Republican state representatives voted Friday to allow the owners of small businesses — and anyone who organizes their finances for tax purposes as one — to escape paying the voter-approved income tax surcharge on the wealthy to fund education.
And that would cut hundreds of millions of dollars from what is supposed to go to schools.
SB 1783, approved on a 31-25 party-line vote, creates an entirely new alternate tax category for small business, generally those now organized in a way so their income passes through to their owners. That means the owners now compute what they owe the state on their personal income tax forms, after deducting all business expenses.
Proposition 208, approved by voters by a 51.7% margin in November, imposes a 3.5% surcharge on adjusted personal income of amounts above $250,00 for individuals and $500,00 for married couples filing jointly. Under current law, that means the net earnings of the business retained by the owner.
But here’s the thing: That surcharge applies only to tax categories that existed last year when Proposition 208 was approved. And since this new “small business” classification did not exist last year, the surcharge would not apply at all to anyone opting to use that new category.
The tax relief in SB 1783 goes far beyond what the Republican-controlled legislature already did when they voted earlier this week to cap all income taxes at 4.5%.
In that case, unable to overturn what voters approved, lawmakers created a workaround: The wealthiest would still have to pay the 3.5% surcharge. But, with the 4.5% cap, they would have an effective tax rate of just 1% on their earnings.
But the voter approval of Proposition 208 also means that lawmakers have to make up the difference of what the high-income earners would otherwise have paid. So that guarantees the education programs funded by Proposition 208 would get all the money promised.
SB 1783 changes all that.
“This would create a loophole for the wealthiest in Arizona to file as a small business so they can avoid paying the 3.5% surcharge that Arizonans said they want to support education,” said House Minority Leader Reginald Bolding, D-Laveen.
And there are fiscal implications: Legislative budget analysts figured that anyone who now is subject to the Proposition 208 surcharge and is eligible to use the small business classification will do so if it lowers their taxes. And they concluded that, out of the estimated $836 million Proposition 208 was expected to raise for education, SB 1783 would slash that by about $292 million.
Rep. Shawnna Bolick, R-Phoenix, said the exemption is justified. She pointed out that campaign materials for the initiative said it would not affect small businesses.
And Rep. Bret Roberts, R-Maricopa, said that means the proponents either were confused “or they willfully lied.”
But Rep. Mitzi Epstein, D-Tempe, said that the campaign statement is true and that Proposition 208 is not a tax on business.
She pointed out that what’s subject to the tax is not the gross proceeds of any business. It’s what’s left to the owners after they pay all expenses
That list that can include everything from employee salaries and equipment purchases to other deductions. And it also encompasses what remains after any other deductions, like money a business owner puts into a 401(k) retirement account.
What that leaves — and what’s subject to the Proposition 208 surcharge — Epstein said, is the net income the owner pockets, and only above $500,000 for a married couple.
But Rep. Steve Kaiser, R-Phoenix, said that ignores how businesses operate.
He said they retain net earnings to help them weather the ups and downs of businesses. And it is those net earnings, Kaiser said, that are subject to the tax.
The measure needs final approval by the Senate before going to Gov. Doug Ducey. He is likely to sign it because he opposed Proposition 208.
That could lead to litigation.
The Voter Protection Act, a provision of the Arizona Constitution, bars lawmakers from repealing or making changes in anything approved at the ballot. The only exception is for amendments that “further the purposes” of the original law, and then only with a three-fourths vote.
Rep. Domingo DeGrazia, D-Tucson, said he believes what’s in SB 1783 runs afoul of the provision even though it doesn’t actually repeal the levy.
“The legislature cannot do indirectly what it cannot do directly,” he said.
And attorney Roopali Desai, who represents the Invest in Ed Committee that put the initiative on the ballot, has said the key is whether courts believe the change would “undermine the ultimate will of the voters.”
Half of whatever ends up being raised from Proposition 208 is earmarked for schools to hire teachers and classroom support personnel, a category that also includes librarians, nurses, counselors and coaches. Those dollars also could be used for raises.
Another 25% would be for support services personnel. That covers classroom aides, service personnel, food service and transportation.
There’s 12% for grants for career and technical education programs and 10% for mentoring and retaining new teachers in the classroom. The last 3% is for the Arizona Teachers Academy which provides tuition grants for people pursuing careers in education.