By Kate Cox.
Nothing is certain except death, taxes…and states challenging the limits of federal power.
In October 2023, Governor Katie Hobbs announced the one-time Arizona Families Tax Rebate after a bipartisan coalition in the State Legislature passed Senate Bill 1734. This was welcome news to qualifying Arizonans who could expect to see a rebate of up to $750 for single and head of household taxpayers, and up to $1,500 for married taxpayers who file jointly. However, this program for returning state revenues to Arizona families was slightly soured after the United States Internal Revenue Service (IRS) determined that the rebate was subject to federal income tax, i.e. that this refund of surplus money taxpayers previously paid as state income tax would count as income for the purpose of determining federal income tax liability.
As a result, when Arizona families file their taxes, they may have to pay some of their Arizona tax rebate to the federal government. While this came as a surprise to the approximately 700,000 Arizona families who received the rebate, it came as an even bigger shock to State officials. Just a few months before the Arizona Legislature voted to adopt the tax rebate, the IRS issued guidance stating that similar rebates in seventeen other states in 2022 were not subject to federal income tax. In fact, the Arizona tax credit seemed to more closely meet the criteria for not being taxable than some of the states whose rebates were not subject to a federal income tax.
Bipartisan Pushback: Arizona Leaders Unite Against the IRS
Policy-makers on both sides of the aisle are not happy about the IRS’s position that Arizona’s rebate was taxable. Democratic Representative Greg Stanton introduced a bill in Congress, co-sponsored by Republican David Schweikert, that would explicitly exclude the tax rebate from the federal income tax. Arizona Attorney General Kris Mayes urged the IRS to reconsider their decision. Republican Senate President Warren Petersen spoke out saying, “It makes zero sense that the IRS is choosing to hurt Arizona families by taxing a tax rebate. I’m thankful for the help from Senator Sinema’s office in working to get this matter front and center with the IRS and U.S. Treasury.”
Despite these efforts, the Arizona Department of Revenue had to communicate to Arizona taxpayers that they would have to give part of their rebate to the federal government in the form of income tax. However, the State’s opposition to the IRS’s position is not entirely altruistic. Admittedly, when the State authorized this rebate, they expected to see some of this money return to state coffers by way of transaction privilege tax, better known as sales tax.
State Sovereignty on Trial: Arizona Files Suit Against the IRS
In February 2024, Arizona Attorney General Kris Mayes announced that she would be taking action on behalf of the State. She filed a lawsuit against the IRS in federal district court on February 21, 2024.
Arizona’s legal team argues that the rebate should be classified as a return of tax payments rather than income. By the State’s reasoning, these funds are essentially being “returned” to taxpayers due to surplus state revenues, akin to a tax refund rather than new income. Arizona contends that the IRS’s treatment of the rebate as taxable income contradicts its previous guidance on similar rebates, adding that Arizona residents are being unfairly singled out. The state further asserts that the IRS is overstepping its authority by imposing tax burdens on state-created programs intended to benefit local residents, which they argue should be within Arizona’s jurisdiction to administer without federal interference.
Welfare Wars: The Power Struggle Over the Well-Being of Our Communities
In October 2024, the IRS presented a motion to dismiss the case, arguing that Arizona’s claims lack merit, that the State lacks standing, and that the IRS is within its rights to classify the rebate as taxable income under federal law.
Arizona responded to the IRS’s motion by reiterating that the rebate should be seen as a return of state-collected funds rather than federally-taxable income. The State’s attorneys emphasized that the rebate was created to address Arizona’s specific economic conditions and that the IRS’s guidance in 2022, which recognized certain state rebates as non-taxable, should apply to the Arizona Families Tax Rebate.
The State also contended that the IRS’s claim of a lack of standing is invalid because of the impact the IRS policy has on Arizona families, and the state has a legitimate interest in protecting its residents from what it views as federal overreach. Moreover, Arizona’s legal team raised concerns about the implications of the IRS’s inconsistent treatment of state rebates, arguing that it infringes on state sovereignty by imposing federal tax rules on funds that belong to state residents.
State v. Federal: What Happens Next?
The court’s decision on the IRS’s motion to dismiss, argued in Arizona District Court on October 23, 2024, is still pending. No matter the outcome, the decision and trajectory of this case will have broad legal implications. The case revolves around the extent of federal authority over state-initiated tax credits and other tax-related incentives. If the IRS prevails, it could establish a precedent limiting state tax policies designed to sidestep federal tax liabilities. A victory for Arizona might solidify state powers to establish tax credits that aid local residents, without interference from federal tax codes.
However, this legal battle also underscores the deeper conflict over the boundaries of federal and state power. Arizona has argued that the tax rebate is tailored to address specific state-level challenges, like poverty and housing insecurity. This comes in light of the broader debate over whether states or the federal government are better equipped to design welfare programs that meet the unique needs of local populations. Additionally, a win for Arizona could boost local innovation and experimentation across the country with states enacting tax incentives in areas where federal programs might be less responsive or effective, leading to a more diversified approach to welfare policy across the nation.
Whether the court sides with Arizona or the IRS, the outcome could influence the future of state-led tax rebate programs and further define the scope of federal influence over state tax policies. This case serves as a reminder that even in matters of fiscal policy, the tension between federal oversight and state sovereignty continues to be a central issue in American governance that crosses the political aisle. Arizona’s lawsuit against the IRS represents not only a fight over tax definitions, but also a broader struggle for control over state-directed economic relief.
Kate is a Phoenix-native and undergraduate alumna of the University of Arizona who spent her college years engaging in the democratic process on political campaigns and interning at the Arizona State Legislature and her early career leading public policy initiatives in state government. She is now a third-year law student at Arizona State University with a strong interest in constitutional law and government representation. She has had the opportunity to hone her legal researching skills while working with Judges at both the Arizona Court of Appeals and the United States District Court.