Impact of Arizona Supreme Court’s Decision on SB1828 Referendum for Arizona Tax Practitioners

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.

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