2021 Arizona Tax Law Changes

The Arizona legislature and Governor Doug Ducey passed some significant changes to Arizona tax law in 2021, some of which were designed to circumvent provisions of voter-approved Proposition 208. In November 2020, Arizona voters narrowly approved Proposition 208, a law imposing an income tax surcharge on Arizona’s wealthier citizens to help fund public education. Prop 208 effectively created a new top marginal tax rate of 8 percent. In Arizona, voter approval is required to change or repeal citizen-initiated state statutes, so Ducey and lawmakers created some workarounds. Following is a summary of some of the 2021 tax law changes.

Ceiling on top individual income tax rate imposed

Arizona Senate Bill 1827 was signed into law by Governor Ducey on June 30, 2021. Most notably, it provides that as of January 1, 2021, the combined tax rate of the 3.5 percent income tax surcharge and the highest income tax rate imposed on individuals cannot exceed 4.5 percent. For 2021, this preserves the 4.5 percent highest tax bracket. For 2022 and following years, it reduces the individual income tax rate to as low as 1 percent, keeping the total tax rate to 4.5 percent or lower.

Change in individual income tax rates

Arizona Senate Bill 1828 was also signed into law by Governor Doug Ducey on June 30, 2021. Among other provisions, the bill made changes to Arizona’s individual income tax rates. Beginning January 1, 2022, Arizona’s four tax brackets will be replaced by two.

Tax rates for single and married persons filing separately:

$0 - $27,272                                        2.55 percent of taxable income

$27,273 and over                                $695 plus 2.98 percent of the amount over $27,272

For married filing a joint return or Head of Household:

$0 - $54,544                                        2.55 percent of taxable income

$54,545 and over                                $1,391 plus 2.98 percent of the amount over $54,544

These rates will be further reduced when the Arizona general fund reaches more than $12,782,800,000 and, the two rates will be replaced by a single flat rate of 2.5 percent when general fund revenue exceeds $12,976,300,000. In January 2021, the Governor’s Office of Strategic Planning and Budgeting projected that the general fund revenues would exceed the later amount in fiscal year 2024.

Change in tax rates for estates and trusts

Senate Bill 1783 removes the current requirement to tax the income of estates and trusts at the rates imposed on single individuals. Beginning January 1, 2022, the four estate and trust tax brackets will be reduced to two. The top tax rates will drop incrementally from 4.5 percent to 2.75 percent as the balance in the state’s general fund revenue reaches the amounts established by SB 1828.

Arizona small business income tax established

Senate Bill 1783 also creates a new classification of income to be reported on the new Arizona small business tax return. Currently, the income of partnerships and S corporations is passed through to business owners and taxed on the owners’ individual income tax returns. Under the new law, small business owners can elect to have the business income taxed at the level of the business itself. This provision is retroactive to January 1, 2021. The election is made each tax year by filing the Arizona small business tax return. The election can be revoked by filing an amended Arizona small business tax return and a corresponding Arizona individual income tax return. The annual election will allow business owners to choose the most advantageous level of tax for any given year.

SB 1783 prescribes the small business income tax rate for:

  1. a) Tax year 2021 as 3.5% of taxable income;
  2. b) Tax year 2022 as 3.0% of taxable income;
  3. c) Tax years 2023 and 2024 as 2.8% of taxable income; and
  4. d) Tax year 2025 and each year thereafter as 2.5% of taxable income.

Workaround for limits on state and local taxes

In 2019, the amount of state and local taxes (SALT) individual taxpayers could deduct on their federal income tax returns was capped at $10,000. Since then, many states, including Arizona, have looked for ways to allow their citizens to deduct more than this amount.

House Bill 2838, also signed into law on June 30, 2021, allows owners of partnerships, S corporations, and limited liability companies to take a credit against their individual income tax payment if they elect to pay additional state tax at the business level. The entity level tax substitutes for the individual’s income tax payment which would have been subject to the $10,000 cap. Since the SALT deduction cap does not apply to business taxes, this effectively allows business owners to avoid the cap.

This Arizona provision is effective for tax years beginning after December 31, 2021. The IRS has agreed that state laws allowing this tactic are permitted.

Arizona’s new tax laws allow for plenty of tax planning for 2021, but Proposition 208 and the new Arizona tax laws are controversial and may be subject to changes as litigation and talk of a referendum go on. Come talk to one of our tax professionals if you would like to discuss some possible tax-saving strategies.

About this Author

Susan is experienced in tax research, not-for-profit taxation, trusts and estates, and sales tax. She has prepared tax returns for pubic charities, private foundations, and charitable trusts as well as unrelated business income tax returns for numerous charities.