Mayes sues IRS over decision to tax 2023 tax rebates for AZ parents

Arizona Attorney General Kris Mayes filed a lawsuit against the Internal Revenue Service on Wednesday to block the federal government from taxing an income tax rebate given to many Arizona parents last year.

At issue was the IRS’s determination in January that Arizonans would have to pay federal income taxes on those state tax rebates, which were approved as part of the state budget in 2023. Arizonans who filed state tax returns in 2019, 2020 or 2021 and claimed at least one dependent were eligible to receive a rebate of up to $750.

The IRS had issued guidance in February 2023, about three months before Arizona lawmakers approved the tax rebates, that similar rebates in 21 states made the year before were not subject to federal taxes. In August 2023, issued additional guidance that said the February guidance was only applicable to 2022 tax payments.

But, Mayes noted in her lawsuit, the IRS “did not identify a single program that it had found nontaxable for 2022 but would have found taxable in other years.” Instead, the IRS said that state tax payments to taxpayers wouldn’t be taxable if they were for “promotion of the general welfare” and aren’t compensation for services.

And many of those 2022 tax refund programs in other states were less targeted than Arizona’s. For instance, taxpayers in Alaska, Colorado, Delaware, Idaho, and Indiana received rebates without any consideration of income. And California gave money back to all taxpayers who earned less than $500,000 a year. 

But in December 2023, the IRS told the Arizona Department of Revenue that Arizonans would have to pay federal taxes on the state rebate. The decision was announced orally during a video meeting, and nothing was provided in writing until Feb. 15 — and that came only in response to a letter that Mayes sent to the IRS demanding an explanation.

“The IRS’s determination was arbitrary, capricious, inequitable, and unlawful,” Mayes wrote in the lawsuit.

“There was no reasoned basis to deprive Arizona and its taxpayers of consistent and equitable treatment, particularly given that the Arizona Tax Rebate — unlike other approved programs — was available only to taxpayers with dependents who met the income requirement to claim a Dependent Tax Credit,” Mayes added.

In that Feb. 15 letter and a video conference call that day, the IRS claimed that the February 2023 guidance “did not reflect a legal determination” for how tax rebates would be considered taxable. 

Mayes claims that the IRS’s decision to tax the rebates means Arizonans will be forced to pay $20.8 million in federal taxes that would otherwise stay in the state — and that means $480,000 less sales taxes for the state and local governments.