Arizona Tax Increase, Estimated Tax Payments, and Proposition 208

Trusts & Estates, Tax Update

Arizona Tax Increase, Estimated Tax Payments, and Proposition 208

Proposition 208 Imposes New Income Tax. On November 3, 2020, Arizona voters approved Proposition 208. Proposition 208 imposes a 3.5% income tax surcharge on taxable income exceeding $250,000 ($500,000 for joint filers and heads of household). This increases the highest income tax bracket in Arizona from 4.5% to 8%.

Arizona Estimated Tax Payment Requirements. Individuals (including nonresidents) in Arizona must make estimated payments if their Arizona gross income in the current year and in the previous year exceeds $75,000 ($150,000 for joint filers). To avoid penalties, the total estimated tax plus any taxes withheld must equal at least 90% of the current year’s tax due or 100% of the previous year’s tax liability.

For example, if X’s 2019 tax liability was $100,000 and X’s 2020 tax liability was $150,000, to avoid a penalty, X would need to have withheld taxes and paid estimated tax of at least $100,000 (which is 100% of the 2019 tax). If instead, X’s 2019 tax liability was $150,000 and X’s 2020 tax liability was $100,000, to avoid a penalty, X would need to have withheld taxes and paid estimated tax of at least $90,000 (which is 90% of the 2020 tax).

Estimated Taxes in Light of Proposition 208. Proposition 208 is currently being challenged in court. If Proposition 208 is upheld, taxpayers will be subject to the additional 3.5% tax for tax years beginning in 2021. If it is not upheld, then taxpayers will not have to pay the additional 3.5% tax.

The Arizona Department of Revenue has reminded taxpayers that they are only required to pay an amount equal to 100% of their 2020 income tax liability to avoid estimated tax penalties in 2021. (This is assuming that the 2021 tax liability will be greater than the taxpayer’s 2020 tax liability because there is a 3.5% tax increase.) A taxpayer can choose not to consider the additional 3.5% income tax surcharge when calculating the Arizona estimated tax payments he or she needs to pay for 2021, so long as he or she pays total estimated (and withholding) taxes in an amount at least equal to 100% of the taxpayer’s 2020 tax liability. For example, if the taxpayer’s 2020 tax was $300,000, there is no estimated tax penalty for the 2021 tax year as long as the total estimated (and withholding) taxes are at least $300,000 for the 2021 tax year.

Caution. If an individual chooses not to take into account the additional 3.5% income tax surcharge when calculating his or her estimate tax payments (or withholdings), he or she should be prepared to pay the additional income tax if Proposition 208 is upheld by the courts.

Potential Impact On Large Trusts and Estates. A.R.S. §14-1311(A) imposes on trusts and estates the same taxes that are imposed on individuals. Therefore, trusts and estates may also be required to pay the additional 3.5% surcharge tax on trust income over $250,000. Trusts and estates may want to consider whether distributions to beneficiaries may reduce overall tax liability. The trustee and beneficiaries may also want to consider whether moving the trust to another state is appropriate or possible.

Potential Impact on Grantors of Grantor Trusts. If a trust is a grantor trust, the trust grantor should be aware (as should any Arizona taxpayer) that his or her Arizona income tax liability could increase. If that tax increase is a concern for cashflow or other reasons, the parties to a grantor trust may want to consider whether a modification is appropriate or possible.

Potential Impact On Business Owners. Individuals who are owners of a pass-thru entity (such as a partnership or S corporation) may want to consider the financial impact of this additional tax on their personal income tax returns. They may want to consider whether provisions (such as provisions for required distributions to pay taxes) under a partnership agreement, operating agreement, shareholder agreement, or other agreement should be amended.