Court Denies Arizona's Motion to Enjoin IRS From Taxing State Rebate Payments

(Parker Tax Publishing April 2024)

A district court denied the state of Arizona's motion for a preliminary injunction to enjoin the IRS from imposing and collecting federal income tax on onetime payments made by the state of Arizona beginning in October 2023 to certain Arizona taxpayers. The court found that it likely did not have jurisdiction to issue the injunction under the Anti-Injunction Act and found that the alleged damage to the state resulting from its obligation to issue 1099s was not the appropriate subject of injunctive relief. State of Arizona, et al. v. IRS, 2024 PTC 108 (D. Ariz. 2024).

Background

On March 13, 2020, the President declared a national emergency pursuant to the National Emergencies Act based on the outbreak of COVID-19. In 2022, 21 states made special payments to their citizens in part to provide relief during the pandemic. In early 2023, recipients of these payments were confused as to whether the payments were includable in taxable income for their 2022 federal tax returns. Acknowledging this confusion, the IRS issued a press release (IR-2023-23) providing guidance on how it would treat those 2022 payments for the purpose of federal income tax. The IRS stated that in the interest of sound tax administration and other factors, taxpayers did not need to report these payments on their 2022 tax returns, and the IRS would not challenge the treatment of the 2022 payments as excludible from income on an original or amended return.

On August 30, 2023, the IRS issued more guidance in IR-2023-158 to further clarify what types of special payments from states are includable in federal taxable income. That guidance went beyond the earlier guidance, which was solely focused on special payments made in 2022, to explain what types of payments are typically exempt from federal income tax: "Most taxpayers receiving state tax refunds do not have to include the state tax refund in income for federal tax purposes. As a general rule, taxpayers who choose the standard deduction on their federal income tax returns do not owe federal income tax on state tax refunds." But as the guidance went on to specify, for those who itemize: "Payments made by states under legislatively provided social benefit programs for the promotion of the general welfare are not included as income on an individual recipient's federal income tax return. To qualify for the general welfare exclusion, state payments must be paid from a governmental fund, be for the promotion of general welfare (that is, based on the need of the individual or family receiving such payments), and not represent compensation for services. Determining whether payments qualify for this exclusion is a complex, fact-intensive inquiry that depends on a number of considerations."

On May 11, 2023, the COVID-19 national emergency expired. That same day, Arizona Governor Katie Hobbs signed Senate Bill 1734 ("Arizona Tax Rebate") into law. That bill authorized onetime payments to Arizona taxpayers who claimed a dependent tax credit and had a tax liability of at least $1 in the 2021, 2020, or 2019 tax year. The bill did not authorize any payments for families that did not owe tax in the relevant years, nor did it cap total payments to actual Arizona income tax liability for the relevant years. The payments could be issued no earlier than October 15, 2023. The payments were explicitly excluded from recipients' Arizona gross income. The bill's legislative findings stated that inflation was at a forty-year high and that responsible budgeting allowed the state to take action to mitigate the harmful impacts of inflation by returning a portion of the surplus to the state's taxpayers with dependents.

In August 2023, the IRS issued Notice 2023-56 to describe the rules it applies when determining the tax treatment of state refunds or payments. On August 30, 2023, the IRS hosted a call for states to discuss the guidance. A representative from the Arizona Department of Revenue (ADOR) was on that call. In October 2023, the ADOR asked the IRS for guidance on whether the payments would be includable in federal taxable income. In an email to the IRS, the tax policy executive for ADOR stated that "[w]hether Arizona's rebate is subject to federal income tax is ultimately a federal determination." He also explained that: "Arizona's rebate was enacted after the federal government lifted the Covid emergency and based on what I read it seemed at that point that Arizona's 2023 rebate would likely be taxable. I later read the [IR-2023-158] and thought it was possible that Arizona's rebate could fall under the general welfare provisions."

In a follow up email sent in November 2023, the Arizona tax policy executive wrote "[w]e don't need official legal guidance or anything like that, just sort of a head's up (taxable or not taxable) . . . [t]he issue is we are currently having to proceed as if the rebate is taxable for federal purposes." The ADOR further indicated it was already preparing Forms 1099 for payment recipients. In a December 2023 meeting, the IRS informed the ADOR that the payments were not exempt from treatment as income. The ADOR made 1099s available to all recipients by January 31, 2024.

In February 2024, Arizona filed a lawsuit against the IRS alleging violation of equal sovereignty, unlawful taxation of non-income, unlawful denial of general welfare or disaster relief exclusions, violation of the Administrative Procedure Act, and violation of Congress's taxing power. Arizona moved for a preliminary injunction, asking the court to enjoin the IRS from imposing and collecting federal income tax from the Arizona Tax Rebate. Arizona acknowledged that it was not seeking direct monetary relief on behalf of its taxpayers. The state alleged that, as a political entity, it suffered damage separate from that suffered by its taxpayers from the IRS's determination to tax the rebate. First, the state asserted that it lost $480,000 in transaction privilege taxes because the federal tax liability on their state rebates will not be available to spend in Arizona. Second, the state alleged damage due to its obligation to issue 1099s to rebate recipients. Third, the state alleged sovereign injuries because the IRS treated Arizona's 2023 tax rebate differently from how it treated the 2022 rebate of 21 other states.

Analysis

The district court denied Arizona's motion for a preliminary injunction. The court found that under Ninth Circuit precedent established in Confederated Tribes and Bands of Yakama Indian Nation v. Alcohol & Tobacco Tax & Trade Bureau, 843 F.3d 810 (9th Cir. 2016), there was considerable doubt as to whether the court had jurisdiction to hear the state's claim. In Yakima Nation, the Yakima Indian Tribe, a tribal corporation, and a tribal member sought to enjoin the imposition of excise taxes on tobacco products manufactured by the tribal corporation. Based on the Anti-Injunction Act (AIA), a district court dismissed the tribal citizen and the tribal corporation but found that it had jurisdiction over the Tribe's claim despite the Act. On appeal, despite the district court's denial of the Tribe's claims on the merits, the Ninth Circuit found that the AIA completely deprived the district court of jurisdiction over the Tribe's claims. The Ninth Circuit found that the Tribe's injury flowed from the taxation of its members, and thus was wholly derivative of the injuries to the Tribal citizen and corporation. Because the injury was derivative, the Tribe could reasonably expect its interests to be adequately represented and protected in a suit or a refund claim brought by an individual citizen or the tribal corporation.

The court found that Yakima Nation was difficult to fairly distinguish from the facts in this case. Arizona's alleged loss of transaction privilege taxes, the court reasoned, flowed directly from the tax treatment of its taxpayers and was wholly derivative of its taxpayers' injuries. The court therefore believed it was unlikely that it had jurisdiction to hear that particular claim, apart from whether the state met its burden to receive a preliminary injunction based on it.

The court further found that, to the extent the state asserted it was damaged by having to issue 1099s on its state tax rebates, the state did not meet its burden of establishing either that this constituted damage or, if it did, that it was the appropriate subject of injunctive relief. The court said it appeared that the state was required under Code Sec. 6050E(a) to issue 1099s regardless of the IRS's tax treatment of the payments. The court also noted that Arizona had already prepared and made available 1099s to relevant taxpayers. As such, the court found that there was no action regarding the 1099s to enjoin.

The court also found that Arizona failed to adequately explain how the taxation of the state rebate infringed on its sovereignty. In its briefing the state described such damage as "the IRS's disparate treatment of Arizona without reasoned basis" or that the state's "inability to enforce its duly enacted plans" because "each individual Arizona taxpayer files a federal tax return sending money to the IRS that the State had intended to remain in Arizona." The court noted that, as explained above, any asserted damage to Arizona's sovereignty resulting from the taxation of its taxpayers was not a claim over which the court likely had jurisdiction. The court said that Arizona may be asserting some sort of sovereignty claim that is not so derived. But, if so, the court found that the contours of such a claim were insufficiently defined for the court to determine either that the state was likely to prevail, or to fashion preliminary injunctive relief that was tailored to the damage asserted. In light of the United States' own considerable and independent right to tax Arizonans who are also United States citizens, the court declined, at least at this stage of the litigation, to enter an order declaring that the state tax rebate is not subject to any federal taxation.

For a discussion of the exclusion 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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