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
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