In 2022, many states implemented special programs to provide payments to residents for COVID-19 relief and other purposes. Unfortunately, the federal tax treatment of these state payments was not clear, and the rules can be complex.
Long story short?
There was some confusion.
Key questions taxpayers faced included:
This lack of clarity led the IRS to produce two rounds of guidance to resolve the uncertainty plaguing taxpayers nationwide.
As a taxpayer, you must understand how these state payments may impact your federal taxes and what to make of IRS guidance on the subject. For more information, continue reading below.
Short answer: No. The IRS has no legal authority over state tax matters.
However, federal tax law determines the taxability of all income, including income received from state programs and payments.
This is a principal reason why the IRS was called upon to issue guidance on state payments — since the issue directly affects the amount of income individuals are required to report on their federal tax return, it was relevant for the IRS to clarify if these types of payments could be excluded from income under federal law or if they should be reported by taxpayers, even though the payments originated from state programs.
So, the IRS guidance addressed a federal tax issue – not state taxes specifically.
There have yet to be significant revisions to core state tax structures or policies in 2023. Instead, taxpayer confusion and the IRS guidance have been focused on special state payment programs many states implemented in 2022 and 2023 aimed at providing emergency COVID-19 relief, economic stimulus, or disaster assistance.
While these state relief payment programs are new, they have not fundamentally altered the underlying state tax systems.
While the IRS initially said these 2022 payments could be excluded from federal income for that tax year only, covering 17 specified state programs, questions remained about ongoing state payments in 2023 and beyond.
This led to the aforementioned two rounds of IRS guidance.
First, in February of this year, the agency issued News Release IR-2023-23, which provided guidance for the 2023 federal income tax filing season.
However, uncertainty remained about the treatment of state payments in 2023 and future years. Also, some 2022 payments were not issued until 2023, leaving taxpayers unsure if they qualified for exclusion.
To address the ongoing confusion, the IRS provided additional guidance in Notice 2023-56, which addressed these open questions by providing a framework for determining the federal tax treatment of state payments.
Let’s break down what’s covered and what it means for you.
One area of focus in the IRS guidance is state refunds.
Refunds of state income taxes you previously paid are generally not taxable for federal purposes. This is because you originally paid those taxes with already-taxed income.
However, if you itemized deductions and received a federal tax benefit, you may have to report a portion or all of the refund as income.
For example, a state income tax refund would not be taxable federally if you claimed the standard deduction. But if you itemized and deducted the state taxes paid, you may have to report the refund as income to the extent that it reduced your federal tax in the prior year.
The same principle applies to refunds of state property taxes paid. If you claimed the standard deduction, refunds of property taxes paid to the state would not be federally taxable. But if you itemized deductions, you may have to report the refund as income.
The key is whether you received a federal tax benefit from deducting those taxes originally. State tax refunds essentially “recover” that prior deduction.
Another aspect covered in the IRS guidance is the tax treatment of general welfare and state disaster relief payments. These payments can be excludable from income for federal tax purposes under the General Welfare Doctrine or as Qualified Disaster Relief Payments.
Determining whether a payment qualifies for these exceptions requires a complex fact-specific analysis. For example, payments must be based on financial need, paid from a government fund, and not count as compensation for services.
The IRS has reviewed the types of payments made by various states in 2022 that may fall into these categories. In the interest of providing certainty and clarity for taxpayers filing their federal income tax returns, they determined that if a taxpayer does not include the amount of a qualifying payment in their 2022 income for federal income tax purposes, the IRS will not challenge the treatment of the payment as excludable for income on an original or amended return.
It’s important to note that the rules surrounding the taxability of general welfare and disaster relief payments are complex. Taxpayers should consult with a tax professional to ensure they accurately report these payments on their tax returns.
Another specific exclusion applies to qualified disaster relief payments from state or local governments. COVID-19 is considered a qualified disaster for this purpose.
State disaster relief payments related to COVID-19 hardships are presumed to promote general welfare. As such, they can be excluded from federal income through at least May 11, 2023, when the federal disaster designation ended.
Other qualified disasters in the future would also trigger this exclusion for associated state relief payments based on need. This provides another clear exception for certain state payments.
Again, taxpayers in these states must review the IRS guidance and consult with a tax professional to ensure they correctly report their state payments on their federal income tax returns.
Some state relief programs offered payments in 2022 that ended up being paid in 2023 instead. The initial IRS guidance provided transitional relief for designated 2022 state programs, allowing the exclusion of these payments even if received in 2023.
The new Notice 2023-56 extends this treatment to 2022 state payments not issued until 2023. As long as the prior guidance covered the program, you can exclude payments received in 2023 resulting from 2022 state relief programs.
With new state payments being issued in 2023 and beyond, the implications for your federal taxes will depend on:
Absent an exclusion, state payments will generally be taxed like any other income. The new IRS guidance provides helpful direction, but you must evaluate your situation. Consulting a tax professional can help ensure you treat state payments appropriately on your federal return.
The bottom line is additional clarity but also additional complexity. Do your homework to determine if that unexpected state payment needs to be reported federally or if you qualify for an exclusion. With proper planning, you can use the recent IRS guidance on state payments to your advantage.
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Jeff Coyle, CPA, Partner of Rosenberg Chesnov, has been with the firm since 2015. He joined the firm after 20 years of business and accounting experience where he learned the value of accurate reporting, using financial information as a basis for good business decisions and the importance of accounting for management.
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Prior to joining the firm in 2004, Jody was in the private sector where he held senior financial and management positions including General Manager, Chief Financial Officer and Controller. He has experience across industries, which gives him a deep understanding of business.
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