By Howard Fischer
Mail | X: @azcapmedia

PHOENIX — The Internal Revenue Service is telling appellate judges that 750,000 Arizonans are not entitled to a refund of $20.3 million they paid in federal income taxes on a 2023 state tax rebate.

In filings with the 9th Circuit Court of Appeals, Anthony Sheehan, an attorney from the Department of Justice, said the way Arizona gave out the money made it taxable.

He acknowledged the IRS agreed to exempt rebates made by 21 other states from federal taxes. But Sheehan is telling the three-judge panel that legislators in those other states did what federal law allowed: provide relief for residents to help them deal with the costs of COVID.

But the Arizona law — and the $260 million given to residents — had absolutely nothing to do with the pandemic. Instead, he said, it was one way for lawmakers to deal with a $2.4 billion surplus.

Beyond that, Sheehan said the payments were not based on need, with no link between the amount of what the state was calling rebates — up to $750 for a family — and whether they actually had paid that much in state taxes.
Actually, he told the court, the reverse is true: As crafted, the most needy in Arizona were ineligible.

“The payment criteria excluded the poorest residents while allowing payments to high-income residents,” Sheehan wrote.

All that, he said, makes the payments to those who got them subject to federal income tax.

So far, the IRS is winning.

A trial judge last year tossed out a lawsuit filed by Attorney General Kris Mayes seeking to have the taxes paid declared illegal and the money refunded. That now puts the case before the federal appellate judges.
Even if Mayes wins, that doesn’t mean the affected taxpayers should look for a check in the mail.

Sheehan contends that even if $20.3 million paid by Arizonans on that $260 million in rebates never should have been collected by the IRS — a point he is not conceding — the state is in no legal position to sue for refunds of the excess taxes on behalf of its affected residents. Instead, even the state has conceded each would have to file an appeal.

The appellate judges appear to be interested in hearing more. They have scheduled a hearing for November.

At issue is the fact 21 states enacted programs in 2022, during the COVID emergency, to provide special payments to residents. And he said the IRS agreed in all those cases, the cash received was not subject to federal taxes.
But Sheehan told the appellate judges Arizona did not enact its own “Arizona families tax rebate” until May 11, 2023.

The IRS had decided the exemption from federal taxes applied only to rebates made in 2022, Sheehan said. Arizona’s payments of $260 million, however, went out in late 2023.

That, Sheehan said, makes those payments different than in the 21 other states. And that, he told the court in his legal briefs, means the state had no choice but to issue a 1099-MISC form to each rebate recipients and report it to the IRS

All this stems from a provision in the 2023 budget — when the state had a surplus — to provide a rebate to families of $250 for every child younger than 17 and $100 for older dependents, up to a maximum of $750 per family.

That generated about $260 million for 750,000 Arizona families, with the average rebate about $370.

What wasn’t known at the time lawmakers approved the measure was the IRS would later tell the state Department of Revenue it considers the way Arizona made the payments subject to federal income taxes.

Sheenan, in his latest court filings, provided the appellate judges a litany of reasons to reject Mayes’ efforts to sue the IRS to get a refund for affected Arizona taxpayers. And it goes beyond lawmakers here not meeting the deadline — as did the other states — to enact the rebate.

For one, he told the judge, the whole purpose of exempting rebate dollars from federal income taxes was to help people deal with the effects of the pandemic.

But that, Sheehan said, wasn’t what was behind the Arizona plan. And he noted the measure never once mentioned COVID or the IRS guidance about what would be tax exempt.

Instead, the legislation said the purpose was related to the fact “inflation is at a 40-year high, putting gas, groceries and other necessities out of reach for many Arizonans.”

“Responsible budget has allowed this state to take action to mitigate the harmful impacts of inflation by returning a portion of the surplus to this state’s taxpayers with dependents,” the law said.

There was a political element to the whole program — one that had nothing to do with COVID.

When enacting the budget in 2023, lawmakers found they were sitting on a $2.4 billion surplus. That was the amount left over after adoption of a funding plan for the upcoming fiscal year and made required adjustments for inflation and program growth.

To line up the votes, budget negotiators agreed to give each lawmaker money to allocated — generally $30 million for senators and $20 million for representatives, with a separate allocation for the governor — from that surplus.

Lawmakers had the option of pooling their shares.

Democrats put some money into a one-time $300 million funding boost for K-12 education. The $150 million deposited into the housing Trust Fund also came out of Democrats’ pooled dollars.

Sen. Jake Hoffman, chair of the legislative Freedom Caucus, sought to do the same for a tax rebate. But he found only some fellow GOP lawmakers were going along. Others, however, chose to earmark their shares for projects ranging from traffic circles, pavement improvements, sidewalk construction and extending highways, leaving only $260 million allocated for the rebate.

Aside from the rebate not being related to COVID, Sheehan pointed out this was hardly based on need. In fact, he said, the reverse was true.

On one hand, the rebates were paid strictly based on the number of dependents. And that it didn’t even require a showing that any family actually had paid that amount in state taxes.

“Because Arizona’s payments were not capped, they did not qualify as refunds,” Sheehan told the judge. As crafted, it even allowed a family that had paid as little as $1 in state income taxes to qualify for the maximum $750.

Conversely, Sheehan pointed out, only those who claimed a least one dependent on their 2021 state tax returns were eligible. So no relief for individuals or couples without children.

Then there’s that requirement to have paid at least $1 of state income taxes on that return or in two earlier years to qualify for the rebate.

There are no numbers immediately available about who doesn’t pay taxes. But state law exempts up to $14,600 income for single people and $29,200 for married couples filing jointly. Plus there are exemptions for things like Social Security benefits, active duty military and military retirement pay, and up to $2,500 for certain government pensions.

None of those who owed no taxes got any money.

Refunds aside, Mayes is pursuing another legal theory in her lawsuit against the IRS.

She said if the IRS had not taken that $20.8 million from state residents, they would have spent it here. And Mayes said the state would have collected about $480,000 in sales tax.

Snow dismissed any injury to the state as “derivative and speculative.” He said the state, in its lawsuit, admitted that the only certainty was that if Arizonans had retained the money they would have been free “to spend it as they saw fit.”

Sheehan told the appellate judges there was no basis for that $480,000 figures. And even if Arizonans had that much more to spend, he called it “speculative” to say the state would have benefited.

“They are free to use their money as they see fit, and not necessarily on items subject to Arizona sales tax,” he said.