Federal taxability of state-issued stimulus payments is causing frustration for taxpayers and tax professionals. Indeed, whether or not state-issued stimulus payments are federally taxable may be the most asked question of this filing season.
For California’s taxpayers, the frustration and confusion boiled over into the Procedurally Taxing blog where guest blogger Bob Kamman, a Phoenix-area attorney, wrote an open letter to former IRS Commissioner Chuck Rettig. The letter states that, because the potential federal taxability of California’s state payments was in question well before Rettig left office, Rettig’s IRS should have issued guidance before he left rather than leaving it to acting commissioner Douglas O’Donnell to figure out during the 2023 filing season:
“Californians wish you had pushed IRS to answer this question before you left office November 12. After all, IRS should have anticipated it when Governor Newsom signed AB 192 into law on June 30, 2022.”
O’Donnell’s letter goes on to summarize the issue California filers are facing:
“The state law made it clear that these payments were not subject to state income tax. But apparently, no one was sure how IRS would view them. So with an abundance of caution, envelopes, and postage, the Franchise Tax Board (that’s what California calls its Department of Revenue) decided to send 1099-MISC forms to anyone who received $600 or more. The FTB explained it was doing this because “The MCTR payments may be considered federal income.”
Or, they may not be. Don’t ask them, ask IRS. It must be a difficult question because so far there is no answer. And it has now become a subject of debate for tax practitioners.”
After that post went viral (well, it went viral for tax nerds) the IRS took notice and issued a statement on February 3:
“The IRS is aware of questions involving special tax refunds or payments made by states in 2022; we are working with state tax officials as quickly as possible to provide additional information and clarity for taxpayers. There are a variety of state programs that distributed these payments in 2022 and the rules surrounding them are complex. We expect to provide additional clarity for as many states and taxpayers as possible next week.
For taxpayers uncertain about the taxability of their state payments, the IRS recommends they wait until additional guidance is available or consult with a reputable tax professional. For taxpayers and tax preparers with questions, the best course of action is to wait for additional clarification on state payments rather than calling the IRS. We also do not recommend amending a previously filed 2022 return.”
When California (and Californians) speak, the IRS takes notice because California is the most populous state in the U.S. Of the top three, it is the only one with an income tax. Texas and Florida are second and third, respectively, with New York coming in at fourth. Nevertheless, taxpayers in several other states are asking the same question, and how that question is answered often depends on which state issued the payments and on some underlying principles of federal tax law.
In general, §61 of the Internal Revenue Code (IRC) says that gross income includes “all income from whatever source derived” unless a specific exception exists. With respect to the federal taxability of state economic stimulus payments three such exceptions may exist:
- Refunds of state taxes where the taxpayer did not receive a federal tax benefit
- Payments under the General Welfare Doctrine
- Qualified Disaster Relief Payments
Generally, refunds of state taxes paid by individuals are only federally taxable to the extent a federal benefit was claimed for paying state taxes. In other words, the payments could be federally taxable if the taxpayer itemized on their 2021 Form 1040 (Schedule A), took a deduction for state taxes paid, and subsequently got a refund for those taxes.
Taking the deduction on Schedule A while getting a state tax refund means that the deduction taken for taxes paid was larger than it should have been. Money refunded the following tax year must be claimed as income as would any additional amount considered a refund of state taxes paid that was provided as an economic stimulus payment. In this case, payments to taxpayers who took the standard deduction or who had a state balance due that exceeded the amount of any additional refund payments would not be federally taxable.
The General Welfare Doctrine states that “Payments made under social benefit programs for the promotion of general welfare are excludable from gross income under a concept known as the general welfare doctrine. This applies only to governmental payments out of a welfare fund based upon the recipient’s need, and not as compensation for services.” While only the portion of the General Welfare Doctrine that applies to payments made by Tribal Governments has been formally codified (IRC §139E) it would appear that the Doctrine’s three-prong test: 1) from a governmental fund; 2) promotes the general welfare; and 3) is not compensation for services provides a reasonable basis for claiming payments are not taxable at the federal level in the absence of IRS or state guidance.
Tom Gorczynski, a Phoenix-based Enrolled Agent, notes in a recent newsletter that “IRC §139 provides a general exclusion for qualified disaster relief payments received by an individual. Any organization can issue the payment, including businesses and state and local governments.” He goes on to state “The Covid-19 pandemic is a qualifying disaster” and “Many payments issued by states over the last several years could be excluded under §139 if the legislation authorizing such payments invoked relief due to the COVID-19 pandemic. As expected, it will depend on the facts and circumstances of the payment and the legislative intent behind it.”
Clearly, in the absence of additional guidance from the IRS, taxpayers will have to both understand the source of the refunds and the intent of their state legislatures in issuing them before being able to make an informed decision as to the federal taxability of the payments. This amounts to extra work for paid professionals and, quite possibly, an undue burden on taxpayers who prepare their own returns.
Hawaii issued “Act 115” refunds to eligible taxpayers in 2022. Andrea Carr, a Hawaii-based CPA, noted on Twitter recently that Hawaii doesn’t consider its payments taxable at the state or federal level. The Hawaii Department of Taxation website states, “Act 115 refund would not be included as income on the federal or State return. Unlike an ordinary refund of state taxes that must be included in income, Act 115 refund is not received as a result of a deduction claimed for state taxes paid.” Because of this stance, Hawaii is not issuing information returns (Forms 1099-G or -MISC) to taxpayers who received these payments.
According to statements made by representatives of New Mexico’s Taxation and Revenue Department (NM-TRD) before the local chapters of both the National Association of Tax Professionals (NATP) and the National Society of Enrolled Agents (NAEA), New Mexico’s “refundable tax rebates” are considered tax “refunds” that are not taxable at the state level but they are not commenting on potential federal taxability. NM-TRD did make clear that it will not be issuing any forms or letters to taxpayers showing the amount of their rebate payment(s). Consequently, New Mexico’s taxpayers and tax professionals, in the absence of IRS guidance, are left to wonder if these payments are refunds of state taxes that are taxable under IRC §61 or a more general refund of state taxes (money from the state’s tax coffers), considered non-taxable based on the same logic used by Hawaii.
Massachusetts & Virginia
Massachusetts issues what is known as a 62F refund annually to its taxpayers. According to the Massachusetts Office of Administration and Finance, “All tax refunds, including the 62F refunds, are taxable by the federal government to the extent that the recipient claimed itemized deductions on his or her federal return for Tax Year 2021, including his or her state income tax. Refund recipients who itemized on their federal returns for Tax Year 2021 will receive a Form 1099-G from the Department of Revenue by January 31 of the year following the year in which the refund was received.”
Virginia is also considering its one-time refunds federally taxable for taxpayers who itemized and will be issuing Form 1099-G. According to its website, “Your Form 1099-G reflects any refund or overpayment credit you received from us last year (Box 1), and any corresponding interest (Box 2). This year, it will also include the amount of your one-time tax rebate (if you received one from us, and itemized deductions last year). If you itemized deductions last year, you may need to report these amounts as income on your federal income tax return.”
If your state issued a refund or rebate during the tax year 2022 and, after reviewing any state-issued information on the topic, you are unclear as to whether or not that income should go on your Federal 1040, you may want to consult with a tax professional or wait a bit longer to file your tax return(s) until the IRS issues guidance later this week.