Judge says he's not likely to block IRS from taxing Arizonans' rebate

U.S. District Judge Murray Snow also said during a Tuesday hearing that he was not even convinced the state has a right to sue over an Internal Revenue Service finding that the rebates about 750,000 Arizona families received last year are taxable.

But Snow said the state is likely to be successful in limiting the reach of the taxes, to the amount that exceeded taxes actually paid by the state’s residents in the three years covered by the rebate. But he said that’s only if he gets past the issue of legal “standing.’’

And although he seemed to warm to the state’s arguments that the IRS ruling was illegal as the nearly hour-long hearing went on, he said he still was unlikely to immediately block the IRS from collecting an estimated $20.8 million that state taxpayers will likely owe if it is upheld.

An IRS attorney, Amy Matchison, said told Snow that was the right path. Not only does the state lack the legal standing to sue, she said, but upending the status quo by issuing the preliminary injunction sought by Arizona would throw a monkey wrench into a tax filing season that is just two weeks from ending.

All this has left Arizonans who got the rebate up in the air over whether they should declare and pay taxes on those dollars.

The state paid out about $260 million in payments, which averaged $370 and maxed out at $750 per family. Arizona Attorney General Kris Mayes is seeking an order that the rebate proceeds are not taxable.

A large number of taxpayers have already filed, many have paid and many others might not even know they owe taxes on the payments, Matchison said.

She said if the judge issues the order Mayes wants, it could trigger audits for tens of thousands of taxpayers to determine what they owe. Those audits are not only unwelcome, but the IRIS lacks the staff to conduct them, she said.

There’s a complicating factor.

Strictly speaking, Arizona isn’t suing on behalf of the taxpayers who got the rebate, but only for its own potential losses, which it says equal about $400,000 in sales tax revenue it would collect if people bought goods with the money they instead will owe in additional federal taxes.

Matchison said the state’s potential losses are mere guesswork that have too few facts backing them to give the state the right to sue.

“It’s too highly attenuated a chain of events to establish causation, and there’s too much guesswork here based on the independent decision-making of third parties,’’ she told Snow.

That prompted a question from Snow. “Where’s the line?’’ he asked. “Where’s the line between standing and no standing?’’

“I think you have to have something more than what the state has shown here,” Matchison said.

She also said it’s the Legislature’s fault the IRS determined the rebates were income that needed to be reported.

Matchison called it a “self-inflicted injury’’ because lawmakers did not tie the rebate to a disaster like 21 other states did before Arizona enacted its rebate. The IRS considered that while determining Arizona’s rebates were taxable while the other states’ were not.

The tax rebate, included as part of last year’s state budget deal, was passed the day President Joe Biden ended the COVID-19 emergency declaration. Arizona’s Republican-controlled Legislature said it was issuing the rebates to help families hit hard by rampant inflation and did not mention the pandemic or any disaster.

At issue for individual taxpayers is owing more money to the IRS. Someone who got a $500 tax rebate and is in the middle of the federal government’s seven tax brackets would owe about $110 in additional taxes.

Matchison said if the Legislature had written in the law that the rebates were needed to deal with a disaster, the IRS would likely have made a different decision.

That’s not how Assistant Attorney Clinten Garrett framed the question.

For him, the decision to tax the rebate checks was arbitrary and illegal because state tax rebates and refunds are not normally taxable. He urged Snow to stop the IRS from forcing Arizonans to pay just because it is a complex legal issue.

“I think the question at this point is if the IRS has made a wrongful determination (on the taxes), what can be done about that,’’ Garrett told Snow. “Are we really going to ask Arizonans to pay that tax and wait months or years’’ for a refund while the case winds its way through the courts?

But Snow said he’s not sure he can even rule that the IRS decision to tax the rebates was illegal as Garrett wants.

Even if he agrees with Arizona’s argument, Snow said, there is clearly at least some amount that is taxable because the rebates exceeded what some people paid in state taxes and are therefore considered income.

But Garrett pushed on, saying the state wants Snow to bar the IRS from collecting taxes on the rebates and to refund any payments already made.

Snow promised a decision on what he called “a difficult case’’ as fast as he can.