Judge Declares AZ Tax Rebates Subject to Federal Taxes

Recent federal court rulings have dashed hopes for many Arizonans expecting to keep the full amount of their state tax rebates. Those who received these rebates last year, totaling around $20.8 million in federal income tax payments, will not see that money returned.

U.S. District Court Judge Murray Snow dismissed claims from Arizona Attorney General Kris Mayes that the one-time payments—up to $750 per family—should be exempt from federal taxes, unlike similar rebates in other states. Mayes’ argument leaned on examples where recipients were allowed to retain all their funds.

In his ruling, Judge Snow clarified that Arizona’s situation differs from those others, affirming the IRS’s standpoint that the payments are taxable income. In addition, he stated that only individual taxpayers who claim to have suffered harm due to the IRS decision have the standing to sue.

Despite this, Arizona’s legal team attempted to argue that the state itself incurred harm, estimating a loss of about $480,000. They based this on the premise that had Arizonans kept their rebate money, it would have circulated within the state, generating sales taxes. However, Judge Snow criticized this claim as speculative.

He further pointed out that even the state conceded only that residents would have had the discretion “to spend as they saw fit” if they hadn’t had to pay federal taxes. Mayes expressed disagreement with the ruling, maintaining that tax relief meant to benefit Arizona taxpayers should not have been seized by the IRS.

The rebate program, part of the 2023 budget during a state surplus, intended to distribute $250 for each child under 17 and $100 for older dependents, capping at $750 per family. This initiative provided financial relief to approximately 750,000 Arizona families.

Following the IRS’s classification of these payments as taxable income, the state sent 1099-MISC forms to rebate recipients, signaling federal tracking of the payments, like a W-2 form does for wages. The Attorney General’s Office subsequently filed a lawsuit against the IRS.

Arizona lawmakers argued that their intent was for tax revenue to return to residents rather than be redirected to federal taxation. They maintained the payments were not compensation for services and should therefore be non-taxable, especially as other states had managed similar rebates without federal tax implications.

However, Judge Snow emphasized a critical distinction: other states provided their rebates in 2022 as part of COVID relief measures, which tied them to a federally declared disaster. Arizona’s payments, by contrast, stemmed from a budget surplus, cited specifically as a response to inflation impacts rather than pandemic relief.

Moreover, the IRS highlighted a significant difference in income thresholds for eligibility. Payments in other states included income restrictions, qualifying them for exclusion under the “general welfare” provision. Arizona’s criteria allowed individuals earning up to $200,000 and couples up to $400,000 to receive the rebate, thus encompassing a larger pool of taxpayers.

Concerns about the fairness of the program arose, as individuals with no tax liability in previous years were ineligible for the rebate. This affected lower-income Arizonans, further complicating the argument for the rebate’s need-based component.

Ultimately, the amount individuals owed varied based on their income tax bracket. For example, a single individual receiving a $500 rebate in the 22% tax bracket would owe back $110 to the IRS, making the tax implications significant for many recipients.