Arizona’s Tax Cut: What the Flat Tax Means for You

Arizona has shifted its income tax structure from a progressive system, where tax rates increased with income, to a single, flat rate for all individual taxpayers. The new tax law establishes a single individual income tax rate of 2.5 percent for all taxpayers, regardless of their income level. This reform, which took full effect in January 2023, replaced a multi-bracket, progressive system.

Understanding Arizona’s Flat Tax

The previous system featured multiple tax brackets with rates that increased as income rose. For tax year 2021, rates ranged from 2.59% to 4.5%. A voter-approved measure, Proposition 208, had also introduced a 3.5% surcharge on high-income earners to fund education, which would have created a top marginal rate of 8%. Subsequent legislative action and court rulings nullified this surcharge, paving the way for the flat tax structure.

This legislative path involved several bills, with Senate Bill 1828 being the one that outlined the framework for collapsing the state’s marginal income tax brackets into the single 2.5% rate.

Calculating Your Individual Tax Liability

The transition to a 2.5% flat tax simplifies how Arizonans calculate their state income tax. The calculation is now Arizona’s adjusted gross income multiplied by 2.5%, before accounting for any credits. This single calculation replaces the previous need to determine which of several income brackets applied to different portions of income.

Consider a single individual with an annual taxable income of $50,000. Under a prior-year structure with multiple brackets, their liability would have been approximately $1,386. With the new 2.5% flat tax, the same individual’s liability is now $1,250. The effect is different at higher income levels, as an individual with $100,000 in taxable income would see their liability fall from around $3,200 to a straightforward $2,500.

The change is more pronounced for a high-income earner with $250,000 in taxable income. Under the old progressive system, a large portion of their income would have been subject to the highest marginal rate of 4.5%, resulting in a total state tax liability approaching $10,000. With the 2.5% flat tax, their liability on the same $250,000 is now $6,250.

Adjustments to Family Tax Credits

The tax reform package also increased the dependent tax credit to provide relief for families. The law established a non-refundable credit of $100 for each dependent under the age of 17. To claim the credit, a taxpayer must meet the same general qualifications used for federal purposes, which involves providing more than half of the dependent’s support and having them live with the taxpayer for more than half the year.

For example, a family with a calculated tax liability of $2,000 and two eligible children can claim a total of $200 in dependent tax credits ($100 per child). This credit is subtracted directly from their tax liability, reducing their final tax bill from $2,000 to $1,800. The credit can reduce a taxpayer’s liability to zero, but no excess amount is paid as a refund.

Implications for Business Entities

The tax reform also introduced changes for business owners operating as pass-through entities, such as S corporations, partnerships, and LLCs. For these businesses, profits and losses are typically “passed through” to the owners’ individual returns and taxed at their personal income tax rates.

A provision allows these pass-through businesses to make an annual election to pay tax at the entity level. This optional tax rate was lowered to 2.5% to align with the individual flat tax. The primary motivation for this change was to create a workaround for the $10,000 federal limitation on the State and Local Tax (SALT) deduction, which was put in place by the Tax Cuts and Jobs Act of 2017.

By paying tax at the entity level, the payment becomes a deductible business expense on the company’s federal return, rather than a limited personal deduction for the owner. This can provide a federal tax benefit for owners of profitable pass-through businesses. The income taxed at the entity level is then excluded from the owner’s Arizona adjusted gross income to prevent double taxation.

This election is most advantageous for businesses whose owners are impacted by the federal SALT deduction cap. The decision to make the election should be evaluated annually based on the financial situation of the business and its owners.