Tag: news

An All Too Familiar Conformity Issue for Arizona Tax Professionals

“ADOR Outlines Executive Order and 2025 Tax Year Income Tax Forms,” Arizona Department of Revenue mailing list, January 22, 2026

As we prepare for the 2025 filing season, Arizona tax professionals who may be new to the Arizona specific quirks of annual conformity find themselves in a unique procedural posture for filing tax returns. However, as those who been in practice for many years in Arizona knows, a federal bill passing during the year with significant changes that, if adopted in full by Arizona would result in a substantial reduction in revenue, generally means that the conformity answer won’t likely be settled until after the April 15, 2027 unextended filing deadline.

Arizona Department of Revenue and Tax Forms

The Arizona Department of Revenue (ADOR) has issued individual income tax forms for the 2025 Tax Year that assume conformity with federal tax changes and incorporate state-level executive directives before they are officially enacted into law. This presents a technical non-conformity issue. Arizona’s tax law typically references federal values, such as adjusted gross income or itemized deduction computations, based on federal law as it stood on January 1, 2025. However, the federal “One Big Beautiful Bill Act” was not enacted until July 4, 2026, meaning the current ADOR forms anticipate federal law that post-dates Arizona’s current statutory reference date.

The Arizona Department of Revenue (ADOR) conventionally publishes tax forms based on this simplifying assumption, a practice that may seem unconventional to tax professionals outside of Arizona. This is because the state legislature historically does not adopt tax conformity—especially in years with a significant revenue impact—until the final budget bill is passed at the end of the regular legislative session. Based on past experience, this typically occurs well after the April 15 filing deadline. Most often either the Legislature and Governor agree to conform to all federal changes or only fail to conform to a limited number of items, so this default allows returns to be filed in a timely manner while limiting the number of taxpayers that must later amend their returns.

This article outlines the technical guidance provided by ADOR regarding the filing of 2025 returns and analyzes the specific provisions introduced by Governor Hobbs’ Executive Order 2025-15. Practitioners must understand the “file now, potentially amend later” stance taken by the Department and the specific tax relief measures currently embedded in the forms.

The “Presumed Conformity” Approach

Historically, ADOR has issued forms based on the assumption that the Arizona Legislature will conform to Internal Revenue Code (IRC) changes made in the prior year. For the 2025 tax year, this practice has been codified and expanded via Executive Order (EO) 2025-15.

The Department has explicitly stated that the 2025 forms reflect a “regular process of assuming conformity” to the IRC. The primary driver for this early release is the federal enactment of Public Law No. 119-21 (“H.R. 1”) in July 2025. Because Arizona law mandates Federal Adjusted Gross Income (FAGI) as the starting point for state income tax calculations, ADOR determined that failing to update forms to align with federal changes would disrupt the filing process for practitioners and taxpayers alike.

The specific concern cited by the Executive is the standard deduction. Since tax year 2019, Arizona has conformed to the federal standard deduction. The Governor’s office noted that H.R. 1 includes a higher standard deduction for tax year 2025. Without the Executive Order directing ADOR to update the forms to match this federal amount, approximately 90% of Arizona taxpayers (those claiming the standard deduction) would face immediate non-conformity, resulting in potential confusion and administrative rework.

The “Middle Class Tax Cuts Package” (The Governor’s Position)

Beyond standard IRC conformity, the 2025 forms include specific subtractions derived directly from Governor Hobbs’ Executive Order. The EO identifies these as the “Middle Class Tax Cuts Package”.

Practitioners should note that the 2025 forms currently allow for the following five specific provisions:

  1. Increased Standard Deduction: Matching the levels contemplated in H.R. 1,.
  2. Subtraction for Seniors: The EO specifies this as an “additional deduction of $6,000 for Arizonans aged 65 and older”. ADOR guidance confirms this subtraction is present on the released forms.
  3. Subtraction for Qualified Tip Income: Included as a specific line item subtraction,.
  4. Subtraction for Qualified Overtime Compensation: Included to provide relief for hourly workers,.
  5. Subtraction for Qualified Vehicle Loan Interest: This allows for the deduction of qualifying car loan interest,.

Incorporating these specific federal changes into the 2025 Arizona tax forms constitutes a departure from established practice. Typically, a bill solely advancing the Arizona conformity date to January 1, 2026, would not include these items in calculating Arizona taxable income.

Arizona utilizes its own distinct standard deduction, which is similar to, but not identical to, the federal standard deduction as it existed prior to the 2025 Tax Cuts and Jobs Act. Furthermore, the last four provisions listed do not impact federal Adjusted Gross Income (AGI) and are not treated as itemized deductions. Instead, they operate to reduce taxable income in a manner akin to the IRC §199A qualified business income deduction, which is never permitted for Arizona tax purposes. Their function is exclusively to be used in calculating federal taxable income pursuant to IRC §83.

It is important to recognize that while H.R. 1 reduced taxes for top earners and altered federal credits, ADOR’s forms only adopt the changes affecting FAGI and the specific relief measures directed by the Governor. Federal credits found in H.R. 1 that do not impact FAGI are not included on the Arizona forms.

Filing Guidance and Amendment Risks Given Subsequent Legislative Action

The most pressing question for CPAs is procedural: Should we hold returns until the Legislature convenes in January 2026?

ADOR’s guidance is unequivocal: No. Taxpayers should not wait to file.

However, this creates a distinct risk of bifurcation between the Executive’s forms and the Legislature’s eventual statutes. If the Legislature passes a conformity bill consistent with the forms released by ADOR, no further action will be required.

Conversely, if the Legislature does not approve these specific provisions, or passes a conformity bill that differs from the Governor’s EO (such as the provisions contemplated in SB 1106), taxpayers who utilized these subtractions may need to file amended returns.

The Legislature has passed a conformity bill that differs significantly from the Governor’s proposed Middle Class Tax Cut bill. The Governor subsequently vetoed the passed bill, and an override is highly improbable because the vote was strictly partisan. This situation arose following the issuance of the EO.

Penalty Relief Safe Harbor

Anticipating the potential need for mass amendments, ADOR has established a safe harbor for taxpayers caught between the Executive Order and Legislative action.

If a taxpayer files a 2025 return utilizing the provisions in the current forms, and those provisions are later deemed inconsistent with the final law passed by the Legislature:

  • ADOR will provide specific guidance on how to amend.
  • Taxpayers will not be subject to penalties or interest, provided the amended return is filed by October 15, 2027.

Conclusion

The release of the 2025 forms represents a strategic administrative move to prevent the “costly rework” of millions of returns regarding the standard deduction. However, by including the specific “Middle Class Tax Cuts” (senior, tip, overtime, and vehicle loan subtractions) prior to legislative approval, the Department has shifted the burden of monitoring legislative developments to the practitioner community.

We are advised to prepare 2025 returns using the forms as issued, taking advantage of the increased standard deduction and new subtractions where applicable. However, client communication letters should likely include a caveat regarding the pending legislative session and the remote possibility of a required amendment should the Legislature reject the Governor’s tax package.

Key Takeaway:

Per the Department of Revenue, tax professionals should:

  • File with Current Forms: Ensure all filings utilize the most up-to-date forms.
  • Monitor Legislation: Closely watch the 2026 Legislative Session for changes to Arizona’s conformity related to H.R. 1 and any subtraction modifications proposed by the Governor.
  • Utilize Safe Harbor: Rely on the October 15, 2027, safe harbor provision, which is anticipated to be necessary in the likely case where the final legislation differs from the Governor’s Middle Class Tax Cuts Proposal.

Prepared with assistance from NotebookLM.

The Statutory Void: How Sirius and Norwood Could Combine to Create Automatic SE Tax Liability for LLC Members

The Fifth Circuit’s recent decision in Sirius Solutions, L.L.L.P. v. Commissioner, No. 24-60240 (5th Cir. 2026), creates a strict textualist framework for the self-employment (SE) tax exclusion under I.R.C. § 1402(a)(13) for cases that would be appealed to the Fifth Circuit Court of Appeals.

While this decision provides a safe harbor for state-law limited partners, it simultaneously dismantles the functional analysis test that Limited Liability Company (LLC) members have historically relied upon to claim the exclusion. When the strict textual definition of “limited partner” adopted in Sirius is combined with the Tax Court’s precedent in Norwood v. Commissioner, a dangerous syllogism emerges: LLC members, lacking the specific state-law title required by the Fifth Circuit, may default to the general rule of inclusion regardless of their participation levels.

The General Rule of Inclusion: The Norwood Principle

To understand the risk posed by Sirius, one must first revisit the baseline established in Norwood v. Commissioner, T.C. Memo 2000-84. In that case, the Tax Court addressed the SE tax liability of a general partner in a medical supply partnership who spent only 41 hours on partnership matters during the tax year. The taxpayer argued that because his interest was passive, his distributive share should be exempt from SE tax.

The Tax Court rejected this argument, establishing a bright-line rule: unless a partner falls within the specific statutory exception for limited partners, their distributive share of trade or business income is subject to SE tax under Section 1402(a). The court held that the taxpayer’s “lack of participation in or control over the operations of [the partnership] does not turn his general partnership interest into a limited partnership interest”.

Crucially, Norwood established that for partners falling outside the specific Section 1402(a)(13) exception, economic reality regarding participation is irrelevant. The court stated: “That petitioner spent a minimal amount of time engaged in the operations of [the partnership] is irrelevant to this determination… [The distributive share is] subject to the taxes imposed by section 1401 on self-employment income… regardless of whether [the partner’s] involvement is passive or active”.

The Sirius Trap: Narrowing the Exception to State-Law Labels

Prior to Sirius, LLC members navigated the Norwood inclusion rule by arguing that, functionally, they occupied a position analogous to limited partners. However, the Fifth Circuit’s decision in Sirius Solutions ostensibly forecloses this “functional equivalent” argument by insisting on a strict adherence to the text of the 1977 statute.

In Sirius, the Fifth Circuit held that the “limited partner” exception applies only to a specific legal status. The Court declared: “When § 1402(a)(13) says ’limited partner,’ it is referring to a limited partner in a state-law limited partnership that has limited liability”. The opinion emphasizes that the “touchstone of a ’limited partner’ in 1977 was limited liability”, but inextricably links this liability protection to the specific entity format of a limited partnership.

While the Sirius court noted in a footnote that “we do not discuss whether members of another entity, such as an LLP or LLC, may also qualify for the limited partner exception”, the logic of the opinion presents a severe obstacle for LLC members. The Court expressly rejected the Tax Court’s approach of inquiring into the “functions and roles” of the partners. Instead, the Fifth Circuit vacated the lower court’s decision because it relied on an “erroneous passive investor rule”.

The Intersection: Why LLC Members May Be Left with No Defense

The combination of Norwood and Sirius leaves LLC members in a statutory void.

First, under Sirius, an LLC member cannot claim the Section 1402(a)(13) exclusion based on the plain text. An LLC member is not a “limited partner in a state-law limited partnership”. The Norwood court explicitly addressed the necessity of proper form, stating: “A limited partnership must be created in the form prescribed by State law”. Since an LLC is not a limited partnership under state law, the member fails the threshold definition established by the Fifth Circuit.

Second, the “functional analysis” escape hatch has been welded shut. In the past, an LLC member might have argued, “I act like a limited partner, so treat me as one.” However, Sirius explicitly condemns the IRS and Tax Court for applying a test that balances an “infinite number of factors in performing its ’functional analysis test’”. If the Fifth Circuit refuses to look at the “functions and roles” of a partner to grant the exclusion to a state-law limited partner, it is difficult to see how they would apply a functional test to grant the exclusion to an LLC member who lacks the requisite statutory title.

The Consequence: Irrelevance of Participation Level

If an LLC member cannot qualify as a “limited partner” under the Sirius definition, they revert to the general rule of Section 1402(a). Here, Norwood dictates the outcome.

In Norwood, the court held that because the taxpayer was not a limited partner, his income was subject to SE tax “regardless of whether [his] involvement is passive or active”. The court explicitly stated that the “passive activity rules under section 469 have no application in this case” regarding SE tax liability.

Norwood based its decision on the logic that the general rule of the first paragraph of IRC §1402(a) tells us partners pay self-employment tax on income from a trade or business carried on the partnership. It states:

(a) Net earnings from self-employment. The term “net earnings from self-employment” means the gross income derived by an individual from any trade or business carried on by such individual, less the deductions allowed by this subtitle which are attributable to such trade or business, plus his distributive share (whether or not distributed) of income or loss described in section 702(a)(8) from any trade or business carried on by a partnership of which he is a member (emphasis added);…

To avoid this result, a partner needs to look to the exceptions found enumerated in the remainder of IRC §1402(a), of which IRC §1402(a)(13) provides the limited partner exception found in this case.

While the Tax Court in Renkemeyer, Campbell & Weaver, LLP v. Commissioner, 136 TC 137, effectively reversed the Norwood analysis as applied to LLCs, the Fifth Circuit panel clearly states that the functional analysis the court turned to in Renkemeyer is not an appropriate inquiry to define the “limited partner, as such” in IRC §1402(a)(13).

Therefore, applying the Sirius logic to an LLC member results in the following position:

  1. The LLC member is not a “limited partner” because they are not in a state-law limited partnership.
  2. The LLC member cannot use a “functional analysis” to prove they are a limited partner, as that test is erroneous.
  3. Without the Section 1402(a)(13) exclusion, the member is subject to the general rule of Section 1402(a).
  4. Under the general rule (Norwood and the plain text of IRC Section 1402(a)’s first paragraph), the member’s distributive share is fully subject to SE tax, even if they spent zero hours working for the entity.

Conclusion

While Sirius Solutions is a victory for traditional limited partnerships, it creates a high-stakes environment for LLCs electing partnership taxation. By defining “limited partner” strictly by reference to state-law limited partnerships and rejecting functional inquiries, the Fifth Circuit may have inadvertently subjected all LLC members to the Norwood regime: automatic SE tax liability on all trade or business income, regardless of whether the member is a passive investor or an active manager. As the Sirius court noted, “state law creates legal interests… but the federal statute determines when and how they shall be taxed”. Without the specific state-law interest of a “limited partnership,” LLC members currently lack a judicially recognized shield against self-employment tax in the Fifth Circuit.

Prepared with assistance from NotebookLM.