IRS Provides Guidance On Federal Tax Treatment of 2023 State Tax Refunds

(Parker Tax Publishing September 2023)

The IRS provided guidance on the federal tax status of refunds of state or local taxes and certain other payments made by state or local governments to individuals. The guidance updates the previous guidance provided in IRS news release IR-2023-23, which only described the taxability of payments made during 2022. Notice 2023-56.

Background

In 2022, a number of states implemented programs to provide state payments to certain individuals residing in their states. Many of these programs were related, directly or indirectly, to the various consequences of the COVID-19 pandemic, and the programs varied in terms of the types of payments, payment amounts, and eligibility criteria.

In response to numerous requests for guidance on how individuals should treat these payments on their 2022 federal income tax returns, on February 10, 2023, the IRS issued a news release, "IRS issues guidance on state tax payments to help taxpayers" (IR-2023-23), to provide certainty for the 2023 federal income tax filing season. The news release stated that "in the best interest of sound tax administration 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 from income on an original or amended return." The news release identified 2022 payment programs in 17 states that qualified for this treatment. As the news release made clear, the guidance in the news release applied only for payments made in 2022.

Notice 2023-56

The IRS received requests for guidance regarding the federal income tax consequences of state payments made in 2023 and future years, as well as requests that states be allowed to provide comments on the guidance. On August 30, the IRS issued Notice 2023-56 to respond to these requests.

State Income Tax Refunds

Under the tax benefit rule, if an individual claimed the standard deduction on the individual's federal income tax return for the tax year in which the individual paid state taxes, a state income tax refund (related to the prior payment of those state taxes) in a subsequent tax year is not includible in the individual's gross income for federal income tax purposes. An individual who itemized deductions and deducted amounts of state income taxes paid, however, is required to include the state tax refund in gross income on the individual's federal income tax return to the extent that the individual received a federal income tax benefit from the prior federal income tax deduction.

Example: In January 2023, State A enacted a statute providing that certain state funds be returned to certain individuals as a refund of states income taxes paid in 2021. Pursuant to that statute, State A will pay up to $250 to individuals who filed State A income tax returns for tax year 2021 as single filers and up to $500 to spouses who filed as married, filing jointly, but the payment cannot exceed an individual's State A income tax liability for tax year 2021. Brian filed a State A income tax return in 2022 for tax year 2021 as a single filer. Brian reported State A income tax liability of $2,500, all of which he paid through income tax withholding in 2021. Brian filed his federal income tax return in 2022 for tax year 2021 and claimed the standard deduction. In 2023, State A paid Brian $250 as a refund of his State A income taxes paid for tax year 2021.

State A's payment of $250 to Brian is a state tax refund of Brian's State A income taxes paid for tax year 2021. Brian claimed the standard deduction on his federal income tax return for tax year 2021. Thus, Brian did not deduct State A income taxes paid on his federal income tax return for tax year 2021. Accordingly, Brian is not required to include the $250 State A income tax refund in his federal gross income on his federal income tax return for tax year 2023.

Code Sec. 6050E requires State A to file with the IRS and furnish to Brian a Form 1099-G, Certain Government Payments, that includes the $250 payment in Box 2, state or local income tax refunds, credits, or offsets, unless the State A refund officer (as defined in Reg. Sec. 1.6050E-1(b)(1)) verifies that Brian did not claim itemized deductions for federal income tax purposes. Thus, Brian may receive a Form 1099-G from State A that includes the $250 payment even though Brian is not required to include the payment on his federal income tax return for tax year 2023.

State Property Tax Refunds

The IRS further advised that if an individual claimed the standard deduction on the individual's federal income tax return for the tax year in which the individual paid state taxes, a state property tax refund (related to the prior payment of those state taxes) in a subsequent tax year is not includible in the individual's gross income for federal income tax purposes. An individual who itemized deductions and deducted amounts of state property taxes paid, however, is required to include the state tax refund in gross income on the individual's federal income tax returns to the extent that the individual received a federal income tax benefit from the prior federal income tax deduction.

Example: In March 2023, State C enacted a statute providing that certain state funds be returned to certain individuals who paid state property taxes in 2021. Pursuant to that statute, State C will pay individuals a refund equal to the lesser of 10 percent of State C property taxes paid or $300. Denise was liable for State C property taxes of $2,800 for tax year 2021, which she paid in 2021. Denise filed her federal income tax return in 2022 for tax year 2021 and claimed itemized deductions totaling $9,000, which included the $2,800 property tax payment and which reduced her federal income tax liability for the year. In 2023, State C paid Denise $280 as a refund of her State C property taxes paid for tax year 2021 and made no other payments to Denise.

State C's payment of $280 to Denise is a state tax refund of her State C property taxes paid for tax year 2021. Denise claimed the $2,800 property tax payment as a deduction on her federal income tax return for tax year 2021, with a corresponding reduction in her federal income tax liability for the year. Accordingly, Denise is required to include the $280 State C property tax refund in her federal gross income on her federal income tax return for tax year 2023.

State C is not required to file or furnish an information return with respect to the $280 payment to Denise. Code Sec. 6050E does not apply because the payment is a refund of state property taxes paid, not a refund of state income taxes. Code Sec. 6041 does not apply because the total payments from State C to Denise in 2023 were less than $600. The fact that no information return is required does not relieve Denise of the obligation to include the $280 in her federal gross income.

Spillover Payments under 2022 Programs Covered by News Release IR-2023-23

Some of the 2022 programs covered by the guidance in IRS news release IR-2023-23 provided for certain state payments under the program to be made in early 2023. The IRS stated that, to the extent that the news release provided that an individual taxpayer could exclude such a state payment received in 2022, individual taxpayers who did not receive a payment under the program during 2022 may exclude a state payment received in 2023 under the 2022 program from federal gross income.

Example: In 2022, State E enacted a program to make state payments to its residents who met certain requirements (2022 program). Under the 2022 program, each State E resident who filed a 2021 State E income tax return was entitled to receive $750. State E made most of the state payments under the 2022 program on or before December 31, 2022. Under the 2022 program, State E may make remaining 2022 program state payments in early 2023. State E made a 2022 program state payment of $750 to Fred on January 15, 2023. State E's 2022 program was listed in IRS news release IR-2023-23 as one of the programs that would be treated as qualifying for an exclusion from federal gross income for 2022 payments.

Because State E's January 15, 2023, state payment to Fred resulted from the 2022 program, which was listed in IRS news release IR-2023-23 as qualifying for an exclusion from federal gross income, Fred may exclude this state payment from federal gross income on his federal income tax return for tax year 2023. Because the state payment from the 2022 program is not federal gross income to Fred, State E is not required to file with the IRS or furnish to Fred a Form 1099-MISC, Miscellaneous Information.

State Payments Excluded from Income Under the General Welfare Exclusion

Under the general welfare exclusion, state payments made under a state program for the promotion of the general welfare are not includible in an individual's federal gross income. To qualify under the general welfare exclusion, state payments must be made from a governmental fund; be for the promotion of the general welfare (that is, based on individual or family need); and not represent compensation for services.

Example: In 2023, State G makes state payments to eligible residents under an "Energy Relief Payment Program" to help those low-income residents who may not otherwise be able to afford to pay their heating bills. Eligible residents were limited to those who lived in State G full time in 2021 and filed a State G income tax return for tax year 2021 no later than October 31, 2022. State G pays $650 to low-income taxpayers who filed as single or married, filing separately, for tax year 2021. Harriet filed a State G income tax return for tax year 2021 as a single filer. State G paid a $650 state payment to Harriet in 2023.

Payments that State G makes under its Energy Relief Payment Program are made for the promotion of general welfare and are excluded from federal gross income under the general welfare exclusion. Thus, Harriet may exclude the $650 state payment from federal gross income for tax year 2023 under the general welfare exclusion. State G is not required to furnish to Harriet an information return that includes the $650 state payment.

For a discussion of the tax benefit rule, see Parker Tax ¶76,901. For a discussion of the general welfare exclusion, see Parker Tax ¶79,901.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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