IRS Guidance On Federal Taxability Of State Refunds Remains Problematic

On February 10, after appeals from many in the tax industry, the IRS issued guidance on the taxability of state-issued economic impact payments. Of the twenty-one states that issued some type of payment, the IRS determined that seventeen (including California) were made “for the promotion of the general welfare or as a disaster relief payment” and, consequently, are not taxable at the federal level. For the remaining four states (Georgian, Massachusetts, South Carolina, and Virginia) the payments could be taxable if the taxpayer itemized their deductions in 2021 and received a refund of state taxes paid. Still confused? You aren’t the only one. It’s almost as if the guidance created more questions than answers.

For example, Adam Markowitz, a Florida Enrolled Agent, has asked, “Do we really believe the IRS is gonna figure out how to A) not send out notices to taxpayers who don’t report 1099MISCs from CA or B) refund the money to taxpayers who did?” Both are good questions considering it took the IRS almost two years to finish correcting tax returns that were filed before unemployment compensation became excludable for tax year 2020.

For example, assume Jane Doe is a California taxpayer who got a Form 1099-MISC for $700 in California state-issued economic impact payments. Because Jane needs her refund she filed her taxes early. Markowitz notes she “pays the tax on that $700 she got from CA because she didn’t know any better. IRS doesn’t refund her the $84 automatically.” Or maybe the IRS does get Jane her refund (plus interest), it just takes them 18 months to do it depriving Jane of money she needs and charging the interest expense and the cost of adjusting Jane’s return (multiplied by the millions of returns they have to adjust) to American taxpayers.

Sounds bad, right? It could actually be worse. Suppose instead that Jane waited for the IRS guidance and left the $700 off of her federal 1040. She is then surprised to get a CP2000 matching notice in July stating that a Form 1099-MISC for $700 was left off of her federal return and she owes the IRS $84 plus interest. Jane has the right to respond to the notice but, even assuming she understands the notice (many taxpayers simply pay the amount on the notice rather than taking the time to determine if the notice is correct and then providing a response), she is out the time it takes to develop her reply. Jane then has to pay a fax service to fax her response to the IRS (assuming a fax number is provided) or has to mail her response. In either case, Jane could be waiting for an IRS response to her response for 90 days or more.

Alternatively, Jane could exercise her right to representation and pay someone to handle the notice for her which could cost her anywhere from $150 to $300, or more. Jane is still made to wait for her money but is also now running in the red because hiring the representative cost her more than the amount in dispute. A cynical person might think that the IRS is hoping she’ll just pay the notice “no questions asked.” Tax professionals often wonder how many taxpayers simply pay tax on erroneous IRS notices because they don’t understand how to check their accuracy or how to respond—or because they are simply too scared of “being on the IRS’ radar” to mount a defense. Markowitz asks, “Who loses when the IRS does stupid s*** like this?” He answers, correctly, “Jane, of course. The exact person the $700 was supposed to help.”

Sarah Moessinger, an Enrolled Agent in Raleigh, North Carolina, points out, “If Jane was relying on a state or federal refund to pay some bills, the delay in filing is also hurting her.” Indeed, depending on her bills, the entire $84 easily could be eaten up in late fees and credit card interest.

Markowitz states that this is not a “no harm, no foul” decision and that the IRS “ultimately made the decision they had to make because they waited so long.” Unlike the unemployment compensation exclusion, which was enacted by Congress in the middle of the 2021 filing season, the IRS was aware that states were issuing these payments and wondering about their taxability at the federal level since summer of 2022.

Markowitz isn’t the only one who feels that the IRS guidance is a suboptimal response. Writing as a guest blogger for the Procedurally Taxing blog, Bob Kamman notes,

“Rather than expressing its views on a court ruling, IRS simply admitted that it will go along with what TurboTax and H&R Block

have been doing for weeks.

Of course, that’s not what IRS said in the Notice. But it’s the only conclusion that can be drawn from the failure to cite any precedent or establish any new framework for analysis. Instead, we are told that “IRS will not challenge the taxability of payments related to general welfare and disaster relief.”

“Challenge” may be a word that describes working at IRS, but is it an appropriate term for interaction between the Service and taxpayers?”

Kamman provides the following translation of the IRS-speak provided in the guidance: “TurboTax and other software companies, along with H&R Block and other major tax preparation companies have been ignoring these payments for the last three weeks. Exclusion was the only practical solution.”

Kamman also notes that in a recent webinar on the future of IRS funding sponsored by Tax Analysts former IRS Chief Counsel Michael Desmond stated that perhaps rather than viewing taxpayer interactions “through an enforcement lens” that “the IRS can really do a lot on the front end to lay out those programs in a way, put guidance out on the front end and address all of the open questions or as many as possible for new programs like that, so you don’t have compliance issues on the back end.” In other words, the IRS could use some of its new funding to proactively address taxpayer interactions and to provide taxpayers with usable guidance before problems arise. Of course, in the same webinar, the man who could have ensured that this entire problem was avoided by instructing the IRS to issue prompt guidance on the state payments (former IRS Commissioner Chuck Rettig) spent his time reminding viewers of how hard IRS employees worked during the pandemic as if that were still, or ever, in question.

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