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.[10] The bill takes effect from and after December 31, 2021.[11]
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.[12]
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.[13]
Example 1
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).[14]
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.”[15]
Election
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.[16]
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.[17]
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.[18]
Analysis
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.
Example 2
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.[19]
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.
Analysis
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.[20]
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.
Analysis
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.[21]
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.[22]
Analysis
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.[23]
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 small business income tax (ARS §43-1711)[24]
Analysis
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.[25]
Analysis
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.
Example 3
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.[26]
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.[27]
Analysis
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.[28]
[1] Notice 2020-75, November 9, 2020, https://www.irs.gov/pub/irs-drop/n-20-75.pdf (retrieved November 9, 2020)
[2] Notice 2020-75, Section 2.02(3)
[3] Notice 2020-75, Section 3.01
[4] Notice 2020-75, Section 3.02(2)
[5] Notice 2020-75, Section 3.02(1)
[6] Notice 2020-75, Section 3.02(1)
[7] Notice 2020-75, Section 3.02(3)
[8] Notice 2020-75, Section 3.02(4)
[9] Notice 2020-75, Section 4
[10] HB 2828, Chapter 425, Fifty-fifth Legislature, First Regular Session, July 9, 2021, https://www.azleg.gov/legtext/55leg/1R/laws/0425.htm (retrieved July 15, 2021)
[11] HB 2828, Chapter 425, Fifty-fifth Legislature, First Regular Session, July 9, 2021, Section 8
[12] ARS §43-1014.A
[13] ARS §43-1014.A
[14] ARS §43-1014.B.1
[15] ARS §43-1014.B.2
[16] ARS §43-1014.A
[17] ARS §43-1014.D
[18] ARS §43-1014.C
[19] ARS §43-1014.D
[20] ARS §43-1014.B.3 and §43-581.C
[21] ARS §43-1021.16
[22] ARS §43-1021.16
[23] ARS §43-1075.B
[24] ARS §43-1075.A
[25] ARS §43-1075.C
[26] ARS §43-1071.G
[27] ARS §43-1071.G
[28] ARS §43-1021.16
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