Are state tax refunds and rebates subject to federal taxes? It depends.

The federal taxation of state-issued stimulus payments is causing frustration among taxpayers and tax professionals. In fact, whether or not stimulus payments issued by the state are subject to federal taxes may be the most frequently asked question this filing season.

For California taxpayers, the frustration and confusion boiled over to the Procedurally Taxing blog, where guest blogger Bob Kamman, a Phoenix-area attorney, wrote a 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 long before Rettig left office, Rettig’s IRS should have issued guidance before he left rather than let the Acting Commissioner Douglas O’Donnell will figure it out during the 2023 presentation. Station:

“Californians wish he had pushed the IRS to answer this question before he left office on November 12. After all, the IRS should have anticipated it when Governor Newsom signed AB 192 into law on June 30, 2022.”

O’Donnell’s letter goes on to sum up the problem facing California taxpayers:

“State law made it clear that these payments were not subject to state income tax. But apparently no one was sure how the 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 that it was doing this because “MCTR payments may be considered federal income.”

Or they may not be. Don’t ask them, ask the IRS. It must be a difficult question, because so far there is no answer. And now it has become a topic of debate for tax professionals.”

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 regarding excise 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 to taxpayers. There are a variety of state programs that distributed these payments in 2022, and the rules surrounding them are complex. We hope to provide additional clarity for as many states and taxpayers as possible next week.

For taxpayers who are uncertain about the taxability of their state payments, the IRS recommends that 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 further clarification on state payments rather than call the IRS. We also do not recommend amending a previously filed 2022 return.”

When California (and Californians) speak up, the IRS takes note because California is the most populous state in the US Out of the top three, it is the only one with an income tax. Texas and Florida rank second and third, respectively, and New York ranks fourth. However, taxpayers in many other states are asking the same question, and the answer to that question often depends on the state that issued the payments and some underlying principles of federal tax law.

In general, Internal Revenue Code (IRC) §61 says that gross income includes “all income derived from any source,” unless there is a specific exception. With respect to the federal taxation of state economic stimulus payments, three such exceptions May exist:

• State tax refunds where the taxpayer did not receive a federal tax benefit
• Payments under the General Doctrine of Well-being
• Qualified Disaster Relief Payments

In general, state tax refunds paid by individuals are only subject to federal tax to the extent that a federal benefit was claimed for paying state tax. In other words, the payments could be subject to federal taxes if the taxpayer itemized on their 2021 Form 1040 (Schedule A), took a deduction for state taxes paid, and later obtained a refund for those taxes. Taking the deduction on Schedule A while getting a state tax refund means that the deduction taken for the taxes paid was more than it should have been. Money refunded the following tax year must be claimed as income, as well as any additional amounts that are considered a refund of state taxes paid that were 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 subject to federal tax.

The General Welfare Doctrine establishes 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 government payments from a welfare fund based on the beneficiary’s need, and not as compensation for services.” Although the only part 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 general well-being; and 3) compensation for services does not provide a reasonable basis to claim that the payments are not subject to federal tax in the absence of IRS or state guidance.

Tom Gorczynski, a Phoenix-based registered agent, notes in a recent newsletter that “IRC §139 provides a general exclusion for qualified disaster assistance 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 qualified disaster” and “Many payments issued by states in recent 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, absent additional guidance from the IRS, taxpayers will need to understand both the source of the refunds and the intent of state legislatures in issuing them before they can make an informed decision about the federal taxation of the payments. This equates to extra work for paid professionals and, quite possibly, an undue burden on taxpayers preparing their own returns.

Hawaii

hawaii issued “Law 115” refunds to eligible taxpayers in 2022. Andrea Carr, a Hawaii-based CPA, recently noted on Twitter that Hawaii does not consider its payments subject to tax at the state or federal level. The Hawaii Department of Taxation website states that “the Act 115 refund would not be included as income on a federal or state return. Unlike a regular refund of state taxes that must be included in income, the Act 115 refund is not received as a result of a claimed deduction for state taxes paid.” Because of this stance, Hawaii does not issue informational returns ( Forms 1099 -G or -MISC) to taxpayers who received these payments.

New Mexico

According to statements made by representatives of the New Mexico Tax and Revenue Department (NM-TRD) to local chapters of the National Association of Tax Professionals (NATP) and the National Society of Enrolled Agents (NAEA), “discounts New Mexico Refundable Tax Refunds are considered tax “refunds” that are not taxable at the state level, but do not comment on potential federal taxation. NM-TRD made it clear that it will not issue any form or letter to taxpayers showing the amount of their refund payment(s). Consequently, New Mexico taxpayers and tax professionals, in the absence of IRS guidance, are left wondering whether these payments are refunds of state taxes subject to tax under IRC §61 or a more general refund of state taxes (money from the state tax coffers) considered non-taxable under the same logic used by Hawaii.

Massachusetts and 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 62F refunds, are taxable by the federal government to the extent the recipient claimed itemized deductions on their federal return for tax year 2021, including their state income tax. Refund recipients who itemized their federal returns for the 2021 tax year will receive a Form 1099-G from the Department of Revenue by January 31 of the year following the year the refund was received.”

Virginia is also considering its one-time refunds subject to federal taxes for taxpayers who itemized and will issue Form 1099-G. According your website, “Your Form 1099-G reflects any refund or overpayment credit you received from us last year (box 1), and any applicable interest (box 2). This year, it will also include the amount of your one-time tax refund (if you received one of 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 is one that issued a refund or abatement during the 2022 tax year and, after reviewing any information issued by the state on the subject, you are unclear as to whether or not that income should be included on your federal 1040, you may want to consult with a tax professional or wait a little longer to file your tax return(s) until the IRS issues guidance later this week.