using the standard Arizona income tax rules for individuals (under Chapter 10 of Title 43) or partnerships (under Chapter 14 of Title 43).
If the entity fails to pay the entity-level tax, the Department of Revenue “may collect the amount from the partners or shareholders based on the proportionate share of income that is attributable to each partner or shareholder for Arizona tax purposes.”
The law seems to require two steps for this tax to apply:
The partners or shareholders must consent to be taxed at the entity level and
An election must be made by the entity on or before the due date (including extensions) of the business’s Arizona income tax return.
The law does not provide any details on either how the partners’ or shareholders’ consents are to be documented, if there must be unanimous consent, if corporate and tax-exempt partners must also consent, nor any other specifics on how the entity will make this election. Rather such details will have to come from the Department of Revenue under the authority granted to the Department in this section.
Equity Holders to Whom the Election Does Not Apply
The election does not apply to:
Partners or shareholders that are not individuals, estates or trusts and
Partners or shareholders who are individuals, estates or trusts and who opt out or waive the right to opt out of the election.
The inclusion of partners or shareholders who waive the right to opt out of the election in the list of those to whom the election does not apply appears to be a drafting error. The provision is at odds with what would appear to be the intent of a partner or shareholder who formally waives the right to opt out and also directly at odds with the language found at ARS §43-1014.D that requires that a partner or shareholder who waives the right to opt out to be included in the election.
Continuing with the facts in Example 1, assume that Wilma decides to opt-out. In that case, the $18,750 that represents her Arizona source income would not be included in taxable income in computing the entity’s entity-level tax. Only the $75,000 of income allocated to Al would be subject to the tax, resulting in an entity-level tax of $3,375.
Opting Out of the Election
A single partner or shareholder can decide that while the entity may be making this election, they don’t want the election to apply to them, perhaps because they will not have any Arizona tax liability or would lose a credit for the tax paid to Arizona on their home state income tax return. Under the law such an option to opt-out must be made available to each shareholder.
A partnership or S corporation that intends to make this election:
Shall notify all partners or shareholders who are individuals, estates or trusts that they have the right to opt out of the election for their share of the income and
Shall allow at least 60-days to each such partner or shareholder to make the opt-out election.
If a partner or shareholder fails to respond within 60 days or waives the right to opt out, the partner or shareholder will be included in the election per ARS §43-1014.D.
As was noted in the section describing the equity holders to whom this election does not apply, ARS §43-1014.C provides an exactly opposite treatment for partners or shareholders who waive the right to opt-out of the election. While that appears to be a drafting error, it is part of the law as enacted and, unless changed by the Legislature, at best creates ambiguity as to the status of such a partner or shareholder.
Unless the Department of Revenue provides a clarification on how the agency will apply that text (or the text is changed by the Legislature), it would appear that partners and shareholders should be advised not to specifically waive their right to opt out, but rather just let the 60-day time period expire if they wish to be part of the election.
Although less of an issue, the law appears to first require a consent from the partners or shareholders to make the election, but then they must be offered the ability to opt-out. Hopefully the Department of Revenue will allow using a single form to consent to the entity’s election and, at the same time, indicate if the individual equity holder plans to opt out.
Estimated Taxes for Electing Entities (ARS §43-581.C)
Entities making the entity-level tax election will be required to have made payments of estimated taxes under the estimated tax rules found at ARS §43-581.
Estimated taxes will be required for an entity making the entity-level election:
If the entity’s taxable income exceeded $150,000 in the prior year and
The payments shall be made in a manner that is consistent with rules that apply to individuals.
The Department will need to clarify if the $150,000 is measured based on the taxable income reported on the Form 165 or 120S for the prior year even if no election is made, or if the $150,000 is solely the taxable income computed for the entity-level tax only. But, presumably, the relief available for individuals who owed no tax the prior year should apply even if the entity is deemed to have income in excess of $150,000 in the prior year unless the election to pay the entity-level tax was made in that prior year.
Addition to Income on the Individual Return (ARS §43-1021.16)
The key to getting a full federal tax deduction for the state taxes is that the tax is deducted in computing non-separately stated income from the partnership or S corporation, reducing the amount of income that would flow onto Schedule E and be included in adjusted gross income.
Because of that, the law provides for adding back the partner’s or shareholder’s share of the taxes deducted to Arizona gross income for Arizona income tax purposes. But it goes further and also requires adding back “similar” taxes imposed by other states—a concept that will appear again in the credit for taxes paid to other states.
The add-back provision concludes with the following sentence:
This amount shall be reflected in the partner’s or shareholder’s Arizona gross income and the Partnership’s or S corporation’s Arizona taxable income.
The intent of that sentence is not completely clear. The Department of Revenue may shed some light on what impact that sentence would have on the amount that is added back to income.
As well, this add-back may serve to put the taxpayer in worse shape than without the election if the taxpayer is both able to itemize on the Arizona return and does not have other state and local taxes of at least $10,000.
Prior to TCJA, the taxpayer would have gotten a deduction for all Arizona taxes paid as an itemized deduction. That would still be true if the taxpayer’s total state and local taxes are less than $10,000. In such a case, the taxpayer should consider opting-out of the election by giving notice to the entity during the 60-day period allowed for opting out.
Credit for Entity-Level Tax Against Title 43 Taxes (ARS §43-1075)
A credit is allowed against “taxes imposed by this title” for a partner or shareholder of an entity that elects to pay the entity-level tax. The credit is initially the amount of tax paid by the entity that is attributable to the partner’s or shareholder’s share of income taxable in Arizona.
The taxes potentially imposed that are apparently eligible to be offset with the credit would include:
The regular income tax (ARS §43-1011 for individuals, ARS §43-1301 for estates and trusts)
The income tax surcharge for public education (ARS §43-1013)
The law does not provide any order in which these taxes are offset, although the credit appears available to offset all of the taxes. Whether the Department of Revenue will provide for an ordering of the offset or if the taxpayer will be allowed to select the amount of credit used against each tax remains to be seen.
If the credit exceeds the taxes due under those provisions, the excess is carried forward for up to five years against the subsequent years’ income tax liability.
Presumably the “income tax liability” refers to all of the taxes under Title 43, though it is interesting that previously the section referred to all taxes under this title (Title 43). Again, we will need to wait and see how the Department of Revenue interprets this provision.
The fact that the credit is not refundable and has a limited life of five years means care must be taken to opt-out by an equity holder who has insufficient tax due to be offset. Even if the credit could be used in later years, the taxpayer is accelerating the payment of the tax if they don’t have a sufficiently large tax liability.
Given the large number of Arizona tax credits available, taxpayers should be asked about their intent to make tax credit donations and warned about the issues that can take place if they reduce the taxes too much. In that situation, paying the entity-level tax would be counterproductive.
Credit for Other States’ Similar Passthrough Taxes
A problem that arises with passthrough taxes involves the credit given for taxes paid by other states, as to pass muster under Notice 2020-50 (and thus accomplish the goal of working around the limit on the deduction of state and local taxes on Schedule A), the tax must be imposed on the entity. However, state provisions granting a credit for taxes paid to other states generally look only to taxes imposed upon and paid by the individual. This has the effect for out of state interest holders paying taxes to each state (directly to their home state and indirectly via the entity to the state where the passthrough entity is located) without obtaining a credit to offset either tax.
Wayne, an Arizona resident, holds a minor interest in XYZ, Inc., an S corporation operating in New Jersey. All other partners are New Jersey residents. The S corporation elects to participate in New Jersey’s optional entity level tax, the Business Activity Income Tax (BAIT). Wayne’s share of the income of the S corporation is $100,000 and his share of the BAIT is $10,000.
While Wayne gets a $10,000 tax credit against his New Jersey income tax, he pays tax on the entire $100,000 to Arizona with no tax credit for taxes paid to New Jersey. We will assume his New Jersey tax computed to be $10,000, thus is entirely offset by the tax credit. Wayne pays a 4.5% tax rate to Arizona on the income (we’ll assume he uses only the cap on combined rates), paying $4,500 to Arizona.
Had the New Jersey S corporation not made this election, Wayne’s income would have been $110,000. We’ll assume Wayne’s tax to New Jersey would have still been $10,000.
Given that the Arizona rate was well below New Jersey’s, in this scenario Wayne would have received a full credit against the $4,500 increase in Arizona tax. Even considering the extra benefit for the federal deduction at the 37% rate, Wayne is still $800 worse off than if the New Jersey S corporation had not made the BAIT election. However, the other shareholders don’t face this problem, so for them it’s a major reduction in federal taxes with no negative state tax impact.
Beginning in 2022, Arizona law will now allow a credit for taxes that the Department of Revenue considers “similar” to that imposed under the Arizona elective entity-level tax found at ARS §43-1014 (such as the New Jersey BAIT) that is subject to tax for Arizona income tax purposes.
The credit will be no more than the credit that would have been allowed had the income been taxed at the individual level and not taxed at the entity level.
Since Arizona is not taxing this income at the entity level, this appears to refer to the tax that would have been due if the income had been taxed on the other state return at the individual level.
As was mentioned earlier, these similar taxes will have to be added back to Arizona income.
The Legislature has sent to the Governor for signature SB 1783 that would create an elective Arizona Small Business Income Tax.
In SB 1783 the Arizona Legislature created the option for Arizona taxpayers to elect to file a separate tax return for the portion of their income that represents Arizona Small Business Income. Such income would be subtracted from the income reported on the electing taxpayer’s Arizona individual income tax return. The rate will be gradually reduced over a number of years, eventually falling to the new standard income tax flat rate of 2.5% found in ARS §43-1011.
Why Elect to Pay This Tax?
Initially some might wonder about this tax, as it is imposed at approximately the highest Arizona marginal tax rate (although that will eventually become a flat rate), and would require the preparation of a separate Arizona small business tax return which can create various complications. It seems the taxpayer is volunteering to do extra work in preparing an additional return and still end up with, at best, the same Arizona tax bill.
Well, the taxpayer will not have the same tax bill if the taxpayer is subject to the surcharge under ARS §43-1013 for public education. As that tax is based on Arizona taxable income, removing Arizona small business adjusted gross income from an individual’s taxable income would remove it from that tax.
This effect has not gone unnoticed by those who collected the signatures to get Proposition 208 on the ballot and, during the House vote on the bill, a motion was made to require a 75% vote to approve the bill, claiming it was an impermissible modification of Proposition 208 in violation of the Voter Protection Act of 1998 that severely restricts the Legislature’s ability to modify items enacted by the voters. That motion was overruled on a party-line vote in the House.
Thus, advisers should not be surprised to see this provision challenged in court as not having been validly passed as required by the Arizona constitution. Of course, it’s not exactly clear that this law directly violates the VPA, but it does mean we may face uncertainty about the status of this provision, much as we have over Proposition 208 itself.
It is also possible that those groups that put Proposition 208 on the ballot in 2020 via a successful signature drive may start a signature drive to refer the law to the voters at the next general election. There is a 90-day period beginning when the Legislature adjourns the session (referred to as adjourning sine die) before bills take effect (referred to as the general effective date) except for bills that contained an emergency clause and passed with a 2/3rds majority in both chambers. This bill did not have such a clause and barely passed in each chamber.
For such bills lacking emergency clause protection, the general effective date gives a period when those opposed to the law may obtain sufficient signatures to refer the bill to the voters. Due to the tight deadlines, such a petition drive would likely start almost immediately after sine die. If such a drive starts, advisers would need to watch for the following items:
Are sufficient signatures submitted by the general effective date for the session? If petitions are not submitted by that date, the law would now go into effect. While the opponents could prepare an initiative to repeal the law and gather signatures for that, in that case the law would remain in effect at least until the 2022 election results are certified.
If sufficient signatures were presented, are the petitions in compliance with state law and are there sufficient valid signatures on the petitions. Only if the petitions are found to comply with the rules for submitting such petitions and a sufficient number of signatures are found to be valid would the law’s enactment be held pending a vote. If that happens then the law would not be in effect until after the voters give the law approval or throw it out. Note that it seems likely we’d see court challenges to the validity of the signatures or petitions if the elections authorities find there are sufficient valid signatures, so it may take a while to find out for sure if there will be a referendum vote.
If there is a referendum vote, then the final answer would come when the votes are certified for the election in question.
We’ll just say that tax planning may get rather complicated as advisers will need to pay attention to the courts and the success/failure of attempts to refer some or all bills to the voters.
Due to uncertainties around this tax applying to 2021 returns, as well as Proposition 208 and the other tax changes enacted late in the session, advisers need to carefully follow the results of any court challenges, as well as any attempt to refer one or more of the Legislature’s bills to the voters. The success or failure of these various challenges to the provisions would have a major impact on the Arizona taxes due, especially for individuals with income above the cut-off for the Proposition 208 surtax.
Advisers will need to develop plans that assume various combinations of results until the outcome of these challenges is resolved. Similarly, care should be taken to delay as long as possible any actions that are being chosen assuming a specific outcome for the various challenges, just in case the ultimate result is not what the taxpayer may expect.
Definitions for the Arizona Small Business Income Tax
A number of terms are important to understand to determine which clients are eligible to consider this election, as well as which items of income and deduction would end up being reported on the separate tax return.
Small Business Taxpayer
Only small business taxpayers are eligible to make this election. ARS §43-104.20 defines a small business taxpayer as “any individual taxpayer who reports on the taxpayer’s federal income tax return any income that constitutes Arizona small business gross income as defined in section 43-1701.”
Arizona Small Business
An Arizona small business is defined as an “activity that generates Arizona small business gross income.”
Resident Taxpayers: Arizona Small Business Gross Income
For Arizona residents, Arizona small business gross income means “the sum of the amounts, whether positive or negative, that are included in a taxpayer’s federal adjusted gross income for the taxable year, computed pursuant to the Internal Revenue Code, and that are reported on the following schedules and forms or on equivalent successor schedules and forms designated by the Internal Revenue Service:”
…any amount reported on Schedule D, capital gains and losses, that is recognized with respect to either the taxable disposition of an ownership interest in any entity other than a publicly traded entity, or the taxable disposition of capital assets used in connection with a trade or business activity, including goodwill and going concern value.
Advisers must recognize that the name given to income subject to this tax can lead taxpayers and advisers to fail to include all of the income that properly belongs as items subject to this elective tax.
Although the law refers to Arizona small business income, the law does not require for a resident that such income arise from Arizona sources. So a resident taxpayer who has significant income from an out of state partnership will still find that amount included in Arizona small business income.
As well, while the capital gains included in Arizona small business income must arise from sales of non-publicly traded securities or from assets used in a trade or business, dividends and interest are not required by the statute to arise from non-publicly traded securities or accounts related to the conduct of a trade or business. Similarly, ordinary income flowing through to Schedule E from a trust or estate would not need to arise from a trade or business—so a distribution from a retirement plan that was included as part of the trust’s DNI would also become part of Arizona small business income.
Resident Taxpayers: Arizona Small Business Taxable Income
For an Arizona resident, Arizona small business taxable income means the Arizona small business adjusted gross income minus any deductions allowed in Article 3, Chapter 10, Title 43 of the Arizona Revised Statutes (the standard deduction found at ARS §43-1041 or itemized deductions found at ARS §43-1042).
Arizona Small Business Adjusted Gross Income
Arizona small business adjusted gross income will be computed by taking Arizona small business adjusted gross income and reducing it by the additions and subtractions provided in ARS §§43-1021 and 43-1022 only to the extent the subtractions directly relate to Arizona small business adjusted gross income. However, no deduction under ARS §43-1022.28 (removing Arizona small business adjusted gross income) is allowed in computing Arizona small business adjusted gross income.
Election to Be Subject to the Arizona Small Business Income Tax
A taxpayer elects to be subject to the Arizona Small Business Income Tax on a year by year basis by filing the Arizona Small Business Income Tax Return to report the taxpayer’s share of Arizona Small Business Income Gross Income on a timely basis. Thus, electing this status for one year will not automatically make the election for the following year, nor will it bind the taxpayer to making that election in a following year.
Note that if the return is not filed timely, the taxpayer will lose the ability to make the election for the year in question—thus we may need to worry about the 90% rule found in ARS §42-1107, as it states that the Department may grant an extension to file “if at least ninety per cent of the tax liability disclosed by the taxpayer’s return for the reporting period is paid and if the request for extension is received or mailed on or before the date the return is otherwise due to be filed.”
The same 90% requirement exists for those who look to rely on the filing of a federal extension.
As well, this rule appears to apply on a return by return basis. As the Arizona Small Business Income Tax Return is a distinct return, the 90% rule may need to be met on that return and, as there is no corresponding federal return, a separate Arizona extension request for the Small Business Income Tax Return may be required.
The Department does have the authority to write rules here, so the agency may use its discretion to take a broader view of what counts as an extension of time to file in this case—but, if not, this could be a major malpractice trap for CPAs.
The timing of the election could create issues if this law is referred to the voters following a successful referendum campaign. A referendum would delay enactment of the law until after votes are certified in the election where the referendum appears (presumably in November 2022, certified by the beginning of December 2022). While the law does provide a retroactive effective date, there’s still no provision for a late election and filing of the form as the law is written.
If there is a successful referendum signature drive, it is possible the Department of Revenue will provide some method to file a “placeholder” Arizona Small Business Income Tax Return for 2021 so that the taxpayer can take advantage of these rules if the voters approve the bill. If so (and only time will tell if such an option is made available), advisers will need to become aware of how such rules will work.
Similarly, the Legislature might provide some sort of mechanism in the next session to make a “late” election should the bill be approved by the voters if it is facing such a vote later in 2022.
The election to have the Arizona Small Business Income Tax apply can be revoked by simply filing amended returns.
Another potential malpractice trap exists for CPAs since while a taxpayer can retroactively remove an election to pay this tax, the statute does not allow the taxpayer to make an election on an amended return to be subject to this tax. Thus, if a later exam creates significant income that makes the election preferable, the taxpayer will not be able to make this election.
Clients should be made aware of the option to make this election, especially if a taxpayer’s income falls just below triggering the surtax and the return contains positions where it’s reasonably possible an exam might result in additional income that would push the taxpayer into the education surtax range for Arizona. The client’s decision should be documented by the CPA in such a case.
Tax Rates for the Arizona Small Business Income Tax Return
In the original version of the bill, the rate was going to be a flat 4.5% and the Senate passed the bill with this rate back in March. However, with the passage of SB 1828 in the final set of budget bills the maximum tax rates are now scheduled to be reduced. When this bill was picked up in the House at the end of the session, an amendment was made to revise the rates.
The rates will be:
For tax years beginning in 2021, the tax will be 3.5% of Arizona small business taxable income;
For tax years beginning in 2022, the tax will be 3.0% of Arizona small business taxable income;
For tax years beginning in 2023 and 2024, the tax will be 2.8% of Arizona small business taxable income; and
For tax years beginning after December 31, 2024, the tax will be 2.5% of Arizona small business taxable income.
The rates are not perfectly aligned with the highest Arizona marginal rates for the regular income tax and these rates are not subject to the revenue triggers that control the reduction in regular income taxes found in SB 1828 enacted at the same time.
Assuming the revenue targets are met in the first year they could trigger a reduction of rates for the regular income tax, the top Arizona tax rates per year would be:
2.98% for 2021 and 2022
2.53% for 2023 and
2.5% (flat rate) for 2024 and later years
Thus, until 2025 the Arizona small business income tax rate will be higher than the highest Arizona marginal income tax rate under the regular Arizona income tax rules (excluding the education surtax). From 2025 forward the rate will be the same as the flat rate, assuming revenue targets have been met by September 30, 2024.
However, the law limits deductions in computing Arizona small business adjusted gross income:
Deductions other than those deductions already reflected in the net amounts reported on the federal schedules prescribed in section 43-1701 may not be taken against Arizona small business adjusted gross income in computing Arizona small business taxable income.
The bar on additional deductions means, for instance, that Arizona small business adjusted gross income will not be reduced by the various adjustments to income, such as retirement plan contributions for partners and proprietors, the deductible portion of self-employment taxes or the self-employed health insurance deduction. This will serve to increased Arizona adjusted gross income and the deduction allowed against Arizona taxable income.
In most cases this will further reduce the amounts subject to the education surtax and have a net tax reduction, but it is possible that the subtraction may result in negative Arizona taxable income for the regular income tax in rare circumstances.
Credits for Income Taxes Paid to Other States Against Arizona Small Business Income Taxes
One consequence of removing this income from the standard Arizona income taxes is that it would create issues for the credit for taxes paid to other states to the extent that tax is paid on those categories of income included in Arizona small business adjusted gross income. The new Arizona small business income tax has been given its own credit for taxes paid to another state.
This credit only applies to income subject to the Arizona small business income tax and an income tax imposed by another state.
The credit may not exceed the proportion of the tax payable under the Arizona small business income tax as the small business income subject to tax in the other state or country and also taxable under this chapter bears to the taxpayer’s entire small business income on which the tax is imposed by this chapter.
It is not clear how this tax will be interpreted by states where an Arizona resident claims a credit on the non-resident state for taxes paid to Arizona (California, Indiana, Oregon and Virginia). It is possible those states will not allow a credit for taxes paid on an individual’s Arizona Small Business Income Tax Return, since the income would not be part of income subject to tax on the Arizona income tax return. This could complicate the election for taxpayers where most Arizona small business income originates in one of those states.
Application of Arizona Income Tax Credits Against Arizona Small Business Income Tax
Another complication introduced by the Arizona small business income tax is the ability to use the plethora of Arizona income tax credits against this income. To take care of this issue, provision is made to apply the tax credits against the Arizona small business income tax.
The credits allowed for the regular Arizona income tax (found at Chapter 10, Article 5 of Title 43 of the Arizona revised statutes) are allowed against the Arizona small business income tax to the extent the credit is derived from items otherwise included in computing Arizona small business gross income. To the extent the credits allowed by this rule exceed the tax due under the Arizona small business income tax, the excess amount of the credits claimed by the Arizona small business is allowed as a credit against the regular Arizona income tax.
How this works may depend on how the Department of Revenue interprets the language requiring the credit be derived from items otherwise included in computing Arizona small business gross income. Will the taxpayer be allowed to treat all individual credits as derived from Arizona small business gross income by allowing the taxpayer to treat any payments necessary to trigger the credit as coming from this source? Or will taxpayers have to show the items are “business related”—so that, say, the credit for a contribution to a private school tuition organization would only be allowed if the taxpayer could demonstrate a business purpose for the donation? Or would it be even stricter, limiting the credits to those that can only be obtained by a taxpayer operating a trade or business (say flowthrough S corporation corporate school tuition organization credits)?
While the law provides a mechanism to take leftover credits from this tax to be used against the taxpayer’s regular income tax liability, there’s no mechanism to allow excess individual credits to flow onto this return to offset any remaining tax due on the small business income tax return.
Regardless of any other law, the nonresident provisions of the Arizona standard income tax (found at ARS Title 43, Chapter 10, Article 6) apply in the case of nonresidents such that Arizona small business gross income includes only that portion of federal adjusted gross income that represents income from sources within this state. All standard nonresident income tax rules in that article apply to the extent the provisions directly relate to Arizona small business gross income.
Arizona Department of Revenue Authorized to Adopt Rules and Prescribe Forms
The law provides that “[t]he Department may adopt rules and publish and prescribe forms necessary to administer this chapter.” The “Department” refers to the Arizona Department of Revenue and “this chapter” refers to Chapter 17 of Title 43 of the Arizona Revised Statutes—the small business income tax provisions.
The rules and other guidance developed by the Department of Revenue for this elective tax will be important for advisers to track to be sure the Department’s view of these provisions agree with the adviser’s view of the provisions. Advisers should watch to see what indications the Department gives regarding the timing of issuing such guidance.
Another practical problem involves the filing of this form. Will the Department accept this form for electronic filing and will tax software be updated to include this form as part of the vendor’s Arizona income tax package? While most will hope those answers are yes, it is possible that the answer to one or both questions might be no.
Timing will also be an issue—as a brand new tax filing, it is possible it may take software vendors who do plan to support the filing additional time to develop and test software to allow the filing, potentially delaying the filing of returns for those who wish to make this election.
Finally, advisers will need to check and see if their vendor will calculate an optimization (the election is made if it saves tax) or if the advisers will need to manually check for each client. As well, if the software does perform an optimization advisers will want to assure there is a way to reverse the “optimized” choice if factors suggest that might be the more prudent move.
Proposition 208, on the ballot in the 2020 general election, would add a new surcharge to Arizona income taxes that is set to take effect for tax years beginning from and after December 31, 2020—or, for most taxpayers, calendar year 2021 individual tax returns.
As of the early morning following the election, the Proposition held a 135,856 vote lead with the Arizona Republic website showing 85.02% reporting (presumably election day votes in addition to the majority of the early voting ballots). While not an insurmountable lead, it is very possible that Proposition 208 will pass and thus clients will be calling about its impact.
So I’ve decided to take the risk and detail how the provision would work, assuming it actually does pass and become law. If that doesn’t happen, treat this as an analysis of a proposed law that never became law–but right now it looks like it will pass (we’ll see if we know more by later in the week).
The details of the provision are outlined below.
New ARS §43-1013.A.1 and 2 provide for the new tax. The tax applies at a rate of 3.5% on taxable income in excess of
$250,000 for single individuals or those filing married filing separately or
$500,000 for those filing as head of household or a married couple filing a joint return.
The new section reads as follows:
43-1013. Income tax surcharge for public education
A. In addition to any other tax imposed by this chapter, for taxable years beginning from and after December 31, 2020, there shall be levied, collected and paid an income tax surcharge to advance public education in this state as follows:
1. In the case of a single person or a married person filing separately, a surcharge at the rate of three and one-half percent of taxable income in excess of $250,000.
2. In the case of a married couple filing a joint return or a single person who is a head of household, a surcharge at the rate of three and one-half percent of taxable income in excess of $500,000.
B. Notwithstanding sections 42-1116 and 43-206, the department shall separately account for revenues collected pursuant to the income tax surcharge imposed by this section, and shall deposit those revenues in the student support and safety fund established by section 15-1281.
C. The income tax surcharge levied by this section must be collected regardless of whether the income tax rate brackets in this chapter are changed, replaced or eliminated by an act of the legislature.
EXAMPLE 1, MARRIED COUPLE FILING JOINT RETURN, BELOW EXEMPTION LEVEL
Wayne and Susan are a married couple filing a joint return. Their Arizona taxable income for 2021 is $450,000. Since their taxable income is less than $500,000 (the surtax level found at ARS §43-1013.A.2 for the married filing joint status), they will not face an addition to their Arizona income tax for 2021 under ARS §43-1013.
EXAMPLE 2, SINGLE INDIVIDUAL
Wilma, an unmarried individual who has a filing status of single, has Arizona taxable income of $600,000 for 2021. In addition to the regular Arizona income tax due on Wilma’s 2021 Arizona income tax return, Wilma will owe an additional surcharge under ARS §43-1013 of $12,250 (3.5% of ($600,000 – $250,000)).
EXAMPLE 3, HEAD OF HOUSEHOLD
Assume the same facts as in Example 2, except that Wilma qualifies to file as head of household. In that case, Wilma’s additional tax under ARS §43-1013 will be $3,500 (3.5% of ($600,000 – $500,000)).
EXAMPLE 4, MARRIAGE CREATING A TAX REDUCTION UNDER ARS §43-1013
Robert and Cynthia are considering getting married before the end of 2021. Robert’s Arizona taxable income if he remains unmarried at year end and files as a single individual will be $400,000, while Cynthia’s Arizona taxable income as a single individual will be $75,000. If they are married before year end their joint Arizona taxable income will be $475,000 (note, this would not have to be the case, but we will assume that for purposes of this illustration). If they are married they plan to file a joint return.
If they do not marry before the end of 2021, Robert will face a §43-1013 surcharge of $5,250 while Cynthia will not have any surcharge applied to her return.
If the couple does marry before year end, there will be no surcharge on their joint return as their taxable income will be below the surcharge level. Thus, in this case a marriage would reduce their combined surcharge.
EXAMPE 5, MARRIAGE CREATING A TAX INCREASE UNDER ARS §43-1013
The impact of marriage is a bit different in certain cases where one or both of the individuals considering marriage qualify for head of household filing status.
If we assume that Robert has a dependent that would qualify him for head of household filing status, and that Cynthia’s Arizona taxable income is $250,000 the results are a bit different. We will again assume that the couple’s joint Arizona taxable income would the total of their individual filing status taxable incomes, or $725,000 in this case.
If they do not marry before the end of 2021 there will be no §43-1013 surcharge imposed on either tax return. Robert’s taxable income of $475,000 is below the $500,000 level at which the surcharge begins to be imposed on head of household filing status taxpayers, while Cynthia’s taxable income is at the maximum level she could have as a single individual without triggering the tax.
But if the couple marries, they now will see their combined income tested against a single $500,000 Arizona taxable income level before they begin to pay a surcharge—that is, exactly the same amount as Robert was granted when filing head of household status. The joint return would see a §43-1013 tax imposed on $225,000 ($725,000 – $500,000), for a surcharge of $7,875 (3.5% of $225,000).
Special rules apply to the Department of Revenue’s rulemaking for this provision, found in Section 7 of the Proposition:
Section 7. Exemption from rulemaking
For the purposes of adopting rules to implement this act, and for twenty-four months after the effective date of this act, the department of education, the state board of education and the department of revenue are exempt from both of the following:
1. Any executive order or other directive purporting to limit or restrict the ability of the department of education, the state board of education and the department of revenue to adopt new rules.
2. The rulemaking requirements of title 41, chapters 6 and 6.1, Arizona Revised Statutes, except that each department shall provide the public with a reasonable opportunity to comment on proposed rules and shall publish otherwise-exempted rules.
 ARS §43-1013, Added by Proposition 208, 2020 General Election, November 3, 2020
The Arizona Department of Revenue announced that the agency is now accepting electronically filed corporate and partnership income tax returns. Arizona had been one of the few states, if not the only one, that could not accept electronically filed entity returns.
The news release on the website notes that while the program is voluntary for 2019 returns, beginning with 2020 returns these entities will be required to file return electronically. The statement provides:
Legislation signed into law in 2017 gives companies an e-file option in 2020 for tax year 2019 and becomes mandatory for corporations starting in 2021 for tax year 2020 returns. The 2017 legislation also initiated a multi-year phase-in period for businesses required to file and pay transaction privilege tax (TPT) electronically. In 2019, the e-filing threshold was $10,000 with 77 percent of the more than 2.1 million TPT returns filed electronically. For 2020, businesses with an annual transaction privilege tax and use tax liability of $5,000 or more during the prior calendar year, will be required to file and pay electronically. In 2021, the threshold is reduced to $500 or more during the prior calendar year.
Arizona Department of Revenue News Release – January 6, 2020
The California Office of Tax Appeals in the Matter of the Appeal
of Blair S. Bindley, OTA Case No. 18032402 ruled
that an Arizona individual who had a contract for screenwriting services for
two California LLCs had California source income on which he had to pay tax, even
though all services were performed in Arizona.
California, like many other states, has moved to pure market-based
sourcing for apportioning sales in a business setting. Under California Revenue & Taxation Code
(RT&C) §25128.7, apportionment for the vast majority of businesses with
California operations is based solely on the sales factor. RT&C §25136(a)(1) assigns a sale to California
to the extent that the purchaser of a service received the benefit of the
service in California.
In this case the taxpayer argued that he had performed all of the services in California Arizona, so he did not have a sufficient connection with California to trigger a requirement to file a return and report the income to the Franchise Tax Board.
California imposes its tax on any nonresident carrying on a business
within the state of California (RTC §18501(a)).
The OTA opinion notes that nothing in the statute requires that the
taxpayer be physically present in the state of California. The Court found that the taxpayer received income
from California LLCs, with he and his sole proprietorship deemed to be conducting
business in California, making the proprietorship’s income subject to apportionment
under California’s apportionment rules.
So now the question becomes where
did the taxpayer’s buyer receive the benefit of the services provided, not where
the taxpayer performed such services.
Under Reg. §25136-2(c)(2) provides that where a business is the taxpayer’s
customers, the place where the customer receives the benefit of the services is
determined under the following rules:
(A)The location of the benefit of the service shall be presumed to be received in this state to the extent the contract between the taxpayer [i.e., appellant] and the taxpayer’s customer[s] [i.e., Mindbender and Lakeshow] or the taxpayer’s books and records kept in the normal course of business, notwithstanding the billing address of the taxpayer’s customer, indicate the benefit of the service is in this state. This presumption may be overcome by the taxpayer or [FTB] by showing, based on a preponderance of the evidence, that the location (or locations) indicated by the contract or the taxpayer’s books and records was not the actual location where the benefit of the service was received.
(B) If neither the contract nor the taxpayer’s books and records provide the location where the benefit of the service is received, or the presumption in subparagraph (A)is overcome, then the location (or locations) where the benefit is received shall be reasonably approximated.
(C) If the location where the benefit of the service is received cannot be determined under subparagraph (A) or reasonably approximated under subparagraph (B), then the location where the benefit of the service is received shall be presumed to be in this state if the location from which the taxpayer’s customer placed the order for the service is in this state.
(D)If the location where the benefit of the service is received cannot be determined pursuant to subparagraphs (A), (B), or (C), then the benefit of the service shall be in this state if the taxpayer’s customer’s billing address is in this state.
The OTA opinion applies these rules,
coming to the determination that since the LLCs are registered and located in California,
the second test is met, with the benefit received in California:
Public records from the California Secretary of State provided by FTB show that both Mindbender and Lakeshow are registered and located in California. Moreover, appellant’s contracts with Mindbender and Lakeshow both list California addresses. Appellant also concedes that Mindbender and Lakeshow are California LLCs. Based on the evidence in the appeal record, we find that it was both reasonable and rational for FTB to conclude that both LLCs received the benefit of appellant’s services within California. Because we have determined that the LLCs received the benefit of appellant’s services in California under Regulation section 25136-2(b)(2)(B), there is no need to discuss the remaining cascading rules.
The opinion summarized the
findings as follows:
In sum, pursuant to the provisions of the UDITPA relating to the sale of services and the regulations thereunder, appellant’s physical presence does not determine whether he had income derived from California, but rather it is determined by where the benefits of appellant’s services were received.
Not there was much question about the issue, but State Tax Notes (“Arizona Enacts Remote Seller, IRC Conformity Law,” State Tax Notes, June 4, 2019) reported this morning that Governor Ducey signed the income tax conformity/nexus tax bill (HB 2757) into law. The law, now designated as Chapter 273, Session Laws, 54th Legislature, First Regular Session, will go into effect absent the highly unlikely situation that a referendum petition is taken out and is successful regarding this law.
Although it took much longer than normal, and there was much uncertainty about what the Legislature would ultimately do in the end, the Legislature managed to pass an IRC conformity bill as part of the budget process.
HB 2757 scraped through both chambers with the bare minimum number of votes to clear each chamber. It is expected that the Governor will sign this bill.