Court Tosses State of Arizona's Lawsuit Against IRS for Taxing 2023 Rebate Payments

(Parker Tax Publishing December 2024)

A district court dismissed a lawsuit brought by the State of Arizona against the IRS for allegedly unlawfully taxing the state's rebate payments to certain Arizona residents that were paid in 2023. The court held that the state lacked standing to bring the lawsuit after finding that its allegations of lost state and local tax revenue as a result of the IRS's decision to tax the payments, and the IRS's alleged unequal treatment of Arizona, were insufficient to establish an injury in fact. Arizona v. IRS, 2024 PTC 412 (D. Ariz. 2024).

Background

In a February 2023 press release (IR-2023-23), the IRS issued guidance to clarify the federal tax status of special payments made by 21 states in 2022. The IRS stated that if a payment is made for the promotion of the general welfare or as a disaster relief payment - for example, related to the outgoing pandemic - it may be excludable for federal tax purposes. The IRS further stated that the determination of whether payments qualify for these exceptions is a complex, fact intensive inquiry that depends on a number of considerations. Accordingly, the IRS determined that the payments made by 21 states "were nontaxable in whole or in part."

In May 2023, the state of Arizona enacted the Arizona Tax Rebate (Rebate), which was a one-time rebate that "returned tax revenue" to taxpayers who (1) had dependents; (2) had met the income threshold to claim the dependent tax credit; and (3) had paid state income tax in a year between 2019 and 2021. The Rebate provided $250 for each dependent under age seventeen and $100 for dependents age seventeen or older, capped at $750 per taxpayer.

In August 2023, the IRS issued Notice 2023-56 to describe the rules that apply in determining the federal income tax consequences of refunds of state or local taxes and other payments made by or local governments to individuals. In an accompanying news release, the IRS stated that most taxpayers receiving state tax refunds do not have to include the state tax refund in income for federal tax purposes.

In a December 2023 video meeting, the IRS informed the Arizona Department of Revenue that the Rebate was "federally taxable in full." The Arizona Department of Revenue conveyed the IRS's decision to Arizona taxpayers, who paid an estimated $20.8 million in federal taxes to the IRS. The Arizona Department of Revenue calculated that the IRS's decision to impose federal taxes on the Rebate deprived Arizona of approximately $480,000 in state and local transaction privilege tax revenue that would have been derived from taxpayers' spending. Arizona also alleged that the IRS deprived Arizona and its taxpayers of consistent and equitable treatment because the IRS determined that the Rebate was taxable, but that other state refund programs were nontaxable.

Arizona sued the IRS in a district court and requested injunctive and declaratory relief to enjoin the IRS from federally taxing the Rebate. The IRS filed a motion to dismiss, arguing that Arizona failed to establish an injury in fact and therefore lacked standing to bring the lawsuit.

Analysis

The district court agreed with the IRS that Arizona did not establish an injury in fact and granted its motion to dismiss.

The court noted that other federal courts have held that the loss of state tax revenue generally does not constitute an injury in fact for purposes of standing. Moreover, the court found that Arizona failed to show a direct injury in the form of a loss of specific tax revenues. The state's claim that it lost approximately $480,000 of tax revenue as a result of the IRS's decision was, in the court's view, derivative and speculative. According to the court, Arizona's theory was derivative of an alleged harm to Arizona taxpayers who paid the federal tax and depended on a number of assumptions regarding how the taxpayers would have spent their money otherwise. Such a broad theory of standing, the court observed, would allow Arizona to challenge any assessment of federal tax on the speculative notion that Arizona taxpayers would spend the amount they would have otherwise paid in federal taxes on purchases that are subject to Arizona state or local taxes. The court concluded that Arizona did not demonstrate a direct link between the IRS's decision and its loss of state tax revenue, relying instead on a causal chain that was too attenuated to support standing in this case.

The court also rejected Arizona's claim of an injury based on the IRS's alleged unequal treatment of similarly situated states. The court noted that the IRS's February 2023 guidance applied only to the 21 states that made special, one-time payments in the 2022 tax year, and Arizona did not fall within that group of states. The court found that Arizona's payment occurred in 2023 when, among other things, the effects of COVID were different from those in 2022. The court pointed out that Arizona failed to reference a single state that made a one-time payment in 2023 but received different treatment than Arizona received from the IRS. According to the court, since Arizona was not similarly situated with those states that issued special, one-time payments in 2022, the IRS's alleged treatment of those states did not support a claim of unequal treatment.

Even if Arizona showed that it experienced an injury because the IRS allegedly made a different tax determination regarding a similarly situated state's one-time payment in 2023, the court found, such disparity in federal taxing would not necessarily constitute an injury in fact for standing purposes. The court pointed out that the IRS applied the same "complex fact intensive inquiry" in deciding whether to impose federal taxes on the Arizona Rebate that it applied to any other state. In the court's view, the mere fact that this inquiry may have yielded different results in the IRS's decision to impose federal taxes on the Arizona Rebate as opposed to another state's payment did not constitute sufficient injury for standing.

For a discussion of the exclusion from income for payments promoting general welfare, see Parker Tax ¶79,901.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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