United States: Arizona Enacts Several New Tax Measures

The State of Arizona adopted several significant tax measures during the 2021 legislative session, including an individual income flat tax, a high-earner tax bypass, and a federal SALT cap workaround.

Background

Currently, Arizona has four individual income tax brackets for individuals ranging from 2.59% to 4.5%. In addition, under Proposition 208, which the electorate passed in November 2020, a 3.5% state income tax surcharge (the "3.5% tax surcharge") is levied on taxable income exceeding the thresholds of $250,000 for single filers or $500,000 for joint filers (hereinafter referred to collectively as "high-income earners"). Consequently, to the extent applicable, high-income earners would be taxed at a total combined state tax rate of 8% on any income exceeding the thresholds.

Because owners of pass-through businesses, such as partnerships and S-corporations, pay income tax under the individual income tax code, rather than the corporate income tax code, this combined 8% state tax rate was deemed by many to discourage in-state investment and diminish Arizona's economic growth. Citing an effort to restore Arizona's competitiveness, legislation was enacted to make changes to Arizona's income tax system.

S.B. 1827 and S.B. 1828 - 4.5% Individual Tax Rate Cap and Individual Income Flat Tax

On June 30, 2021, Arizona Governor Doug Ducey signed into law S.B. 1827 and S. B. 1828, enacting comprehensive Arizona individual income tax reform.

SB. 1827 - Effective for tax years beginning January 1, 2021, S.B. 1827 enacts a 4.5% cap on the effective tax rate applicable to individuals who would otherwise be subject to the 3.5% tax surcharge. Given that the aggregate of the regular tax rate and the 3.5% tax surcharge is capped at 4.5%, the top income tax rate (not counting the 3.5% tax surcharge) for high-income earners effectively becomes 1%. Under this new law, to the extent applicable, high-income earners would be subject to (i) the 3.5% tax surcharge, plus (ii) an additional 1% regular income tax, so that they are subject to the 4.5% cap.

S.B. 1828 - S.B. 1828 consolidates Arizona's four individual income tax brackets and graduated rates into one flat tax rate by 2023.

The first tax rate reduction applies to tax years beginning January 1, 2022 and is not dependent on revenue triggers, unlike the subsequent tax rate reductions.

For tax years beginning January 1, 2022, the top tax rate on individuals is reduced to 2.98% for joint filers with income over $54,544 ("top-bracket earners").¹

This rate is effective until the Arizona Department of Revenue receives notice that the state general fund revenues exceed $12,782,800,000 at which point the rate is adjusted to 2.75% for top-bracket earners to take effect the following January (e.g., if the notice is provided in September 2022 the lower tax rate takes effect January 2023).²

When the Department receives notice that the state general fund revenues exceed $12,976,300,000, the state will make the final move to the 2.5% flat tax to take effect the following January.

Summary - The following tables reflect the individual income tax rate changes and the 4.5% tax cap enacted by S.B. 1828 and S.B. 1827 for both single filers and married filing jointly:

*For purposes of illustration it is presumed that the revenue triggers are met for the rate reductions as shown in tax years 2023 and 2024.

S.B. 1783 - High-Earner Tax Bypass

S.B. 1783, signed by Governor Ducey on July 9, 2021, creates a new, alternative "Small Business Income Tax" that essentially bypasses the 3.5% tax surcharge, and subjects income from certain sources to tax at a reduced rate of 3.5% in 2021, 3% in 2022, 2.8% in both 2023 and 2024 and 2.5% after 2024. This is a flat tax and not subject to the graduated rates discussed above.

The bill allows a qualifying small business taxpayer, beginning January 1, 2021, to elect to file a tax return with the Arizona Department of Revenue (ADOR) to report the taxpayer's share of Arizona small business gross income. The election is required to be made separately for each tax year and is effective by reporting Arizona small business adjusted gross income (AGI) on a timely filed Arizona small business tax return. The election can be revoked on a timely filed amended Arizona small business tax return and a corresponding Arizona individual income tax return.

To qualify for the Small Business Income Tax, an individual's federal adjusted gross income (FAGI) must include one or more of the following income sources:

• Interest and Ordinary Dividends (Schedule B)
• Profit or Loss from Business (Schedule C)
• Supplemental Income or Loss (Schedule E)
• Profit or Loss from Farming (Schedule F)
• Sale of Business Property (Form 4797)
• Farm Rental Income and Expenses (Form 4835)
• Capital Gains and Losses with Respect to the Taxable Disposition of an Ownership Interest in any Business Entity (Schedule D).

Income reported on a Schedule K-1 qualifies for the Small Business Income Tax under Schedule E. FAGI that includes other income sources, such as salaries, pensions, and social security benefits would continue to be taxed under the standard individual income tax regime.

To take advantage of the Small Business Income Tax rates, a taxpayer may end up filing two different returns: (1) the Arizona individual income tax return (e.g. Arizona Form 140) to report salary, and (2) a separate small business income tax return for the qualifying income described immediately above. For example, if an individual has $1M of FAGI in 2021, of which $800K is Schedule C income and the remainder of which is salary income, the individual will file (1) a separate small business income tax return to report the $800k of income at the reduced small business income tax rate of 3.5%, and (2) a regular Arizona individual income tax return to report the $200K of salary income which salary income would not be subject to the 3.5% tax surcharge because the tax reported on the regular Arizona individual income tax return is below the applicable threshold that must first be satisfied before the 3.5% tax surcharge becomes applicable to a single filer.

The Bill also establishes a Credit for Income Taxes Paid to Other States, allowed against Arizona small business income tax liability, for net income taxes imposed by and paid to another state or country on Arizona small business taxable income. Individual income tax credits are allowed against the Arizona small business income tax to the extent that the credit is derived from items otherwise included in computing Arizona small business gross income. The excess amount of credits claimed by an Arizona small business, to the extent that the credits exceed the Arizona small business income tax due for the tax year, may be used as a credit against the tax imposed on the small business taxpayer for individual income tax purposes.

S.B. 1783 also eliminates requirements that taxable income of estates and trusts fall under the tax rates imposed on individuals.

H.B. 2838 - Federal State and Local Tax ("SALT") Cap Workaround

The Federal Tax Cuts and Jobs Act of 2017 capped the federal deduction for state and local taxes paid by individuals to $10,000 per year for tax years beginning after December 31, 2017. As a workaround to the $10,000 SALT cap deduction many states began to enact an entity-level state tax on pass-through entities, with a corresponding state tax credit to the owners of the pass-through entity.³ An entity-level state tax bypasses the SALT cap because there is no federal SALT cap on the deduction allowed to pass-through entities for taxes imposed upon and paid by the pass-through entity.

Governor Ducey signed H.B. 2838 on July 9, 2021 which creates an Arizona entity-level tax workaround to the federal $10,000 SALT cap. For taxable years beginning from and after December 31, 2021, partnerships, limited liability companies that are taxed as partnerships,⁴ and S corporations may elect to pay a flat 4.5% tax at the entity level.

The entity-level election does not apply to partners or shareholders that are not individuals, estates, or trusts. An entity that intends to make the entity-level election must notify all partners or shareholders who are individuals, estates or trusts of the intent to make the election and that the individual, estate or trust has the right to opt out of the election. The portion of taxable income attributable to (i) a partner or shareholder that is not an individual, trust or estate or (ii) a partner or shareholder that is an individual, trust or estate that opts out of the election, is not included in the entity-level tax.

A credit to the entity's individual partners, members, or shareholders for their pro rata share of the entity-level tax is allowed against Arizona individual income tax if the individual, trust or estate did not opt out of the election In addition, an Arizona resident taxpayer is allowed an individual income tax credit for substantially similar entity-level taxes paid to another state provided that the taxable income attributable to the resident taxpayer from the pass-through entity is also subject to the Arizona entity-level tax.

For federal income tax purposes, if an entity elects to pay the entity-level tax the entity may deduct the tax paid when calculating the business income passed through to the partners and shareholders that did not opt out of the election, effectively bypassing the federal SALT cap.

Challenges to S.B. 1783, S.B. 1827 and S.B. 1828

Referendum petitions have been filed in an attempt to reverse many of the tax law changes enacted by the legislature in S.B. 1783, S. B 1827 and S.B. 1828. If the required signatures for the referendums are collected by the end of September, the referendums would appear on the November 2022 Arizona ballot and Arizona voters would have the opportunity to repeal the tax law changes. A lawsuit has been filed alleging that the referendums are unconstitutional. Until these matters are settled, their impact on the recently enacted tax law changes is unknown.

Footnotes:

1 The rate is 2.55% for joint filers with incomes of $54,544 and less.

2 The rate is 2.53% for joint filers with incomes of $54,544 and less.

3 On November 9, 2020, the IRS issued Notice 2020-75 which states that it is the intent of the IRS to promulgate regulations to allow the entity-level tax SALT cap workaround.

4 Note that single-member limited liability companies that are disregarded for income tax purposes will not be able to take advantage of this workaround.

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