Getting a check in the mail is always nice, whatever the circumstances. But any check is a little less attractive if you find out that you have to take it into income and disclose it to the IRS on your tax return.
Are refunds of state taxes taxed by the IRS?
It turns out to be a surprisingly complex topic. And it was made even more complex over the past year by the patchwork of states that decided to offer extra pandemic relief in the form of refunds or rebates of state taxes.
As taxpayers and tax return preparers started turning to 2022 tax preparation this time of year, those rebate checks became controversial. Twenty-one states offered some kind of rebate or refund. That meant that taxpayers and their tax preparers were all trying to figure out which way the IRS would jump on this issue.
The IRS has now done that, announcing that special payments made by 21 states in 2022 are not taxable and don’t need to be reported on your 2022 taxes. It means that people in the following states do not need to report these state payments on their 2022 tax return: California, Colorado, Connecticut, Delaware, Florida, Hawaii, Idaho, Illinois, Indiana, Maine, New Jersey, New Mexico, New York, Oregon, Pennsylvania and Rhode Island.
Alaska is in this group as well, though it is a more nuanced question there.
Finally, many people in Georgia, Massachusetts, South Carolina and Virginia also will not include state payments in income for federal tax purposes if they meet certain requirements.
How does this “don’t worry about it” relief from the IRS stack up against the usual IRS rules for tax refunds? The usual rules are fact specific. Suppose that you receive an IRS Form 1099-G reporting the state tax refund that you received in 2022.
Do you have to include that payment as income on your federal tax return?
If you did not itemize (say you just claimed the standard deduction), you don’t need to report any part of the state tax refund on your federal return.
But what if you itemized and claimed a deduction for state taxes (some of which you got back)?
If you took an itemized deduction for taxes paid that were later refunded, the IRS has a worksheet you can use to determine how much if any of that deduction you recapture.
In the recent guidance the IRS issued about the state rebates, the IRS included a
helpful review of these general rules. The IRS said it would apply this usual rule to the 2022 pandemic tax rebates made by the states of Georgia, Massachusetts, South Carolina and Virginia.
How about tax rebates from these other states, Alaska, California, Colorado,
Connecticut, Delaware, Florida, Hawaii, Idaho, Illinois, Indiana, Maine, New Jersey, New Mexico, New York, Oregon, Pennsylvania, and Rhode Island?
Taxpayers there got a better deal, courtesy of two little-known tax rules the IRS has been applying more and more in recent years.
The first is the general welfare doctrine, also known as the general welfare exclusion from income. The other is the rules for qualified disaster relief payments, and one or both apply here. Among other justifications for this result, the IRS said this was only a 2022 issue since the pandemic emergency declaration is ending in May 2023.
Curiously, the IRS phrased it not so much as a determination that these payments were not taxable. Rather, the IRS said that if you do not include them in your 2022 form 1040, income, the IRS will not challenge you.
But the IRS also reminded people that outside of this unusual relief, most payments made by states are generally includable in income for federal income tax purposes.
Robert W. Wood is a tax lawyer and managing partner at Wood LLP. He can be reached at Wood@WoodLLP.com.
