By Howard Fischer
Capitol Media Services
PHOENIX -- The Internal Revenue Service has no right to force 750,000 Arizona families who got a state income tax rebate last year to now pay federal taxes on the funds, Attorney General Kris Mayes said Thursday.
And she said if the agency doesn't back off -- and soon -- she may sue, saying Arizonans need answers before the April 15 deadline to file their federal returns.
There was no immediate response from the IRS.
In a four-page letter to Commissioner Daniel Werfel, Mayes said that it was treating Arizonans differently than residents of other states which had issued similar rebates. And she dismissed IRS arguments that what occurred here is legally distinguishable based on a belief those other programs were somehow connected to COVID relief programs.
"But the pandemic emergency declaration appears to have had (ITALICS) no (ROMAN) material bearing on the programs in California, Colorado, Idaho, and elsewhere,'' Mayes told Werfel. "And while sound tax administration is always desirable, it is not a license to treat similarly situated states and taxpayers differently (or arbitrarily) based on unrelated national exigencies that happen to roughly coincide with a particular program.''
Hanging in the balance is how much, if anything, Arizona families are going to owe the federal government of those paper checks and automatic deposits made into their bank accounts last year.
The rebate came about because the Republican-controlled Legislature did not want to use the approximately $1.8 billion surplus to create new, ongoing programs.
Instead, the deal with Gov. Katie Hobbs and Democrats provided some one-time funding like $300 million for K-12 education and $150 million into the Housing Trust Fund. GOP lawmakers each got a certain amount they could use, with many of them proposing earmarks for special projects like road improvements and repairs to the Prescott Rodeo grounds.
But several pooled their resources to create a $260 million pool to provide a rebate of $250 for any child younger than 17 and $100 for older dependents, with a maximum of $750 per family.
The IRS threw a damper on all that by notifying the state Department of Revenue that the funds were taxable and that the state had to inform the federal agency of how much each family got. And that, in turn, requires Arizonans to report the proceeds when they file their federal income tax returns or run the risk of getting one of those unwelcome notices in the mail that what they filed does not match federal records.
How much Arizonans would owe if the IRS does not back off depends on how much they earn.
There are seven 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 who is in the 22% bracket -- from $44,726 to $95,375 for individuals -- would be required to give back $110 to Uncle Sam.
Mayes, in her letter to Werfel, said his agency's determination the rebates are taxable is contrary to IRS policy.
She cited a notice published by the agency that said payments made to individuals by the government under "legislatively provided social benefit programs for the promotion of the general welfare'' need not be included in the recipient's federal gross income, the starting point for computing taxes owed.
Some of her arguments are technical, getting into the fact that the rebates were not available to all Arizonans but only those who met the specified conditions.
But she also told Werfel that his agency has previously concluded that rebate proceeds from programs in other states were not taxable.
"These programs were generally indistinguishable from Arizona's rebate except insofar as they were less restrictive,'' Mayes said.
Consider, she said, the "Colorado Cash Back'' program, a 2022 law which gave residents there a $750 rebate for individuals and $1,500 for married couples filing jointly. Mayes said the IRS is not making recipients pay federal taxes on those dollars.
Ditto, she said, for California's "Middle Class Tax Refund'' which was generally available to all residents who fell within the program's income range and could not be claimed as dependents.
For example, a married couple making up to $150,000 a year with dependents would get an estimated $1,050 payment.
But much of what Mayes is saying falls into some highly technical areas of tax law and how the IRS interprets the code.
For example, some of this goes to the question of whether the rebate should be taxable if it does not exceed the taxes actually paid and if that person did not itemize and deduct those state taxes from his or her federal tax return. She said making everyone pay is "inequitable and arbitrary.''
"It is inequitable because approximately 75% of Arizonans who received a tax rebate payment had a tax liability in excess of the rebate amount,'' she said. Mayes cited figures saying that Arizonans who claimed a rebate had an average tax liability of about $1,700 for the year the rebate was claimed against an average rebate amount of $370.
She said taxing that is "in violation of the IRS' own criteria.''
"And many more Arizonans will be federally taxed on the entire rebate, even though they paid at least some state taxes in an eligible year,'' Mayes said.
The attorney general said she wants a response from Werfel by Feb. 6.
"If we are not able to satisfactorily resolve this issue by then, I will consider all possible avenues for potential legal action on behalf of the state and its taxpayers in advance of this year's filing deadline,'' she wrote.
None of this affects what rebate recipients owe the state. The legislation enacting the rebate spells out that any amounts received are not subject to state income taxes.
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