Arizona Small Business Income Tax
After Proposition 208 passed in the fall of 2020 an education surtax of 3.5% came into effect for 2021 on Married Filing Jointly taxpayers with taxable income exceeding $500,000 (MFJ) or single taxpayers with taxable income exceeding $250,000. Since then, the Arizona Legislature has passed HB 1783 which is intended to mitigate the Prop. 208 effects by shielding Arizona small business income from the education surtax. This law creates a flat 3.5% tax on Arizona small business income, then allows taxpayers to remove that income from regular state taxable income. The 2022 rate is 3.0% before dipping to 2.8% in 2023-2024. For 2025 and after this rate is 2.5%.
Small Business Income “SBI” can be comprised of a variety of income types. The income does not need to come from Arizona sources (for AZ residents) to qualify as SBI. It’s not required that the taxpayer own a business to claim SBI. The following are considered SBI:
- Interest and Ordinary Dividends (Schedule B),
- Profit or Loss from Business (Schedule C),
- Rental Income or Loss (Schedule E),
- Partnership, S-Corporation, Trust K-1 income (Schedule E),
- Profit or Loss from Farming (Schedule F),
- Sale of Business Property (Form 4797),
- Farm Rental Income and Expenses (Form 4835), or
- Capital Gains and Losses on Disposal of non-publicly traded entities.
- Capital Gains and Losses on sales of capital assets used in connection with a trade or business activity.
Wages are not part of SBI and neither are pensions or social security income.
This is effectively done by filing Form 140-SBI and attaching it to a taxpayer’s Form 140 individual income tax return. This is a separate form and the rules do not allow for Form 140 estimated tax payments to be applied towards the 140-SBI tax liability. If pursuing the AZ SBIT a taxpayer who has made estimated tax payments throughout the year might have an overpayment on Form 140 and owe tax with the Form 140-SBI.
Arizona Pass-Through Entity-Level Tax
HB 2838 allows pass-through entities to lower their federal taxable income and thus state taxable income by electing to pay the owner’s share of taxes at the business level. Some quick facts about this bill that sometimes is commonly referred to as the “SALT Cap Workaround”:
- Only available to partners/principals who are individuals, estates, or trusts can elect to pay the entity-level tax on their share of income.
- The entity must notify all partners/principals of intent to make an election, and then begins a sixty-day period to opt-out of the election.
- The portion of PTE income that is attributable to partner/principal who is not an individual, estate, or trust (or who opts out) is not included in the entity-level tax.
- Caution for S-Corporations – if a principal opts out then it could cause disproportionate benefits for the principals and cause a second class of stock which would then cause a termination of the S-Election.
This is effective after 12/31/21. Starting in 2022 a nonrefundable credit will be offered for similar taxes paid to other states. There will be a five-year carryforward period. For these entity-level taxes to be deducted in a given year, the payment must be made before 12/31 regardless of whether a taxpayer is an accrual or cash basis taxpayer.
Importantly, for 2021 if a taxpayer elects PTE level taxes to be paid to other states it will not get a credit in Arizona due to the language about the effective date.
With these new state laws, it’s important to consider facts, circumstances, and a variety of other factors in deciding whether to pursue the 140-SBI favorable tax rate on small business income or electing to pay the pass-through entity level tax. Due to the complexity and personal nature of each set of facts and circumstances, it is recommended you consult with your tax advisor regarding the appropriate tax planning and preparation of tax forms that will be needed.