Arizona Sues IRS Over Federal Tax on State Refund

The Arizona Attorney General filed a complaint against the IRS after the agency did not budge on its stance that a one-time rebate for qualifying taxpayers with dependents is subject to federal tax.

“The IRS’s unlawful determination is so arbitrary, capricious, and inequitable as to constitute an unlawful targeting of Arizona and its taxpayers in a manner that deprives Arizona of its right to make informed budgetary decisions in the best interests of the State and its taxpayers,” read a complaint for declaratory and injunctive relief penned by Arizona Attorney General Kristin Mayes and submitted February 21 with the US District Court for the District of Arizona.

“This lawsuit is about standing up for Arizona taxpayers,” said Mayes in an accompanying press release. “The federal government’s decision to tax these rebates is unfair and unlawful – and I will do everything I can to ensure the tax relief provided to Arizonans by their state government remains in the pockets of Arizona taxpayers, as intended.”

At issue is the Arizona Family Tax Rebate included in Governor Katie Hobbs’ 2023 budget worth $250 for claimed dependents under age 17 and $100 for those older. Arizonans could claim up to three dependents for a maximum rebate of $750. To qualify, a taxpayer must have claimed the state’s dependent tax credit on their 2021 full year Arizona income tax return and had “at least $1 of Arizona individual income tax on their 2021 returns or had at least $1 Arizona individual income tax on their 2020 or 2019 Arizona returns under the same filing status as their 2021 return,” as explained by FAQs posted by the Arizona Department of Revenue (emphasis in original).

If the credit reduced a taxpayer’s liability to zero “in all of these tax years,” they do not qualify for the rebate, the Arizona DOR also clarified.

In guidance released last February (IR 2023-23), the IRS identified 17 states that issued general welfare and/or disaster relief payments in 2022 that were either directly or indirectly related to economic hardships attributable to the COVID-19 pandemic. The IRS decided at the time that it was “in the best interest of sound tax administration” to exempt those state tax rebates from federal taxable income, especially since the pandemic emergency declaration was still in effect.

Later in August, the IRS followed up this position in Notice 2023-56 to provide that the previous guidance only applies to tax year 2022. It also established criteria for the state payment exclusion to the general rule that federal gross income includes all income from whatever source derived. “To qualify for the general welfare exclusion, State payments must (1) be paid from a governmental fund, (2) be for the promotion of general welfare (that is, based on the need of the individual or family receiving such payments), and (3) not represent compensation for services absent a specific Federal income tax exclusion.”

Arizona leadership believed its rebate program met these requirements and was surprised when the IRS conveyed over a video call in December that was not how the agency would proceed. Taxpayers were notified that they would receive a Form 1099-MISC, Miscellaneous Information, to report the rebate on their 2023 federal income tax return.

Mayes elevated the matter to IRS Commissioner Danny Werfel in a January 25 letter, arguing the agency’s determination conflicts with last year’s guidance. “The Tax Rebate unquestionably satisfied the first and third prongs of” the state payment exclusion test “because it was paid out of Arizona’s general fund to qualifying Arizonans, not as compensation for services, read the letter. “It also satisfied the second prong because it was not available to all Arizonans or an undifferentiated class of Arizonans, but rather only to Arizonans (1) with dependents; who (2) claimed a Dependent Tax Credit (a de facto income cap), thereby establishing two measures of need.”

In response, Werfel upheld the classification of the rebate as federal taxable income. Providing analysis from the Office of Chief Counsel, the commissioner’s February 15 letter explained that the general welfare exclusion is intended for payments limited to low-income recipients. “[T]he income limitations for the payments are above the limit of what we generally consider to be covered by the general welfare exclusion,” wrote Werfel. “Eligibility for the payments begins to phase out at $400,000 for married taxpayers filing jointly and $200,000 for all other filers.”

Werfel also dinged the Arizona rebate for not applying to those without income tax liabilities during 2019-2021. “[R]ather than targeting relief to low-income residents with dependents, the legislation expressly excludes such low-income residents from receiving the payments while including almost all similarly situated Arizonans with higher incomes.” He concluded the program is not based on need.

Raising similar points in her initial letter, Mayes wrote in her complaint that her state’s rebate should be treated the same as 2022 relief by other states despite applying to tax year 2023. “[T]he IRS did not identify a single program that it had found nontaxable for 2022 but would have found taxable in other years based on the criteria that it enunciated.”

According to the lawsuit, recipients would remit to the IRS a total $20.8 million, and Arizona would lose out on an estimated $480,000 in sales tax revenue that would be collected from direct rebate spending.

For more information about excluding “general welfare” government payments, see Checkpoint’s Federal Tax Coordinator ¶ J-1480A.