Judge rejects bid to recoup taxes on Arizona family rebates
PHOENIX — Hundreds of thousands of Arizonans who received state tax rebates last year aren't going to get back the $20.8 million they had to pay in federal income taxes on the cash they got.
U.S. District Court Judge Murray Snow tossed out claims by state Attorney General Kris Mayes that the one-time payments — up to $750 per family — were exempt from federal taxes under rules adopted by the Internal Revenue Service. Mayes cited rebates in other states where recipients got to keep all the money.
But Snow, in a new ruling, said what Arizona did is different. And that, he said, means the IRS ruling and the tax liability on the proceeds was correct.
Snow also said that only the people who actually say they were injured by the IRS decision — the individual taxpayers — have the right to sue.
Attorneys for Arizona sought to get around that by claiming the state itself was harmed to the tune of about $480,000. That is based on arguments that had those affected Arizonans actually kept their money instead of paying it in federal taxes they would have spent it in the state on items subject to state and local sales taxes.
Snow wasn't buying it, calling it "speculative.''
In fact, he said, even the state, in its pleadings, admitted that the only certainty was that if Arizonans had retained the money they would have been free "to spend at they saw fit.''
A spokesman for Mayes said she disagrees with the ruling "and continues to believe the tax relief provided to Arizonans by their state government should have remained in their pockets, not unfairly snatched by the IRS.'' But Richie Taylor said he could not comment on whether there will be an appeal.
All this stems from a provision in the 2023 budget — when the state had a surplus — to provide a rebate to families of $250 for every child younger than 17 and $100 for older dependents, up to a maximum of $750 per family. That generated about $260 million for 750,000 Arizona families.
The IRS told the state Department of Revenue it considered such payments subject to federal income taxes.
Based on that, the state issued a 1099-MISC form to each rebate recipient. That covers certain types of miscellaneous compensation, including prizes, that are not covered by other documents federal law requires to be issued.
A copy of those forms went to the IRS — just like a W-2 for wages — making the federal government aware of who got the payments and making the taxpayers liable to report it and pay taxes on it.
The state Attorney General's Office sued.
"When Arizona's elected leaders chose to refund tax revenue to Arizona taxpayers last year, their reasonable expectation was therefore that the money would go to Arizona taxpayers, not to the Internal Revenue Service,'' the state argued in its legal papers. "But the IRS had a different idea.''
The state claimed the payments were not taxable because they were paid out of the general fund to qualifying Arizonans. And, more importantly, the state argues it was not paid as "compensation for services,'' something that would be taxable.
Attorneys for Arizona also pointed out that 21 other states approved rebates of their own. And in each case, the IRS concluded taxpayers in those states owed nothing to the feds.
But Snow noted there is a crucial difference.
Those other states made their payments in 2022. And in each of those other cases, those payments were part of financial relief from the effects of the COVID pandemic and the federally declared disaster
In the case of Arizona, however, the legislation authorizing those 2023 payments made no mention of COVID. Instead, it was promoted as more of a political thing by the Republican-controlled Legislature.
The measure specifically cited inflation being at a 40-year high, "putting gas, groceries and other necessities out of reach for many Arizonans.'' And the law said the rebate was possible because of "responsible budgeting'' that allowed the state to return a portion of the surplus that existed at the time.
The IRS said there's also another key difference between what happened elsewhere and the Arizona program.
In those other states, there were income restrictions. That, the federal agency said, entitled those payments to be excluded under a "general welfare'' provision of tax laws.
That, however, wasn't the case here.
The IRS pointed out that eligibility for the Arizona rebate did not begin to phase out for individuals until they were making $200,000 and $400,000 for married couples filing jointly, a figure that far exceeded the state median income. In fact, the agency's attorney noted, the cutoffs were so high that they did not affect 98% of Arizona single filers and 95% of married joint filers.
What also undermined the state's claim that the rebate had some need-based component was the fact that individuals with no state tax liability in 2019 through 2021 were totally ineligible. And that completely excluded the poorest Arizonans: single residents with income below $12,500 and married couples making less than $25,000.
How much individual Arizonans had to pay depended on how much they earned.
There are seven federal tax brackets, ranging from 10% for individuals with a federally adjusted gross income of up to $11,000 — double that for married couples filing jointly — to 37% for those making $578,126 or more.
So, everything else being equal, a single person with a $500 rebate who was in the 22% bracket — from $44,726 to $95,375 — was required to give back $110 to Uncle Sam.
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