On February 10, 2023, the IRS issued long-anticipated guidance that informs individual taxpayers in 21 states how to treat specific special payments made by those states to certain qualifying taxpayers in 2022. The guidance is mostly taxpayer-friendly and comes just in time for individuals to complete their 2022 tax returns.
A Look Back at Last Year’s Tax Payments
In 2022, 21 states in the U.S. issued various tax payments, such as tax rebates and disaster relief payments. This was possible largely due to the substantial federal payments related to COVID-19 and the current economic situation, which had enabled many states to attain budget surpluses last year. The payments were generally distributed to certain taxpayers below a particular income level, as determined by each state.
The Tax Benefit Rule
Generally, individual taxpayers must include state tax refunds as taxable income upon receipt. However, if no tax benefit was received by the taxpayer for deducting state tax in the year it was paid, the income from a tax refund may be excluded from federal taxable income. This rule allows state tax refunds to be nontaxable if you utilized the standard deduction in the year of the tax payment. Other examples of the tax benefit rule include:
- A taxpayer itemized their deductions and filed Schedule A, but their state tax deduction only included sales tax and/or real estate tax.
- When a taxpayer received no federal tax benefit from state income tax deductions because of the impact of the alternative minimum tax.
It is important to note that there is an exclusion available to payments characterized as disaster relief payments under Internal Revenue Code (IRC) Section 139.
2022 State Payment Treatment
In the latest guidance, the IRS announced it was opting to divide the payments made in 2022 by the 21 states into two categories:
- Refunds of taxes paid
- General welfare/disaster relief payments
Refunds of Taxes Paid
Taxpayers receiving payments from the states where the IRS deemed the payments to be state tax refunds – Georgia, Massachusetts, South Carolina, and Virginia – need to navigate the typical tax benefit rules related to state tax refunds to determine what their reporting obligation and taxation impacts are for their 2022 tax returns. Additionally, Illinois and New York have issued payments that will require the same analysis as above.
General Welfare/Disaster Relief Payments
The IRS has stated that they will not challenge any failure to report the general welfare/disaster relief payments which were made by the 15 other states. Therefore, taxpayers can simply choose to not report these payments on their federal tax returns. This favorable decision was made due to the difficulty of characterizing the payments, applying the tax benefit rule and IRC 139, and considering the timing of the guidance; ultimately, it is a practical solution for everyone involved.