In 2023, Arizona changed from the commonly utilized progressive tax structure to a simplified flat tax system. The state has been slowly modifying tax rules over the course of the past few years and will finally settle into its desired (and lowest) income tax rate.
The flat tax system changes tax liability and compliance rules for all taxpayers. If you own a business in Arizona, here’s what you need to know about how the change may impact your employees and the way you manage your taxes.
What Is a Flat Tax System?
A flat tax system is a system where a tax rate is set at the same number for everyone. Only a handful of states utilize a flat tax system (nine at the time of publication of this article). The flat tax system can be polarizing, with some people claiming that it treats everyone equally under the tax code and some people claiming that it contributes to income inequality. “Flat tax systems can have a negative impact on CPA practices since the simplified requirements for tax filing reduce the need for a CPA to handle complex tax scenarios for taxpayers,” highlights Taylor Fike, Partner at Fike Advisors and Expert Contributor for Mosey.
The theory behind a flat tax system is that it makes tax compliance easier for everyone by allowing everyone to pay the same percentage in taxes regardless of their income. A specific percentage is established, and the rule applies to everyone in that group.
There can be flat tax systems for individual income or corporate income. The percentage rates would be different for each group, but every individual and every corporation would be held to the same rules.
How Do Progressive Tax Systems and Flat Tax Systems Differ?
Most states utilize a progressive tax system designed to alleviate tax burdens on people with smaller annual incomes. A progressive tax system works like this: lower-income individuals and families pay lower percentages in income tax. Higher-income individuals and families pay higher percentages in income tax. Percentages rise with annual income.
Proponents of the progressive tax system claim that it balances the economy by requesting more taxes from people who have enough financial security to pay greater amounts in income tax and relieving individuals who live paycheck to paycheck.
They claim that the flat tax system, while technically egalitarian, will cause states to lose a substantial amount of revenue by providing excessive tax relief to the wealthiest members of a state’s population. An analysis of the budget concluded that the state of Arizona has seen a substantial decrease in revenue and will continue to operate at a deficit into the next year, with the flat tax cited as the cause.
How Does Arizona’s Flat Tax System Work?
The Arizona flat tax system sets the income tax percentage at 2.5% regardless of total annual income. The new system replaces Arizona’s previous two-rate system, where lower-income individuals and families paid 2.55% in income tax and higher-income individuals and families paid 2.98% in income tax. Prior to the two-rate system, Arizona utilized a four-rate system that capped out at 4.5%.
Arizona has been making a slow but steady transition into a flat tax system over the course of the past several years, reducing tax rates by small increments to measure its effects on state revenue before fully committing to a new system. The tax year 2023 is the first official implementation of the state’s flat tax system.
While taxes are increasing or staying the same in most areas of the country, Arizona’s taxes have reduced to a point where they cannot reasonably go lower. This may be a huge drive to people seeking high-powered careers, sole proprietors, and independent contractors. Moving to Arizona substantially reduces tax liability, which makes working in the state highly lucrative.
How Does the Flat Tax System Impact Business Owners in Arizona?
Arizona’s corporate income tax rate is 4.9%, which is on the lower side compared to most states. The tax rate remains unchanged from 2022, when it was established. Arizona has different rules for corporations and businesses deemed to be “small businesses,” which are awarded preferential treatment under the state’s tax code.
Arizona’s small business income tax (SBI) rule, which also went into effect in 2022, allows small business owners to claim small business income tax at a separate rate of 2.8%. That rate is intended to be reduced to 2.5% by the year 2025.
The small business income tax rule is separate from the new Arizona flat tax law, which works differently. The flat tax is intended to reduce taxes on individuals by alleviating the tax burden on their personal income.
Since the new flat tax system only applies to individual income taxes, it isn’t likely to impact business owners as it pertains to their business taxes. It may help to reduce the amount of taxes they pay on personal income they make from their businesses.
The Arizona flat tax system may be good news for sole proprietors and other independent professionals who operate as a one-person business, where all of their income belongs exclusively to them. It may be easier for startup founders to get by on smaller personal paychecks because their tax liability is minimal.
Lawmakers are hoping that the flat tax system in Arizona will impact business owners by improving their revenue. The argument for the flat tax system is rooted in the idea that consumers will have more money to spend with Arizona businesses if they’re paying less money in taxes. Researchers won’t be able to conduct a definitive analysis until the new system has had a sufficient amount of time to impact spending habits.
What Should Arizona Business Owners Know About Tax Compliance?
The Arizona Department of Revenue published a comprehensive guide for Arizona business tax compliance. Arizona is one of the simplest states for corporate tax compliance, but it’s important not to assume that everything is on track to compliance without double-checking and regularly maintaining your tax responsibilities. The flat income tax system will have a minimal impact on business tax compliance.
How Does the Flat Tax Affect Business Taxes?
Arizona’s flat tax does not impact business taxes. It only affects tax withholding from employee paychecks. Calculations for tax withholding should be based on the new 2.5% income tax rate for everyone, regardless of their annual salary or expected annual hourly earnings. Adhering to the new system will prevent employees from overpaying their taxes.
An experienced tax professional will already be aware of the consequences of the switch to a flat tax system. If you outsource your taxes to an expert, you likely don’t have anything to worry about. If you do your taxes yourself, make sure to adjust your calculations to adhere to the new flat tax rate. It should be easier because the percentage will be the same for every member of your organization unless they’ve requested additional withholding or have special tax circumstances.
How Can Businesses Minimize Tax Liability in a Flat Tax System?
Arizona’s tax laws are already designed to minimize tax liability for both individuals and corporations. Minimal tax liability works as an incentive for workers and employers to establish a business presence in the state of Arizona. Contrasted with higher corporate income tax rates (like New Jersey’s 11.5%), businesses in Arizona can breathe a little easier.
Minimizing tax liability is always a concern for businesses. Every business has different needs, expenses, requirements, and regulations. If you feel as though you need to minimize your tax liability, a tax expert would be able to advise you on which steps would be most advantageous to take after reviewing the particulars of your situation. You may be eligible for industry-specific tax breaks or tax breaks specific to your circumstances.
Remember: tax compliance is a serious issue with little room for error. It’s best to seek the advice of a qualified expert before attempting to utilize techniques to minimize tax liability that may jeopardize your business if executed incorrectly or inappropriately.
Stay on Track With the Flat Tax System
As a business owner, you’re responsible for the livelihood of your employees. They’re relying on you to deliver them an accurate paycheck in a timely manner. It’s your responsibility to deduct and withhold an accurate amount from their paychecks and direct the funds to the proper agencies, whether it’s for their taxes, health insurance, or HSA.
You have a lot to do, and Mosey can make things a little bit easier. Our platform keeps all of your compliance needs, including tax compliance, in one spot for better visibility and convenience. Mosey can help you automate compliance and streamline your day-to-day operations — learn more about how Mosey can help simplify tax compliance for your business.
