On Friday, the Internal Revenue Service issued a “stay tuned” alert of sorts that could delay the filing of many tax returns in states, like California, that rolled out special payments or extra refunds last year to offer relief to struggling taxpayers.
The guidance the IRS gives in the coming days could be key for taxpayers in states like Michigan next year, where $180 inflation relief checks could be approved by the state Legislature and turned into a reality.
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Extra cash from individual states elsewhere — while welcome at a time of high inflation and some continued pandemic-related uncertainties last year — creates a long list of questions this tax season.
Right now, there’s debate on what needs to be reported on the federal return and what’s considered taxable. Advice that may be given in one state that had a special refund program might not apply to other states that rolled out extra payments in 2022.
The IRS issued a brief alert Friday that gave a glimpse into the confusing tax-time headache early this season based on payments issued by various states in 2022.
Mark Steber, chief tax officer at Jackson Hewitt Tax Service, called the current tax conundrum “a mess.”
“Many questions — few answers,” Steber said.
How a refund or rebate is structured by a state is key to whether it’s likely to be taxable on the federal level.
Some types of payments to taxpayers by states are generally not taxable at the federal level, Steber said.
If Michigan goes with a refundable income tax credit to taxpayers based on redistributing the state’s surplus, Steber said, it’s possible the proposed $180 payments won’t be taxable at the federal level.
The early indication, Steber said, would be that these proposed Michigan payments would not be taxable. Yet, he said, prudence would dictate and it will be important to wait for IRS clarity.
“The good news is there is some time on these Michigan payments before the next tax return has to be addressed,” Steber said.
Elsewhere, we’re looking at some confusion right now as many file their 2022 tax returns before the deadline on April 18.
Where does the taxability of state payments stand? In general, a payout is viewed as taxable unless there’s a reason listed for why it isn’t in the Internal Revenue Code. But nothing is clear-cut here.
“The issue is that there is no clear answer on federal taxation on the payments and the IRS has not indicated a position,” Steber said.
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You should follow the IRS’ advice and wait
Edward Karl, vice president of tax policy and advocacy for the American Institute of CPAs, said taxpayers would be wise to wait for more IRS guidance on this issue.
“Anything you receive is likely to be taxable unless there’s a specific exclusion for it,” Karl said. “Then the question will be: ‘What is the nature of what each state is rebating, paying to each of its citizens?’ It will just depend.”
The word out of the IRS on Feb. 3 basically told taxpayers to wait and see. Don’t file an amended return, if you’ve already sent a 2022 return to the IRS and received a special payment in 2022 from your state. Don’t file a federal return if you received money from the states involved and you’re not sure whether it’s taxable income or not.
Wait and see — and now we’re two weeks into the start of the 2023 tax season — until the IRS gives more clarity on the tax treatment for these payments.
“You don’t want people starting to guess at what the treatment is,” Karl said.
And he warns that you don’t want to file an amended return now and end up guessing wrong about what the IRS will say in the future about the potential tax treatment for special tax refunds or payments made by several states in 2022.
We can really get deep into the weeds here on IRS tax codes — and specific state programs. One size fits all doesn’t seem to apply.
“In general, the federal tax treatment depends upon how the state structures the payments,” said Mark Luscombe, principal analyst for Wolters Kluwer Tax & Accounting.
Other states — such as New York — offered tax relief in the form of property tax or child care rebates.
In New York, for example, one program focused only on sending $475 million to 1.8 million New Yorkers who received the Empire State Child Credit or the Earned Income Credit, or both, on their 2021 state tax returns. The average payments, issued last October, ended up around $270.
California inflation relief checks
In California, “Middle Class Tax Refund” payments totaling $9 billion were sent to 31.6 million tax filers and their dependents from October 2022 through January. The payments ranged from $200 to $1,050 and the amount varied based on the taxpayer’s income, filing status and the number of dependents reported on the 2020 return. Single people weren’t eligible if their income was more than $250,000 a year on the 2020 return and couples filing a joint return did not qualify if their income was more than $500,000.
Luscombe noted that payments made to taxpayers by a state could be taxable on the federal level, if the state dubs the money as special state income tax refund. Then, it would be taxable now if a taxpayer previously claimed a deduction for state income taxes paid. A tax would be imposed to offset that deduction.
Not everyone, of course, itemizes. Roughly nine out of 10 taxpayers claim the standard deduction. So that might not be an issue for everyone.
And then there’s an obscure tax code. Tax Code Section 139 is often brought up by some states as a way to exclude the income from these special refunds from federal taxes under a “general welfare exclusion.”
Luscombe noted that the general welfare exclusion usually is used for qualified disaster relief payments by a federal, state, or local government, or an agency. The goal is to promote general welfare of a community under duress.
Usually, federally declared disasters apply to a targeted region of the country, often specific counties, for a narrow period of time.
“We have, however, been in the unusual situation with COVID where we have had a federally declared disaster that applied to the entire country that began on March 13, 2020, and that initially had no specified end date,” Luscombe said.
President Joe Biden recently announced that the COVID-19 disaster period will end May 11.
“If the payments are considered to be related to the COVID disaster,” Luscombe said, “they could fall under this general welfare exclusion and not be subject to federal tax.”
But he stressed that the IRS would probably have to examine how the state structured the payments, who was entitled to them, and how they were promoted to determine whether applying the general welfare exclusion was appropriate.
“The existence of the federal declared COVID disaster could provide an argument, if the payments are so structured, that they are not taxable at the federal level,” Luscombe said.
What is the IRS saying in early February?
The IRS said it’s aware of the questions. “We are working with state tax officials as quickly as possible to provide additional information and clarity for taxpayers,” the IRS said in a statement Feb. 3.
The IRS noted that a variety of state programs, which included some complex rules, took place in 2022 to distribute fairly unique payments and state tax refunds
It’s possible, the IRS indicated, that guidance might be available as soon as this week.
Tax season for filing 2022 returns, of course, officially kicked off two weeks ago when the IRS began processing e-filed returns on Jan. 23. Many people file in February once they have a chunk of their paperwork in hand to claim a tax refund.
Now, they’re going to need to wait.
“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,” the IRS stated.
The IRS said the best course of action is to wait for additional clarification on the state payments rather than calling the IRS.
As part of its Feb. 3 alert, the IRS said it does not recommend amending a previously filed 2022 return.
Taxpayers in California seem particularly perplexed on what to do on their 2022 federal returns.
All sorts of taxpayers are wondering whether they need to report their California inflation relief check when filing their taxes. California sent out 7.2 million 1099-MISC forms to tax filers who got at least $600 in this relief cash, according to California’s Franchise Tax Board.
The payments are not taxable on California state income tax returns, but “may be considered federal income,” according to a notice from California tax officials.
The IRS, of course, knows when a 1099 has been issued to a tax filer.
Luscombe said the 1099s could put pressure on taxpayers to pay tax on the payments at the federal level, since the IRS receives those 1099-MISCs. Just receiving a 1099 doesn’t mean the income is taxable, but typically a taxpayer would need to provide an explanation on their federal tax return as to why they should not be taxed.
Again, wait and see. Anyone who wants to get their hands on a big tax refund as soon as possible might not be willing to wait to file a few days or even a few weeks from now. But the experts say they should wait. It’s likely the best bet as confusion fills the air.
In Michigan, we’re definitely going to want to watch how this all plays out elsewhere, too, as Lansing considers sending $180 checks to taxpayers later this year.