IRS: Arizona's 2023 tax rebates for parents were subject to federal taxes

In a new legal filing, the IRS is telling the 9th Circuit Court of Appeals that Arizonans are not entitled to refunds on federal income taxes they paid on a 2023 state tax rebate.

Arizona provided a rebate to families up to $750 based on the number of children in the household.

The IRS collected over $20 million in taxes on those rebates, prompting state Attorney General Kris Mayes to sue. The issue affects about 750,000 Arizonans.

While Mayes claimed other states gave out similar tax rebates the IRS left alone, the federal agency argues those were relief dollars sent to families directly related to the COVID-19 pandemic. Arizona’s were not.

A hearing is scheduled for November.

In filings with the 9th Circuit Court of Appeals, Anthony Sheehan, an attorney for the Department of Justice, said the way Arizona gave out the money made it taxable.

He acknowledged the IRS agreed to exempt rebates made by 21 other states from federal taxes. But Sheehan is telling the three-judge panel that legislators in those other states did what federal law allowed: They provided relief for residents to help them deal with the costs of COVID.

But the Arizona law — and the $260 million given to residents — had nothing to do with the pandemic. Instead, he said, it was one way for lawmakers to deal with a $2.4 billion state budget surplus.

Arizona's legislation said the rebate's purpose was related to the fact that "inflation is at a 40-year high, putting gas, groceries and other necessities out of reach for many Arizonans.''

"Responsible budgeting has allowed this state to take action to mitigate the harmful impacts of inflation by returning a portion of the surplus to this state's taxpayers with dependents,'' the law said.

Arizona provided 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, with the average rebate of about $370.

What wasn't known at the time lawmakers approved the measure was that the IRS would later tell the state Department of Revenue it considers the way Arizona made the payments subject to federal income taxes.

Sheehan told the court the payments were not based on need. There was no link between the amount of what the state was calling rebates and whether residents had paid that much in state taxes.

Actually, he told the court, the reverse is true: The most needy in Arizona were ineligible.

"The payment criteria excluded the poorest residents while allowing payments to high-income residents,'' Sheehan wrote.

All of that makes the payments to those who got them subject to federal income tax, he said.

So far, the IRS is winning.

A trial judge last year tossed out a lawsuit filed by Attorney General Kris Mayes seeking to have the taxes paid declared illegal and the money refunded. That now puts the case before the federal appellate judges.

Even if Mayes wins, that doesn't mean the affected taxpayers should look for a check in the mail.

Sheehan contends that even if $20.3 million paid by Arizonans on the $260 million in rebates never should have been collected by the IRS -- a point he is not conceding -- the state is in no legal position to sue for refunds of the excess taxes on behalf of its affected residents.

Instead, even the state has conceded each resident would have to file an appeal.

Sheehan said there's another thing that makes the Arizona rebates taxable.

Those 21 other states enacted their programs in 2022 and paid them out the same year, during the COVID emergency.

But Sheehan told the appellate judges that Arizona did not enact its own "Arizona families tax rebate'' until May 11, 2023. The payments went out later that year, long after the emergency was over.

Put simply, he said, lawmakers waited too long.

The appellate judges appear to be interested in hearing more. They have scheduled a hearing for November.