Year-End Planning – Arizona Pass-through Entity State Tax Election

Tax year 2022 will be the first year eligible partnerships and S corporations will be able to elect into an Arizona pass-through entity level tax at a rate comparable to that of individual residents of Arizona. The entity level tax is assessed to and paid by the company, deducted against federal taxable income in the year paid, and provides an income tax credit to the respective partner or shareholder for their share of the tax amount. This election could provide a benefit to individual taxpayers that do not itemize or are limited by the $10,000 state and local tax deduction since the taxes paid will be deducted at the entity level rather than being a deduction at the individual level that may not provide a tax benefit in these scenarios.

The pass-through entity must elect to pay this tax and the election must be made with a timely filed income tax return, which gives entities until March or September 2023 to decide. However, in order to obtain the benefit of the state income tax deduction in the current year, the tax must be paid before December 31, 2022.  Alternatively, paying some or all of the entity’s pass-through state income tax liability in the subsequent year would result in a deduction against federal taxable income next year (so the deduction is not lost, but the benefit would be delayed).

The pass-through entity state tax is assessed to only eligible partners and shareholders. The only eligible partners or shareholders are individuals, estates, grantor and/or non-grantor trusts. ARS 43-1014(D) requires that the manager(s) of a partnership or S corporation notify all eligible partners or shareholders of the company’s intent to make the election while providing at least 60 days to opt out of the election.

The following are a few other items to consider:

• The benefit of the pass-through entity state income tax could vary greatly depending on if the company is a partnership or an S corporation;
• Nonresident eligible partners may want to consider opting out of the election;
• Cash flow for tax distributions in December versus next year and related benefit;
• The ability to lower Arizona 4^th quarter estimated taxes if estimates are paid in; and
• IRS Notice 2020-75 is unclear on the deductibility of the state tax on separately stated income tax (i.e. interest, dividends, and capital gains).

Please let us know as soon as possible if you have any questions and if you want to consider making an election on behalf of your company to pay an entity level state income tax payment BEFORE year-end. This timing is important so we can assist with estimating any tax to be paid before year-end and to ensure the notification of your partners/members/shareholders is performed timely.