The Ministry of Social Development says loans taken out by a woman on the benefit to make ends meet count as income.
The ministry said she failed to declare the loans as income and should pay $120,000 back to the government.
The woman, who has name suppression, appealed the civil decision in the High Court in Auckland.
She was approved for a benefit between 2005 and 2010 because she was an unemployed solo parent and because she and her children had health problems.
She took out loans from her parents, a finance company and the bank to stay afloat, but Crown lawyer Nixon Fong said those loans qualified as income, breaching her benefit obligations and putting her in $120,000 overpayment debt.
"It has been recognised by this court that social security benefits are to be reserved for those who truly need them.
"Financial support will only be provided after claimants have used personal and financial resources available to them," Mr Fong said.
The beneficiary's lawyer, Frances Joychild QC, said it has never been MSD policy to make beneficiaries disclose loans.
She said her client was always upfront about her finances and never had cause to declare the extra support she received.
She warned the court that people would be cursed to poverty indefinitely if they were prevented from seeking extra support through loans.
Business loans, familial loans, educational grants and loans are real, tangible solutions that enable single mothers and the unemployed to grow out of poverty and enhance their children's future, she said.
"They would be removed from beneficiaries and that seems entirely contrary, if not, antithetical to the intention behind social security as a whole."
Justice Davidson questioned the Crown over how a loan from a parent could be considered a resource to the beneficiary.
"They can't insist upon it, they can't enforce it, the family member may not be required in any way to provide them assistance ... so why should that be regarded as a resource of the beneficiary?"
Mr Fong replied that a loan only becomes income once it is used for income-related purposes, such as paying bills, expenses or rent.
He argued that a person who has money at their disposal to meet recurring living needs cannot be considered in need of a benefit.
Ms Joychild said the ministry was radically undermining the social security law - and its lawmakers would be turning in their graves.
She said it was ludicrous the loans, which have to be paid back, could be considered income.
"Her borrowed money was simply for the purposes of supporting herself and her children while living on a benefit that was, in of itself, unable to relieve her of hardship."
The ministry's own research showed this was the case for beneficiaries generally, she said, as the benefit is not enough to lift someone out of hardship.
The judge is expected to make a decision in a few weeks.