Rebate money belongs to Arizonans, not IRS, AG Kris Mayes argues in suit against feds

The Internal Revenue Service's decision to tax the rebates received by nearly 750,000 Arizona families last fall is unfair, unlawful and arbitrary, Attorney General Kris Mayes alleges in a lawsuit filed Wednesday in federal court.

Her complaint seeks an injunction to block the IRS from taxing the rebates, as well as a finding that the agency's decision was unlawful.

"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 the Arizona taxpayers, not to the Internal Revenue Service," Mayes wrote in the complaint, using italics to emphasize what she saw as the unfairness of the situation.

The rebates to eligible Arizona parents ranged from $750 to $100, depending on the number and age of the children in a family.

But the IRS in December determined the Arizona Family Tax Rebate was subject to federal income tax. The Legislature exempted the payments from state tax.

The state Department of Revenue and tax preparers are advising taxpayers to fill out a Form 1099 to declare their rebate amount to the IRS. For taxpayers in the 22% bracket, a $750 rebate would carry a $165 federal tax. That bracket applies to married couples who file jointly and earned between $89,451 and $190,750 in 2023, according to IRS guidelines.

The rebate was the creation of the Legislature's Freedom Caucus. It was designed to provide families with dependent children some relief from inflationary costs. It was folded into the state budget and was signed by Gov. Katie Hobbs. She took some credit for the rebates, to the ire of caucus members.

Families were eligible for the rebate if they claimed a dependent child tax credit on their 2021 return and had at least $1 of tax liability in 2019, 2020 and 2021. The rebate granted $250 per child under age 17 and $100 for dependent children age 17 and up.

The lawsuit came after a Feb. 15 meeting that involved Mayes' office, the IRS, a representative of U.S. Sen. Kyrsten Sinema and Senate President Warren Petersen, R-Gilbert.

Petersen applauded the lawsuit.

"We welcome this," he said. "This is what an AG should do."

Suit compares Freedom Caucus rebate to programs in other states

In the lawsuit, Mayes argues the IRS exempted 22 state rebate programs from federal tax in 2022. But in 2023, when Arizona took similar action, the agency determined the state didn't qualify.

She said the IRS' reasoning was arbitrary and unequally applied, and the agency offered conflicting rationales for its determination the rebate is federally taxable.

In all, she estimated the federal tax will take $20.8 million out of Arizona taxpayers' pockets.

The IRS in a Feb. 15 letter explaining its rationale noted all earned income is taxable unless exempted by the IRS. The Arizona rebates didn't meet the criteria for two of the three exemptions: that the payment benefits the general welfare and that the payment is a tax refund.

Arizonans who had no tax liability in the years affected by the rebate criteria did not qualify, IRS Commissioner Daniel Werfel wrote. That left out many low-income families, while benefitting those with much higher incomes, and therefore ran afoul of the general welfare provision, which is based on financial need.

The rebates are not tax refunds, the IRS wrote. A refund represents an overpayment of taxes due, which means the amount varies from taxpayer to taxpayer. The rebate was a standard amount, based on the number of dependent children in a family.

But Mayes argues that the rebate was rooted in need, as families had to claim the dependent child tax credit, which was not available to high-income families.

"The IRS' unlawful determination is so arbitrary, capricious and inequitable as to constitute an unlawful targeting of Arizona and its taxpayers," the lawsuit claims.

Tax pros advise clients to report rebate as income

Tax professionals say they are advising their clients to file the Form 1099, which the state Department of Revenue has provided on its website.

“At this point, I can see absolutely no guidance that is going to have the feds change this," said Christine Z. Freeland, a certified public account.

On its face, the Arizona rebate doesn't meet the general welfare exemption, she said.

At Liberty Tax, owner Shelly Barrett said she's pointing all clients to the 1099 form, which is used to report miscellaneous income.

“They definitely need to be sure that 1099 is included,” Barrett said of taxpayers' filings.

Senate President Petersen said that's what he's doing, even as he maintains the IRS position is illegal. He's already directed his tax preparer to include the Form 1099.

Reach the reporter at maryjo.pitzl@arizonarepublic.com or at 602-228-7566 and follow her on Threads as well as on X, the platform formerly known as Twitter @maryjpitzl.

This article originally appeared on Arizona Republic: AG Kris Mayes sues feds to remove federal tax on AZ family rebate