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
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