August 18, 2021
Arizona joins list of states enacting an elective entity-level tax for pass-throughs
Recently enacted law (Az. Laws 2021, ch. 425 (HB 2838)) establishes an elective entity-level tax for pass-through entities. The new law allows Arizona taxpayers whose business is treated as a partnership or S corporation for federal income tax purposes (hereafter, a PTE) to receive a credit for their share of the PTE-level state and local taxes deducted by partnerships and S corporations. With this credit, the taxpayers could exceed the $10,000 state and local tax deduction limitation imposed by IRC Section 164(b)(6) (the SALT deduction limitation), consistent with IRS Notice 2020-75 (see Tax Alert 2021-0092).
Effective for tax years beginning from and after December 31, 2021, partners, members or shareholders of a PTE may consent to be taxed at the entity level (PTE tax). A 4.5% rate applies to the entire portion of the entity's taxable income that is attributable to its resident partners, members, or shareholders and to the portion of its taxable income that is derived from in-state sources and attributable to its nonresident partners or shareholders for that tax year. If an election is made, all of the following apply:
The PTE tax election does not apply to (1) partners or shareholders that are not individuals, estates or trusts; or (2) partners or shareholders that are individuals, estates or trusts and opt out of, or waive the right to opt of, the election. The portion of taxable income attributable to such partners or shareholders is not included in the PTE-level tax.
Taxpayers, in determining Arizona gross income, must add back state taxes that the PTE deducted for federal income tax purposes, as well as taxes that the AZ DOR identified as substantially similar to Arizona's PTE tax. Arizona's credit for income tax paid to other states is modified so a resident taxpayer may claim the credit for taxes that are imposed by other states and determined by the AZ DOR to be substantially similar to the state's PTE. This credit cannot exceed the amount that would have been allowed if the income were taxed at the individual level, not the entity level. A credit also applies against the entity-level income tax for a taxpayer who is a partner, member or shareholder of a PTE that elects to pay the PTE tax. The credit equals the portion of the tax that is paid by the PTE and attributable to the partner's, member's or shareholder's share of income taxable in Arizona. If the credit exceeds the taxes otherwise due, or if no taxes are due, the unused credit can be carried forward for up to five consecutive tax years.
The PTE election must be made by the due date, or extended due date, of the PTE's return. PTEs intending to make the election must notify all partners, members or shareholders of (1) its intent to make the election; and (2) their right to opt out of the election. Partners, members and shareholders have at least 60 days after receiving the notice to notify the PTE that they are opting out of the PTE election. Partners, members and shareholders who do not timely respond to waive the right to opt out will be included in the PTE election. PTEs making the election to pay the PTE tax and whose taxable income exceeded $150,000 in the prior year must make estimated tax payments in the same manner as individuals.
The new law further authorizes the AZ DOR to adopt rules and issue forms and procedures necessary to administer the new elective PTE tax.
In November 2020, the IRS indicated its intention in Notice 2020-75 to propose regulations clarifying that a partnership or an S corporation computing non-separately stated taxable income or loss for federal income tax purposes could deduct state and local income taxes imposed on its net income for the tax year at issue without regard to the SALT deduction limitation (see Tax Alert 2020-2690). Those regulations have yet to be proposed. In light of the IRS's announcement, some states have enacted an entity-level tax to provide the federal tax benefit to PTE owners in their states.1 Arizona now joins these states. Other states continue to propose similar legislation.2
Arizona's PTE tax provisions are unique to Arizona but share similarities with those enacted by other states. PTEs considering this election in Arizona, and other states, will need to determine whether they may make the election in Arizona and, if so, whether making the election would be worthwhile. The AZ DOR is authorized to issue rules, forms and procedures necessary to implement the new PTE tax law. It is unclear when that guidance will be made available.
1 Before IRS Notice 2020-75 was issued, Connecticut, Louisiana, Maryland, New Jersey, Oklahoma, Rhode Island and Wisconsin had already enacted mandatory or elective PTE taxes similar to the one now enacted by Arizona.
2 After IRS Notice 2020-75 was issued, Alabama, Arizona, Arkansas, California, Colorado, Georgia, Idaho, Minnesota, New York, Oregon and South Carolina enacted similar PTE-level taxes. In addition, a similar elective PTE bill is pending before the governor of Illinois. Bills were vetoed in Michigan and Massachusetts. Bills that would implement a similar elective PTE tax are currently being considered in North Carolina and Pennsylvania.