From Arizona Capitol Times
Reversing a decades-old policy, the Arizona Corporation Commission will allow the owners of small utility companies to pass their income taxes off to consumers across the state.
The commission on Feb. 12 voted 4-1 to allow LLCs and businesses entities known as “S corporations,” which must have 100 or fewer shareholders, to request rate increases to offset the cost of personal income taxes. No companies are currently doing so, but several water companies that unsuccessfully requested that ability last year are expected to take advantage of the new policy.
Supporters of the change say it’s a matter of fairness. Larger companies, known as “C corporations,” are already allowed to pass on their corporate incomes taxes through their rates. Entities that tax income only at the personal level and not at the company level, known as pass-through entities, aren’t able to do the same thing.
Commissioners who supported the change say it will make the system more equitable for smaller companies, give them more capital for infrastructure, discourage them from becoming C corporations and encourage more companies to get into the utility business.
However, critics say the change will lead to higher rates for water and sewer services. They argue that S corporations already get the benefit of not having to pay any corporate income taxes, and that it’s unfair to shareholders of larger companies like Arizona Public Service and Tucson Electric Power, which still must pay taxes on their own investment income. Owners of S corporations, they say, pay only the same personal income taxes as C corporations’ shareholders.
Commissioner Brenda Burns, the lone dissenter, said the two types of companies are so structurally different that they shouldn’t be treated the same way when it comes to the ability to pass on tax costs to ratepayers. It’s appropriate to allow C corporations to pass on corporate income taxes because their shareholders must still pay income taxes on their profits, she said.
Pass-through entities such as S corporations and LLCs aren’t “double taxed,” she said, and they shouldn’t be able to pass on tax costs that larger corporate shareholders have to pay.
“Basically, it was an attempt, I believe to … fit a square peg into a round hole,” Burns said of the new policy. “It’s simply, I don’t believe taxpayers should be paying the personal income taxes off of the profits that personal individuals are making.”
The Residential Utility Consumer Office, which advocates on behalf of ratepayers, also opposed the change. Daniel Pozefsky, RUCO’s chief counsel, laid out a laundry list of concerns in comments filed with the Corporation Commission.
Chief among those concerns were the increased rates that customers will pay if their water and sewer companies are allowed to pass on the costs of personal income taxes. Pozefsky said ratepayers will get “the short end of the stick again” because of the different ways the commission determines income tax liability for the two types of companies, and he worried that C corporations will now ask that their shareholders be reimbursed for their income taxes as well.
RUCO estimated that the change in policy would affect 40,000 customers, who would see a cumulative rate increase of more than $2 million.
“The draft policy will result in a lot of ratepayers in Arizona seeing their rates increase to allow utilities to recover income taxes that those utilities do not even pay,” Pozefsky wrote.
Even Corporation Commission staff opposed the policy change. In a June 2012 staff report, commission staff said personal income tax expenses are not a cost of doing business by the company, and cannot be equated to corporate income taxes.
Because the actual business entity isn’t taxed, the staff report read, there’s no reason to allow S corporation shareholders to pass on their own personal income taxes to ratepayers.
“Since there is no evidence that an income tax liability is actually borne by S corps or certain LLCs, income taxes are not rightly chargeable to the ratepayers,” the staff report read. “Providing for income tax expense for taxes paid by the recipients of pass-through income would be analogous to paying for the taxes borne by shareholders of C corporations for dividends received and places an unfair burden on the ratepayers.”
Commissioner Gary Pierce, who began pushing for the policy change last year, acknowledged that some customers’ rates will increase. But he said the change is needed and fair.
While S corporations don’t pay corporate income taxes, their owners still must pay income taxes on their profits, but without the ability that larger corporations have to pass the cost on to ratepayers. Most private companies already pass on such costs to their customers, Pierce said. But the utilities are government-regulated monopolies, and don’t get to make those decisions on their own.
“We are their economic regulators. But if we tell one company you can make so much money and you’re a C corp and you’re going to pass it through, and we’re telling the others we’re not going to pass it through, so anything you make you guys have to take as income individually, it doesn’t square,” Pierce said. “At the end of the day, I just seek to make it fair.”
S corporations are often smaller companies with limited capital that can’t afford to do things like make needed infrastructure improvements or comply with government mandates on environmental issues like arsenic removal, Pierce said.
One utility, Pima Utility Company, hired former Corporation Commissioner Marc Spitzer to lobby the commission on its behalf. Many others voiced their support for the change as well. Spitzer, who served for five years on the Federal Energy Regulatory Committee, testified the commission about why FERC made a similar policy change.
Spitzer also argued that personal income taxes for pass-through entities like S corporations should be treated similarly to C corporations’ corporate income tax, not the personal income taxes paid by their shareholders.
“Taxes imposed on income are an inevitable business outlay regardless of the entity’s legal form,” Spitzer told the commission. “The fact that the pass-through structure allows the income tax liability generated by Pima to be paid by its shareholders does not change the fact that those taxes are a cost of service.”
Pierce argued that RUCO’s objections were short-sighted, and that in the long run, the new policy will benefit ratepayers. Many of the smaller utilities are “squeezing by” and lack the ability to make needed improvements. Without the policy change, many will be tempted to sell to larger companies or switch to C corporations, which he said are costlier to ratepayers.
“I think that they looked at here and now – right now this could have this effect or that effect,” Pierce said of RUCO. “It felt that it was probably short-sighted on their part.”
However, Pierce said he wasn’t aware of any S corporations switching their tax status thus far.
Pierce said he didn’t know how much rates might increase under the policy, but said he would not think the increases would be large.
Burns said she didn’t know either, but expected substantial increases for some ratepayers.
“I think in some cases it could be pretty significant to the owner. It depends on how many ratepayers, whatever that amount is, it’s spread across,” Burns said.
Several companies asked the commission last year to reconsider the policy, and Burns expected those companies to quickly come back and ask for rate hikes to offset their income taxes.
Arizona’s corporate income tax rate of 6.9 percent will gradually fall to 4.9 percent by fiscal year 2017. The state’s top personal income tax rate, which is paid by pass-through entities such as S corporations and LLCs, is 4.54 percent. The top rate applies to people earning more than $300,000 a year.
Numerous other states already allow smaller utilities to pass on their personal income tax costs through their rates. In the 1980s, the Texas Supreme Court ruled that a utility company should be allowed to defray personal income taxes through its rates because those taxes are “inescapable business outlays” that are “directly comparable” with corporate income taxes passed on by larger companies.
Pierce emphasized that the new policy is not a blanket approval for all 333 water and wastewater companies in Arizona to pass on personal income taxes through their rates. He said the commission will consider companies’ requests on a case-by-case basis.