The Federal Revenue Service essentially informed taxpayers in the majority of states—but not all—that they did not need to record income from special state tax refunds or special payments on their 2022 federal income tax returns after receiving significant outside criticism.
Prior to a week ago, the IRS advised tens of millions of people in 21 states (excluding Michigan) to delay submitting their federal income tax returns until it could provide instructions. The IRS sent this direction late on Friday, and taxpayers should be able to proceed.
The National Taxpayer Advocate questioned why the IRS took so long to resolve whether special tax refunds or special payments will be classified as taxable income on a federal income tax return in a highly critical blog post on Thursday. The tax filing date is April 18, even though tax season started on January 23.
The IRS explicitly stated in a statement released late Friday that residents of 16 states are exempt from disclosing these state catastrophe relief contributions on their 2022 federal income tax returns. These are the states: Maine, New Jersey, New Mexico, New York, Oregon, Pennsylvania, Rhode Island, California, Colorado, Connecticut, Delaware, Florida, Hawaii, Idaho, Illinois, Indiana, and Florida. Special payments in these states, according to the IRS, are for “general welfare and catastrophe relief.”
The IRS highlighted that while Alaska would bring the total to 17 states, the same is true there and that taxpayers must look for “more nuanced” rules. Only the “supplemental Energy Relief Payment received in addition to the yearly Permanent Fund Dividend” is exempt from taxation in Alaska, according to the IRS.
Georgia, Massachusetts, South Carolina, and Virginia have more complicated tax laws that affect taxpayers. Most individuals’ state contributions won’t likely be subject to federal taxation, but some people may.
If the payment is a refund of state taxes paid and the taxpayer claimed the standard deduction on a federal return or the taxpayer itemized deductions but did not receive a tax benefit, the IRS stated that many people in those four states “will not include state payments in income for federal tax purposes.” For instance, if a taxpayer itemized yet over the $10,000 annual cap on state and local income tax deductions, they might not have gotten a benefit.
According to the IRS, if the individual had “a tax benefit in the year the taxes were deducted,” the state special payment in 2022 would be included in their income in those four states.
Before filing a federal return and running the danger of making an error in the process before they knew where the IRS stood, many taxpayers and tax professionals had been waiting for this instruction.
Even though state payments are frequently included in income for federal tax purposes, the IRS stated in its statement that exclusions may apply to several of the special payments made by the states in 2022.
The issue involving “general welfare and disaster relief payments,” according to the release, only arises in the 2022 tax year because the IRS determined that its guidance is “in the best interest of sound tax administration” and takes into account the fact that the pandemic emergency declaration expires in May.
The Alaska Permanent Fund Dividend and any other payments from states made as worker compensation are generally deductible from income for federal income tax reasons, according to the IRS.