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IRS lawyers: Arizona tax rebates can be taxed

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By Howard Fischer
Capitol Media Services

PHOENIX -- Uncle Sam is entitled to a share of the rebates that Arizona issued last year to families with dependents, lawyers for the Internal Revenue Service are telling a federal judge.
In a new court filing, the attorneys say that the payments of up to $750 for about 750,000 Arizona families clearly qualify as "income'' under federal law. And what that means, they said, is it must be reported -- and taxes must be paid -- when Arizonans file their federal tax returns next month.
Unless Judge Murray Snow disagrees, that will mean Arizonans who got the $260 million in rebates either are writing a larger check to the IRS or getting smaller refunds. How much, however, depends on overall income and how much of a rebate they got.
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, someone getting a $500 rebate for two dependents who is in the 22% bracket -- from $44,726 to $95,375 for individuals -- owes $110 to the feds.
Snow has scheduled a hearing for April 2 on the issue.
That suggests he could issue a ruling in time for the April 15 deadline. But even if he doesn't, Arizonans who got a rebate could still declare the income, pay the taxes owed, and then seek a refund it he eventually were to side with the state -- and against the IRS -- that the funds are not subject to federal income taxes.
At the heart of the issue is a provision in the budget adopted by lawmakers last year providing 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.
"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 (ITALICS) to Arizona taxpayers, not to the Internal Revenue Service,'' (ROMAN) the state claimed in its lawsuit. "But the IRS had a different idea.''
But Amy Matchison, an attorney for the tax division of the U.S. Department of Justice, said none of that overrides federal law.
Central to what Snow will have to decide is what is exempt from definitions in federal law and regulations to what constitutes "income'' and is therefore taxable.
In seeking to have the rebates declared tax-free payments, attorneys for the state said that the monies paid out are essentially refunds of taxes already paid. And acknowledged that there is such a carve-out that exempts such payments from federal taxes.
Only thing is, she told Snow, it is clear that isn't the case here.
Matchison pointed out that the rebates were available to anyone who claimed a dependent in 2021 who had a tax liability of at least $1 in 2019, 2020 or 2021.
"Had Arizona capped the amount of its payment at state taxes paid in 2019-2021, then the tax treatment may have differed,'' she said.
"But it didn't,'' Matchison continued. "Accordingly, the payments cannot be considered refunds (or rebates) and must be included in income tax for federal tax purposes.''
The state, however, has another legal theory.
Its attorneys point to another section of the federal tax code that provides for tax-free payments when they are tied to the "general welfare.'' And, the state points out, there were income caps on who is eligible.
Matchison, however, said there is no evidence that this was somehow a program based on need.
She pointed out that income eligibility begins to phase out at $200,000 for individuals and $400,000 for married couples filing jointly.
"Those amounts far exceeded the median adjusted gross income for Arizona filers,'' Matchison said, which is $30,000 for single files and $94,000 for couples filing jointly. In fact, she noted, the cutoff were so high that they did not affect 98% of Arizona single filers and 95% of married joint filers.
And there's something else undermining the state's claim that the rebates were based on need: Individuals with no tax liability in 2019 through 2021 were totally ineligible. That includes single residents with income below $12,500 and married couples making less than $25,000.
"Thus, rather than targeting relief to low-income residents with dependents, the legislation expressly excludes such low-income resident from receiving the payments, while including almost all similarly situated Arizonans with higher incomes,'' Matchison told the judge. "Because the payments are not based on need, they cannot qualify for the general welfare exclusion.''
The state has one more argument.
Its lawyers pointed out that the IRS did allow for an exception from federal taxes for payments made as part of the relief from the pandemic and the federally declared disaster. And attorneys for the state claim Arizona was entitled to rely on the fact that the federal agency did grant favorable tax treatment to payments made by 21 other states.
"But evidence of this 'reliance' is missing from the record,'' Matchison said.
"There is no one reference in the text of the law authorizing the (rebate) payments to the IRS's statement on the 2022 payments, to the COVID-19 pandemic,'' she said. "There is no discussion about whether Arizona actually modeled its program after any of those 21 states that received its desired tax treatment.''
And Matchison said the state law authorizing the rebate makes no mention that Arizona expected the amounts received by residents to be excluded from federal income tax, whether based on general welfare or disaster relief exclusions. In fact, Matchison pointed out, the language in the statute is directly to the contrary.
What the state law does say, she told Snow, is that "inflation is at a 40-year high, putting as, groceries and other necessities out of reach for many Arizonans'' and that because of "responsible budgeting,'' the state was able "to take action to mitigate the harmful impacts of inflation by returning a portion of the surplus to the state's taxpayers with dependents.''
Matchison said even if Snow buys any of the state's arguments about the purposes of the rebate, the lawsuit by Attorney General Kris Mayes and her staff has some fatal legal flaws.
It starts, she said, with the question of standing. That generally requires that a person bringing a legal claim to have suffered some damages.
And that, said Matchison means the people who include the rebate payment on their tax forms and pay the taxes on it. She said there is no right of the state to sue on behalf of its residents.
The state, in seeking to prove standing, is arguing in turn that it actually would suffer a loss. That is based on claims that if Arizonans have to pay higher federal taxes, that means they will be spending less money and, as a result the state, will take in about $480,000 less in sales taxes.
Matchison sniffed at that claim.
"It is pure speculation to suggest any federal tax treatment would cause the payment recipients to spend less on purchases that are subject to Arizona sales taxes,'' she said. Anyway, Matchison told the judge, it really doesn't matter.
"Even if Arizona could show a decline in revenue, it was self-inflicted because Arizona's legislature chose a form of payment that didn't satisfy longstanding principles for exclusion from income,'' she said. "Self-inflicted harms to the state fisc cannot confer standing.''
And there's one more thing.
She said even if the state does have a claim, federal law requires people to pay the taxes first and then file a claim for a refund Only at that point, Matchison said, can a judge decide whether the tax was legal.
On X and Threads: @azcapmedia