Arizona AG tells IRS: Don't tax families for their rebate

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.

She said if the agency doesn’t back off — and soon — she may sue. Arizonans need answers before the April 15 deadline to file their federal returns, Mayes said.

There was no immediate response from the IRS.

In a four-page letter to Commissioner Daniel Werfel, Mayes said the agency is treating Arizonans differently than residents of other states that issued similar rebates. She dismissed IRS arguments that Arizona’s situation is legally distinguishable from those in other states.

Hanging in the balance is how much, if anything, Arizona families will owe the U.S. government out of the tax rebate the state made through paper checks and automatic deposits into their bank accounts last year.

The rebate came about because under a budget deal approved by the Republican-controlled Legislature and Democratic Gov. Katie Hobbs, part of a state surplus was used to create a $260 million pool to provide a rebate. The rebate was 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 that by notifying the Arizona Department of Revenue that the funds were taxable and that the state must inform the federal agency how much each family got. That, in turn, requires Arizonans to report the proceeds when they file their federal income tax returns, or run the risk of getting an unwelcome notice in the mail that their filing 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 — or 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’ arguments

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.

The attorney general said she wants a response from Werfel by Feb. 6.

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“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.

Some of Mayes’ 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 the IRS 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 that 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 involves a 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. Mayes 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 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.