Arizona enacts significant individual income tax reductions

On June 30, 2021, Arizona Governor Doug Ducey signed legislation approving the fiscal year 2022 budget and corresponding tax legislation. Included in the recently signed legislation are two significant tax developments, a personal income tax reduction and rate cap on taxpayers subject to the Proposition 208 surcharge. Additionally, legislation providing a pass-through entity tax intended to mitigate the effects of the $10,000 federal state and local tax deduction limitation and an elective pass-through owner tax are pending before the governor.  

Personal income tax changes

Senate Bill 1828 implements a dramatic reduction of individual income tax burdens. The new law, effective Jan. 1, 2022, replaces the states four income tax brackets with a 2.55% rate for single filers earning up to $27,272 and a 2.98% rate for income over that amount. Those rates will be further reduced to 2.53% and 2.75%, respectively, when general fund revenue reaches $12,782,800,000 for the previous year. The two rates will be replaced by a single flat rate of 2.5% when general fund revenue exceeds $12,976,300,000.

Senate Bill 1827 establishes a capped rate levied on income subject to the 3.5% individual income tax surcharge approved through Proposition 208 last November. Accordingly, the individual income tax rate for taxpayers subject to the surcharge (single filers with income over $250,000 and joint filers with more than $500,000 of income) cannot exceed 4.5%, effective Jan. 1, 2021. For 2021, this effectively preserves the 4.5% highest rate bracket for taxpayers subject to the surcharge. For 2022, taxpayers subject to the surcharge would be capped at a flat 4.5% rate, instead of a combined rate of 6.48% (the 3.5% surcharge plus the new individual flat tax rate of 2.98%), effectively, reducing the individual income tax rate to 1%. Proposition 208 is currently being challenged in the Arizona courts. 

Elective individual income tax and elective pass-through entity tax

Senate Bill 1783 would create a new classification of income and an elective tax on that income titled the ‘small business gross income tax.’ Individuals with qualifying income may elect to pay a flat tax on qualifying small business income in lieu of the individual income tax, effective Jan. 1, 2021. For 2021, the tax rate is 3.5% and reduced annually until it reaches 2.5% in 2025. Taxpayers electing into the tax will also be subject to the standard individual income tax on any non-qualifying income. In determining adjusted gross income subject to the standard personal income tax, the individual taxpayer electing to pay tax as a qualifying small business will be allowed a deduction of income used in determining small business gross income.

Taxpayers should note that this bill creates a new classification of income taxpayer and also creates a tax rate that is different from the rates established under House Bills 1827 and 1828. Essentially, eligible taxpayers may be able to circumvent Proposition 208 surcharge by electing to be taxed under the new small business income tax regime. In addition, taxpayers electing to pay tax as a qualifying small business may create a tax rate benefit between 1.0% and 2.0% depending upon the year of election from 2021 and thereafter.

House Bill 2838 would create a workaround of the federal state and local tax (SALT) deduction limitation created by the federal Tax Cuts and Jobs Act. For years beginning after Dec. 31, 2021, a partnership, S corporation or limited liability company can elect to pay tax on its income rather than on the returns of its owners. Partners and shareholders of entities making the election will be allowed an Arizona income tax credit equal to their share of the entity level tax paid. 

Both Senate Bill 1783 and House Bill 2838 are currently before the governor and expected to be signed. If the governor does not sign or veto one or both of the bills by the 10th day following June 30, 2021, the unsigned bill(s) will automatically become law.  

Takeaways

Taxpayers should be aware that court challenges are expected to Senate Bills 1827, 1828 and 1783 as they are intended to mitigate or circumvent the 2020 voter approved Proposition 208 and its mandated 3.5% surcharge on incomes over $250,000 and $500,000 for separate and joint taxpayers.

Ignoring the existing and expected future challenges to both Proposition 208 and the discussed bills, there are many important implications Arizona individual income taxpayers should consider, especially if they are owners of pass-through entities. RSM’s WNT SALT professionals provided their opinions on the now enacted personal income tax reductions recently. 

Finally, with the anticipated adoption of the pass-through entity tax, Arizona joins a quickly increasing number of states that have adopted or are still considering the SALT deduction limit workaround. Multi-state pass-through entities will need to consider whether or not to the workaround makes sense, as it may not always. 

Taxpayers with questions about recently enacted and proposed tax legislation should consult their Arizona state and local tax advisor for more details.