‘Refund’ States Still Face IRS Complexity on Relief Check Taxes

Despite an IRS clarification that most of the “special payments” provided in 21 states last year won’t be treated as income for federal tax purposes, complexity continues for people in four states that technically structured their payments as tax refunds rather than one-time rebates.

Taxpayers receiving refunds in Georgia, Massachusetts, South Carolina, and Virginia could be on the hook for federal taxes on those payments if they gained a federal tax benefit, the IRS said in a Feb. 10 guidance statement. Residents of the four states falling into this category include people who itemized their deductions and didn’t reach the $10,000 cap on deductions for state and local taxes.

Revenue officials in Georgia, Massachusetts, and Virginia warned taxpayers Monday they could have federal tax obligations in view of the IRS statement. A spokesperson for the South Carolina Department of Revenue declined to comment on federal filing questions and the IRS’s statement.

The Georgia Department of Revenue updated an FAQ on its website to explain that some taxpayers could be taxed federally on their share of the $1.1 billion special refund program enacted last year under HB 1302. Massachusetts and Virginia said taxpayers who received a refund last year for taxes paid in tax year 2021 should have received a Form 1099-G, which can be reported on their federal returns this year. The form is issued by units of government to account for taxable payments.

Some state policy makers applauded the federal agency’s leniency for taxpayers in 17 states that offered special relief payments or rebates. Colorado Gov. Jared Polis (D) said “millions of Coloradans, are breathing a sigh of relief that the IRS and federal government have stepped away from taxing our refunds this year.”

Some analysts said the agency is drawing a hyper-technical line through state pandemic relief programs that were functionally similar, and is penalizing taxpayers in Georgia, Massachusetts, South Carolina, and Virginia in the process.

“This ‘problem’ applies to all 21 states, not just the four that structured their payments as ‘refunds’ rather than rebates,” said Jared Walczak, vice president of state tax projects at the Tax Foundation. “The IRS is taking a formalistic interpretation that four states’ payments offset tax liability, while all the others did not, even though they are functionally equivalent.”

Filing Season on Hold

On Feb. 3 the IRS put the filing season on hold for those who received such payments, calling on taxpayers to wait to file so the agency could provide clarity on the tax treatment of general welfare and disaster relief payments offered by 21 states. An analysis of each program was required because payments by states are generally taxable for federal purposes. Some programs, however, are excludable under the federal “general welfare doctrine” or as qualified disaster relief payments.

After its review, the IRS said “in the interest of sound tax administration” it wouldn’t challenge the taxability of payments offered in Alaska, California, Colorado, Connecticut, Delaware, Florida, Hawaii, Idaho, Illinois, Indiana, Maine, New Jersey, New Mexico, New York, Oregon, Pennsylvania, and Rhode Island. The IRS also released a chart examining features of the relief programs in the 17 states.

Revenue officials in California, Colorado, Florida, Illinois, Indiana, and New York said they were relieved, but not surprised, to see the guidance from IRS.

It’s “a positive thing,” said Darren Dopp, director of external affairs at the New York Taxation and Finance Department, “but we were always confident that our special relief programs were not taxable.”

Refund States

With respect to Georgia, Massachusetts, South Carolina, and Virginia, the IRS said refunds to taxpayers needn’t be included on federal returns “if the payment is a refund of state taxes paid and either the recipient claimed the standard deduction or itemized their deductions but did not receive a tax benefit.” The agency left the door open to impose tax in cases where “the recipient received a tax benefit in the year the taxes were deducted.” As a practical matter, this group of taxpayers includes anyone who itemized on their 2021 federal return, didn’t reach the $10,000 SALT cap, and later collected a tax refund from one of the four states.

Walczak said the IRS’s rationale makes sense. For example, a taxpayer who pays $5,000 in state taxes and then pockets a $1,000 refund check is effectively paying $4,000 in state taxes. If the taxpayer claimed a state and local tax deduction of $5,000 on their federal income tax return, they are gaining an excess tax benefit—something generally taxed under federal rules.

At the same time, Walczak said, the IRS has chosen to “bend the rules” for some taxpayers and be stern with others. He said the agency is being “oddly inflexible given their willingness to disregard rules” in the 17 other states. He said the agency should have considered “a blanket statement of nontaxability” as a matter of fairness to all taxpayers.

Massachusetts and Virginia anticipated the issue earlier in the year and issued 1099-Gs documents to assist state taxpayers as they file their federal returns.

Massachusetts Department of Revenue spokeswoman Nathalie Dailida said payments made last fall under the state’s 62F refund program are taxable by the federal government to the extent that the recipient itemized and benefited from the deduction of those taxes on their federal tax return for the 2021 tax year. She added all Massachusetts taxpayers who collected a refund and itemized received a 1099-G from from the department no later than Jan. 31.

Georgia’s revenue agency offered taxpayers practical advice on filing their federal returns this season. “If you itemized your 2021 deductions, include the special refund, in your gross income to the extent you received a federal tax benefit from the 2021 deduction.”