Key Points:

• Arizona filed a lawsuit to recover $20 million taken from Arizona taxpayers by the IRS

• State lawyers say the IRS improperly taxed one-time rebate checks from 2023 

• 21 other states who passed similar rebates were not taxed

State lawyers are asking a federal appellate court to allow them the opportunity to recover more than $20 million they claim was illegally taken from approximately 750,000 Arizona taxpayers.

In legal briefs, members of the Attorney General’s Office contend that U.S. District Court Judge Murray Snow erred in upholding the Internal Revenue Service’s decision that $260 million in one-time rebates in 2023 were subject to federal taxes.

Murray did not dispute that the IRS reached a contrary decision regarding the one-time payments to residents in 21 other states. But he said what Arizona did was factually different — including the fact that the “rebates” in some cases exceeded the amount of state taxes that some residents paid.

And there’s something else.

Snow stated that only individuals who claim to have been injured by the IRS decision have the right to sue. And none are named as plaintiffs.

But Assistant Attorney General Josh Bendor is telling the 9th Circuit Court of Appeals that the state does have standing to sue.

His proof?

Bendor stated that the IRS collected approximately $20.8 million from state residents. Had they spent that money, he figures the state would have collected about $480,000 in sales tax.

Snow dismissed any injury to the state as “derivative and speculative.” In fact, he said, even 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.”

But Bendor is telling the appellate judges that Snow’s conclusion was “premature,” arguing that the state is entitled to its day in court, something it did not receive when Snow dismissed the case without hearing evidence.

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 an average rebate of about $370.

What wasn’t known at the time was that the IRS would later tell the state Department of Revenue it considers such payments subject to federal income taxes.

Based on that, state revenue officials said they had no choice but to issue a 1099-MISC form to each rebate recipient. That form covers certain types of miscellaneous compensation, including prizes, that are not covered by other documents federal law requires to be issued.

More to the point, a copy of those forms went to the IRS, just like a W-2 for wages, making the federal government aware of who received the payments — and making the taxpayers liable to report it and pay taxes on it.

A key to Bendor’s argument to the appellate judges is that the IRS, in effect, is discriminating against Arizona and its taxpayers. That’s based on his argument that the federal agency allowed residents of other states to keep their full rebates without having to pay federal taxes.

“The IRS treated 21 states favorably and then, without a reasoned basis, treated Arizona unfairly — an action that was arbitrary and capricious in violation of the Administrative Procedures Act and that derived Arizona of equal sovereignty under the U.S. Constitution,” Bendor wrote.

“The IRS cannot dispute its disparate treatment of Arizona,” he continued. “It can only attempt to justify it.”

Bendor also hit back at Snow’s conclusion that any loss to Arizona in sales taxes was speculative. He said the state supported that conclusion with declarations from an economist from the Arizona Department of Revenue.

Bendor said it’s irrelevant if the amount of lost dollars does not equal the state claims.

“The IRS cannot plausibly dispute that taking over $20 million out of Arizona caused the state to suffer at least some tax-loss injury, even if the quantum differs from what Arizona has alleged,” he said.

Strictly speaking, the 9th Circuit cannot order the IRS to refund the money. Instead, all the appellate court can do — if they agree with Bendor — is order Snow to take another look.

But even if the 9th Circuit sides with the state, and even if Bendor can convince Snow to change his mind, that doesn’t mean the Arizonans who had an extra bite taken by the IRS will automatically get a check.

“That would be our preferred relief,” said Richie Taylor, a spokesman for the Attorney General’s Office.

“But the IRS has said that it cannot reliably identify individual taxpayers who paid tax on the tax rebate,” he told Capitol Media Services. “If accurate, taxpayers may need to request refunds from the IRS in the event we ultimately prevail.”

This would mean filing amended tax returns for the 2023 tax year.

As it turns out, the state, while using its $480,000 claimed loss as the basis for being able to sue, isn’t actually asking the federal government for the money. Richie said the presumption is that if Arizona wins and taxpayers do get their $20 million back, they will spend it, and the state treasury will eventually receive its sales taxes that way.