Arizona to Add Elective Entity-Level Income Tax Beginning in 2022 as a SALT Cap Workaround

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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

Arizona Small Business Income Tax Sent to the Governor – How Would it Work?

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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.[1]  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.

Analysis

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.”[2]

Arizona Small Business

An Arizona small business is defined as an “activity that generates Arizona small business gross income.”[3]

Arizona Small Business Income

Arizona small business income is defined as Arizona small business gross income (discussed next) subject to the adjustments provided in the normal adjustments to Arizona gross income for an individual found in Article 3, Chapter 10, Title 43 of the Arizona Revised Statutes (ARS§§43-1021 to 43-1030).[4]

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:”[5]

  • Schedule B, Interest and Ordinary Dividends
  • Schedule C, Profit or Loss from Business
  • Schedule E, Supplemental Income or Loss
  • Schedule F, Profit or Loss from Farming
  • Form 4797, Sale of Business Property
  • Form 4835, Farm Rental Income and Expenses[6]

Such income also includes:

…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.[7]

Analysis

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).[8]

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.[9]

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.[10] 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. 

Analysis

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.”[11]

The same 90% requirement exists for those who look to rely on the filing of a federal extension.[12]

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.[13]

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.

Analysis

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.[14]

Analysis

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;[15]
  • For tax years beginning in 2022, the tax will be 3.0% of Arizona small business taxable income;[16]
  • For tax years beginning in 2023 and 2024, the tax will be 2.8% of Arizona small business taxable income; and[17]
  • For tax years beginning after December 31, 2024, the tax will be 2.5% of Arizona small business taxable income.[18]

Analysis

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.[19]

Analysis

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.[20]

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.[21]

Analysis

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.[22] 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.[23]

Analysis

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.

Nonresident Issues

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.[24]

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.”[25]  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.

Analysis

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.


[1] SB 1783, House Engrossed Bill, June 25, 2026, https://www.azleg.gov/legtext/55leg/1R/bills/SB1783H.pdf (retrieved June 26, 2021)

[2] ARS §43-104.20 as modified by SB 1783

[3] ARS §43-1701.1 as added by SB 1783

[4] ARS §43-1701.2 as added by SB 1783

[5] ARS §43-1701.3 as added by SB 1783

[6] ARS §43-1701.3 as added by SB 1783

[7] ARS §43-1701.3 as added by SB 1783

[8] ARS §43-1701.4 as added by SB 1783

[9] ARS §43-1721 as added by SB 1783

[10] ARS §43-302.A as added by SB 1783

[11] ARS §42-1107.A

[12] ARS §42-1107.B

[13] ARS §42-1107

[14] ARS §43-302.B as added by SB 1783

[15] ARS §43-1171.1 as added by SB 1783

[16] ARS §43-1171.2 as added by SB 1783

[17] ARS §43-1171.3 as added by SB 1783

[18] ARS §43-1171.4 as added by SB 1783

[19] ARS §43-1731 as added by SB 1783

[20] ARS §43-1741.A, A.1 as added by SB 1783

[21] ARS §43-1741.A.3 as added by SB 1783

[22] ARS §43-1742

[23] ARS §43-1075, §43-1742

[24] ARS §43-1751

[25] ARS §43-1702

Arizona Proposition 208 – What Does It Mean?

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.[1]

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[2] or
  • $500,000 for those filing as head of household or a married couple filing a joint return.[3]

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.[4]

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.[5]


[1] ARS §43-1013, Added by Proposition 208, 2020 General Election, November 3, 2020

[2] ARS §43-1013.A.2

[3] ARS §43-1013.A.3

[4] Proposition 208, 2020 General Election, Section 5, November 3, 2020

[5] Proposition 208, 2020 General Election, Section 7, November 3, 2020

Arizona Allows Partnership/Corporate Electronic Filing for 2019 Returns, Will Be Mandatory for 2020 Returns

The Arizona Department of Revenue announced that the agency is now accepting electronically filed corporate and partnership income tax returns.[1]  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

[1] “Electronic Filing Now Available for Corporate Taxpayers in 2020,” Arizona Department of Revenue website, January 6, 2020, (https://azdor.gov/news-events-notices/news/electronic-filing-now-available-corporate-taxpayers-2020  Retrieved January 7, 2020)

Screenwriter Subject to California Tax Even Though All Work Done in Arizona

Photo by Denise Jans on Unsplash

The California Office of Tax Appeals in the Matter of the Appeal of Blair S. Bindley, OTA Case No. 18032402[1] 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.[2]

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.[3]  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.[4]

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.[5]

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.[6]


[1] https://ota.ca.gov/wp-content/uploads/sites/54/2019/08/18032402_Bindley_Decision_OTA_053019.pdf, May 30, 2019

[2] Ibid, p. 4

[3] Ibid, pp. 4-5

[4] Ibid, pp. 5-7

[5] Ibid, p. 9

[6] Ibid

Tax Analysts Reports That Conformity Bill Has Been Signed Into Law

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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.

Arizona Legislature Passes IRC Conformity Bill, Awaits Governor’s Signature

person holding black pen
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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.[1]

Continue reading “Arizona Legislature Passes IRC Conformity Bill, Awaits Governor’s Signature”

iPad As A PDF Device For Continuing Education

I wrote last year about using the Kindle DX in CPE presentations. The DX was the a device that allowed full page viewing of PDFs, which eliminated the need for me to carry around printed manuals. It also suggested that participants might eventually have devices available that would allow the elimination of printed manuals without requiring having electric outlets available for each class participant

Continue reading “iPad As A PDF Device For Continuing Education”

Kindles and CPE Presentations – Some Thoughts

A bit of a Twitter conversation got started on using the Kindle for continuing education materials for CPAs. As I’m a CPE instructor that is actually using a Kindle DX for the presentations I give, I thought a share a few additional thoughts in a forum that allowed more than 140 characters.

I use the Kindle DX to hold the manuals I use during a full day CPE presentation. The Kindle 2, which is a smaller form factor like the original Kindle, does not show PDF files in their native format. That poses a major problem for me, since participants often want a reference to the page in their printed copy. Since the participants are still using a paper manual, I need a device that will let me see exactly what the participants see.

As well, any fancy formatting (such as tables or government forms) won’t tend to survive the reformatting when sent to the smaller device. Considering that one of Amazon’s target markets for the larger Kindle DX is the textbook market, it seems clear that, at least today, it’s the more reasonable device from a features standpoint.

That said, the support for PDF is not as robust as the support for standard Kindle books. You cannot create notes to attach to PDF files, and the Kindle reader doesn’t pay attention to bookmarks in the PDF file for navigation. As well, there is no built in zoom function. The best that a user can do is turn the device sideways, when it will go from showing a full page to showing the page full width in landscape mode. The device is built to automatically sense when the device is turned sideways, but it only reacts to such turns very slowly-at times so slowly as to make a user believe the device won’t recognize the rotation.

For participants the device would pose a couple of problems. A key one is that the Kindle DX costs $489-a significant cost that someone would have to absorb. Aside from use for CPE style textbooks, most CPAs would not have a reason to acquire the DX rather than the smaller (and cheaper) device. The Kindle 2 sells for $190 less than the DX.

As well, it’s probably only reasonable to use the Kindle for distributing CPE materials if all participants are using a Kindle. I doubt it would be practical for some participants to be using a Kindle and others to use a paper manual, at least unless the Kindle was a DX showing PDFs.

Getting materials on the Kindle also would be a bit troublesome with the current structure. There’s no easy way to “push” materials to a Kindle-remember it was designed by Amazon as a way to buy books from them. Materials that don’t originate with Amazon have to be loaded manually onto the Kindle either by emailing them to the user’s special address (for which there will be a charge) or by copying the file to the device after hooking it to the computer.

Copying a file is simple, but I doubt it will be obvious how to do it for users that aren’t computer savvy. You have to mount the Kindle as a drive using a USB connection. On Windows that means it will end up being given a drive letter that can’t be easily predicted, making “pure” step by step instructions impossible to write (on a Mac it will show up as a drive named Kindle in the Finder). As well, the PDF or Amazon book formatted file has to be copied into the documents directory on that drive.

I suspect that CPE administrators would end up spending considerable time, with the current structure, supporting participants who could not get the manual loaded onto their Kindle (presuming we’ve somehow solved the problem of getting them a device). Hopefully Amazon will come up with a “simplified” method for pushing out such materials, but for now it won’t be easy.

That said, the Kindle is a far superior device for viewing texts than a laptop. First, and most important, it doesn’t run out of power five hours after a full charge. A Kindle, because it uses e-ink, only chews up power when you turn a page-keeping a page displayed burns no power. Thus you don’t need power outlets at each desk.

Second, the display is much easier on the eyes than staring at a backlit laptop display all day for reading. Eye fatigue is a major problem when reading from backlit displays for a long period of time.

Third, the display does not wash out in bright light. Rather, it is virtually like paper in how it reacts to light-and, of course, the rooms currently being used for courses have to be ones in which paper manuals are readable.

We also have to remember that not all CPAs have laptop computers, even today. So even if texts were provided in computer friendly formats, there would be some participants that would not be able to “bring along” their computer to the course. Even for those with laptops, some are clearly not very portable. A power outlet has to be provided to each participant.

In Phoenix, another side effect that would not necessarily be very positive, is that a room full of laptops is going to generate a bunch of extra heat in the room (just touch the bottom of your laptop to see what I mean). Kindles don’t do that.

I suspect some sort of ebook reader is likely the future of all training materials. But I’m not sure we’ve yet hit the point where we have a fully workable solution-but it is one that those of us involved in CPE probably need to keep our eyes on.

We may soon, however, be at the point where it might be possible to offer an ebook manual as an option for participants. That is, they could optionally get a PDF manual in lieu of paper. The advantage to participants is they could have the material before class. And, for the organizations presenting, the advantage would be eliminating the cost of printing a physical manual.

I’m certainly not going back to hauling paper manuals in suitcases for when I am traveling to give CPE presentations. But I doubt I’ll be staring at a room full of CPAs holding Kindles looking back at me anytime soon.