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Small-business loophole to avoid education surcharge going to court

Small-business loophole to avoid education surcharge going to court

  • Updated
Invest in Ed initiative

SB 1783, approved this year, allows certain individuals to choose to file their taxes under a newly created “small business” category.

PHOENIX — Backers of the successful effort to raise income taxes on the rich for education are going to court in a bid to void a legislative maneuver that created what they see as a loophole.

A lawsuit filed in Maricopa County Superior Court is attacking the legality of SB 1783. Approved earlier this year, it allows certain individuals to choose to file their taxes under a newly created “small business’’ category.

What makes that significant is that Proposition 208, approved by voters last year, imposed its 3.5% surcharge on taxable income above $250,000 for individuals and $500,000 for married couples filing jointly. But the 2020 initiative has no similar requirement for those in the small business category as it did not exist until this year.

The change has significant implications. Legislative budget staffers said individuals choosing to file under the newly created category will reduce the estimated $940 million the initiative was supposed to raise by $292 million a year.

“For many wealthy Arizonans, it is essentially a get out of Prop. 208 free card,’’ said attorney Roopali Desai who represents Invest in Arizona, the successor to the initiative’s Invest in Education Committee.

More to the point, she contends SB 1783 violates the Voter Protection Act. That constitutional provision bars lawmakers from altering or repealing anything approved at the ballot unless it “furthers the purpose’’ of the underlying measure, something that clearly does not apply here as the purpose was to raise more money for K-12 education.

And Desai is arguing that the Voter Protection Act protects initiatives like Prop. 208 even though, strictly speaking, it does not amend or repeal it.

“The Legislature may not do indirectly what it is prohibited from doing directly,’’ she said.

“The people of Arizona have spoken, and they chose to require the wealthy to pay their fair share for our schools,’’ Desai continued. “The Legislature may be unhappy with that choice, but our constitution doesn’t allow them to undo it.’’

But Sen. J.D. Mesnard, R-Chandler, the architect of the new small business tax category, said he doesn’t believe lawmakers did anything illegal.

“Very simply put, nothing in Prop. 208 stops us from changing our tax code,’’ he told Capitol Media Services. “I think a court will agree that it’s every bit the prerogative of the Legislature to come up with tax policy that helps whatever particular constituency, in this case, our small businesses.’’

The initiative, approved by 51.7% of voters, says people owe an additional 3.5% on earnings above the threshold.

So, for example, a married couple with taxable income of $650,000 a year pay the same tax rates as everyone else for the first $500,000. The surcharge is on the $150,000 balance, or $5,250.

Half of what is collected is for “grants to school districts and charter schools … for the purpose of hiring teachers and classroom support personnel. Those funds also could be used to raise salaries.

Another 25% is for student support, with 10% earmarked to help retain teachers in the classroom, 12% for career and technical education, and the balance into a fund to help pay the college tuition of students who go into teaching.

Mesnard and most Republican legislators never made any secret of their opposition to Proposition 208. That, however, remains untouchable by lawmakers because of the Voter Protection Act.

But Mesnard said none of that keeps the Legislature from altering who is and is not subject to taxes under the individual income tax category.

In particular, Mesnard is arguing that all his measure does is live up to the promises made by proponents of the initiative who argued at several points during the campaign that it would not affect small businesses.

David Lujan, who helped craft the measure, does not dispute that the owners of some small businesses will end up paying more. But he said that, strictly speaking, the claim is true: It does not tax businesses.

That’s based on the argument that the surcharge applies only to net taxable individual income.

For businesses owners, Lujan said, that is what’s left after they deduct all their expenses, from rent and supplies to employee compensation and even money put into tax-sheltered retirement accounts. He said any couple that nets more than $500,000 after expenses can probably afford to pay some additional taxes to support education.

And that, Lujan said, was the intent of the voters who approved the measure.

Mesnard said that’s making some assumptions.

“We’ve got to be careful when we start talking ‘what voters wanted,’” he said.

“We have to get inside the minds of anyone who voted on Prop. 208,’’ Mesnard continued. “And I’m sure there were a myriad of different reasons, conflicted feelings, etc.’’

But he said all that is irrelevant.

“At the end of the day, this is about what’s good tax policy,’’ Mesnard said. And he said SB 1783 simply gives lawmakers the power to create special tax provisions for small businesses just as they can now for large businesses who file corporate tax returns and whose earnings are not subject to Proposition 208.

Desai said that still doesn’t make it legal.

“SB 1783 no doubt substantively alters and takes away from Prop. 208,’’ she argued. And Desai said voters approved the initiative with the full knowledge that the surcharge would apply to all individual taxes, a category that, at the time of the election, included the small business income that Mesnard seeks to remove.

Mesnard said there will be implications if the court agrees, saying it effectively would freeze the tax code the way it is now.


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