Arizona’s pass-through entity tax rate is 2.5%, matching the state’s flat individual income tax rate. Under A.R.S. § 43-1014, a partnership or S corporation can elect to pay Arizona income tax at the entity level on behalf of its individual, estate, and trust owners, and the entity’s payment is then deductible as a business expense on the federal return.1Arizona Legislature. Arizona Code 43-1014 – Entity-Level Tax Election; Partnerships; S Corporations; Rules That deduction is the whole point of the election, and it works by sidestepping the federal cap on personal state and local tax deductions.
Why the Rate Is 2.5%
The PTE rate isn’t set on its own. A.R.S. § 43-1014 pegs it to “the highest tax rate prescribed by section 43-1011,” which is Arizona’s individual income tax schedule. Once Arizona moved to a flat individual income tax, the top rate became 2.5%, and the PTE rate followed automatically.1Arizona Legislature. Arizona Code 43-1014 – Entity-Level Tax Election; Partnerships; S Corporations; Rules If the legislature changes the individual rate later, the PTE rate moves with it.
The entity applies 2.5% to the taxable income attributable to resident partners or shareholders, plus the Arizona-source income attributable to nonresident partners or shareholders. Only income tied to consenting, eligible owners feeds the tax base.
How the Election Cuts Federal Tax
The election exists because of the federal SALT cap. The Tax Cuts and Jobs Act of 2017 limited how much individuals can deduct for state and local taxes on their federal returns.2Tax Foundation. State and Local Tax (SALT) Deduction Without the election, an owner’s share of Arizona income tax flows through to the personal return and gets pinched by that cap.
When the entity elects in, Arizona collects the 2.5% directly from the business. The IRS treats that as a deductible business expense rather than a personal state tax, so it reduces the entity’s income before anything reaches the K-1s. IRS Notice 2020-75 confirmed the treatment, stating that entity-level state tax payments are “allowed as a deduction by the partnership or S corporation” and are “not taken into account in applying the SALT deduction limitation to any individual” partner or shareholder.3Internal Revenue Service. Notice 2020-75 Owners see K-1 income that has already absorbed the state tax, and their personal SALT cap stays untouched.
The 2026 SALT Cap Changes the Math
The federal cap looks different for 2026. The One Big Beautiful Bill Act raised the individual SALT deduction cap to $40,400 for most filing statuses, up from $10,000. Married-filing-separately filers get $20,200. The higher cap begins phasing down at $505,000 of modified adjusted gross income and eventually drops back to a $10,000 floor for the highest earners.4U.S. House of Representatives. Frequently Asked Questions: Tax Changes 2026 and the One Big Beautiful Bill
For owners whose Arizona PTE tax plus property and other state taxes stays under $40,400, the federal benefit of electing in is smaller than it was under the old $10,000 cap. For owners above the $505,000 phase-down threshold, where the cap shrinks toward $10,000, the election still delivers real savings. The higher cap is set to expire in 2030 and revert to $10,000, so the calculation may swing back.
Who Qualifies
Two entity types can elect: businesses treated as partnerships for federal tax purposes and S corporations. The election is available only for owners who are individuals, estates, or trusts. A C corporation partner, another partnership as owner, or a tax-exempt organization cannot be included, and their share of income is simply carved out of the entity-level tax base.1Arizona Legislature. Arizona Code 43-1014 – Entity-Level Tax Election; Partnerships; S Corporations; Rules
Having a non-individual owner doesn’t disqualify the entity from making the election. The entity pays 2.5% on income attributable to its consenting individual, estate, and trust owners, and the other owners are handled outside the election.
The Opt-Out Right
Every eligible owner gets a say. Before making the election, the entity must notify each individual, estate, and trust owner of its intent and their right to opt out, and must give them at least 60 days to respond. An owner who doesn’t respond in that window is treated as having consented and is included in the election.5Arizona Department of Revenue. Arizona Pass-Through Entity Election – Publication 713 An owner who opts out is excluded from the entity-level tax and reports their share normally.
How to Make the Election
The election is made on the entity’s Arizona income tax return: Form 165 for partnerships or Form 120S for S corporations. There is no standalone election form; the entity checks the election box and completes the related schedules on the return itself.6Arizona Department of Revenue. Arizona Form 120S – Arizona S Corporation Income Tax Return Instructions
The election must be made by the return’s due date or extended due date. Miss that deadline and the election is denied, with any related tax payments refunded back to the entity.6Arizona Department of Revenue. Arizona Form 120S – Arizona S Corporation Income Tax Return Instructions The return is due by the 15th day of the third month after the close of the taxable year, so March 15 for calendar-year filers.5Arizona Department of Revenue. Arizona Pass-Through Entity Election – Publication 713 The election is annual, so the entity has to affirmatively choose it each year.
Estimated Payments
Entities that elect in must make quarterly estimated payments if their taxable income from the preceding year exceeded $150,000.7Arizona Department of Revenue. 120/165ES Booklet – Arizona Estimated Tax Payment Those payments follow the standard corporate estimated payment schedule. If the entity’s anticipated tax liability reaches $500 or more, payments must go through electronic funds transfer.8Arizona Department of Revenue. Partnership Highlights Underpayment can trigger penalty interest, so run the projection early.
The Credit on the Owner’s Personal Return
Once the entity pays the 2.5%, each participating owner claims a credit on their personal Arizona return equal to the portion of the entity-level tax attributable to their share of Arizona taxable income.5Arizona Department of Revenue. Arizona Pass-Through Entity Election – Publication 713 The credit prevents double taxation: the state collects once at the entity level, and the owner gets dollar-for-dollar relief personally.
The credit is nonrefundable. It can zero out Arizona liability but won’t create a refund by itself. Any unused portion carries forward for up to five consecutive taxable years, which matters most when an owner’s personal Arizona income outside the pass-through is too small to absorb the full credit in one year.
If the Entity Doesn’t Pay
The election changes who writes the check, not who is ultimately on the hook. If the entity elects in and fails to pay, the Arizona Department of Revenue can collect from the individual partners or shareholders based on each owner’s proportionate share of income.1Arizona Legislature. Arizona Code 43-1014 – Entity-Level Tax Election; Partnerships; S Corporations; Rules Owners in multi-owner businesses should confirm the entity is actually remitting the tax, especially when day-to-day finances sit with someone else.