IRS Clarifies Federal Taxes and State Payments
The IRS has recently announced that "in the interest of sound tax administration and other factors," taxpayers in many states will not need to report various payments on their 2022 tax returns. Specifically, the IRS has determined it will not challenge the taxability of payments related to general welfare and disaster relief.
So what does this mean? Taxpayers 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, but there are additional, special rules in this case.)
A difficult situation
Here's the background: In 2022, certain states were granted special tax refunds or payments related to the pandemic and its associated consequences. A variety of state programs distributed these payments in 2022 and the rules surrounding their treatment for federal income tax purposes are complex, says the IRS. While in general, payments made by states are includable in income for federal tax purposes, there are exceptions that would apply to many of the payments made by states in 2022.
Refund of state taxes paid
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 (for example, because the $10,000 tax deduction limit applied) the payment is not included in income for federal tax purposes.
Payments from the following states in 2022 fall in this category and will be excluded from income for federal tax purposes unless the recipient received a tax benefit in the year the taxes were deducted:
- South Carolina
General welfare and disaster relief payments
If a payment is made for the promotion of the general welfare or as a disaster relief payment, for example related to the outgoing pandemic, it may be excludable from income for federal tax purposes under the General Welfare Doctrine or as a Qualified Disaster Relief Payment, according to the IRS. Determining whether payments qualify for these exceptions is a complex fact-intensive inquiry that depends on a number of considerations.
The IRS has reviewed the types of payments made by various states in 2022 that may fall in these categories. Given the complicated fact-specific nature of determining the treatment of these payments for federal tax purposes, balanced against the need to provide certainty and clarity for individuals who are now attempting to file their federal income tax returns, and given the fact that the pandemic emergency declaration is ending in May 2023 making this an issue only for the 2022 tax year, if a taxpayer does not include the amount of one of these payments in its 2022 income for federal income tax purposes, the IRS will not challenge the treatment of the 2022 payment as excludable for income on an original or amended return.
However, emphasizes the IRS, other payments that may have been made by states are generally includable in income for federal income tax purposes.
This is just a summary of complicated rules and there are exceptions. For details, see the official IRS announcement and as always, contact your R&A professional for guidance.