PHOENIX (CN) — The Internal Revenue Service defended its decision to tax Arizona’s 2023 Family Tax Rebate Wednesday, moving to dismiss a lawsuit from the state claiming violations of federal law and state sovereignty.
In a Phoenix courtroom before U.S. District Judge G. Murray Snow, the state argued that Arizona citizens should be treated the same as citizens of 21 other states who were issued state tax refunds in 2022, and were told they didn’t have to report those refunds on their federal tax returns.
The rebate, a one-time payment included in Governor Katie Hobbs’ 2023 budget, refunded those who claimed dependents on their state tax returns in 2019, 2020 and 2021. Taxpayers received $250 per dependent under the age of 17 and $100 per dependent over the age of 17.
“Arizona has been subject to this IRS action when all these similarly situated states were not,” state attorney Clinten Garrett argued Wednesday.
Snow asked why the state can claim unequal treatment based on separate decisions made in two different fiscal years.
“I don’t think the IRS gets to say there’s something magical about the turning over of the calendar here,” Garrett responded.
“So the IRS guidance can’t change?” Snow asked.
Garrett conceded that the IRS can always change its guidelines, but said changing a final determination without warning or explanation is a different story.
The IRS claims an equal treatment argument is invalid because the Arizona tax returns were paid out in a different year, when different guidelines applied.
The IRS determined in February 2023 that similar rebates given out by 21 other states in 2022 were not subject to federal income tax. Arizona created its tax rebate in reliance on those guidelines.
It wasn’t until December, a month after most families received their refunds, that IRS officials told the state Department of Revenue via video chat that Arizonans would have to list their refunds when filing federal tax returns.
Amy Matchison, representing the IRS, told Snow that the state doesn’t have standing to bring the suit anyway, because it’s individual taxpayers, not the state itself, who were injured by the taxation.
“Its chief alleged injury is a loss of transaction privilege tax, which is wholly derivative of injury to taxpayers,” she said. “There are actual aggrieved taxpayers who can challenge the IRS’ position.”
Roughly 740,000 people received tax refunds through the rebate program, according to court documents.
Because the IRS decided to tax the money, the state says more than $20 million that should be in Arizona families’ pockets has gone back to the federal government. Additionally, the state estimates it lost out on $480,000 in transaction privilege tax it would have made on untaxed refunds.
Snow reminded Garrett the courts rarely grant states Article III standing to sue the federal government based on loss of tax revenue. Garrett clarified that courts only do when the state has a specific claim rather than a claim of general revenue loss.
But Matchison pointed out that the state’s estimated transaction privilege tax loss is just that — a non-specific estimation. She said individuals should file their own class action if they want a refund on the federal taxation.
Because the federal tax on the state rebates has already been collected, Snow wondered whether the case is moot because there’s nothing left for him to enjoin. Garrett asked that he enjoin the IRS from rejecting any requests from Arizonans seeking refunds on those taxes.
Snow did not indicate when he would decide on the IRS’ motion for dismissal.