IRS tells 21 states how to handle last year's special payments

After much outside criticism, the Internal Revenue Service basically told taxpayers in most — but not all — states that they do not need to report income from special state tax refunds or payments on their 2022 federal income tax returns.

Tens of millions of taxpayers in 21 states — not including Michigan — were told a week earlier to hold off filing their federal income tax returns until the IRS could give guidance. The IRS gave such guidance late Friday — and taxpayers should be able to move forward.

The National Taxpayer Advocate issued a highly critical blog Thursday that questioned why the IRS waited so long to address whether special tax refunds or payments will be treated as taxable income on a federal income tax return. Tax season began Jan. 23, but the tax filing deadline isn’t until April 18.

The IRS began accepting and processing 2021 federal income tax returns on Jan. 24, 2022.

In its statement late Friday, the IRS clearly spells out that people in 16 states do not need to report these state disaster relief payments on their 2022 federal income tax returns. The states are California, Colorado, Connecticut, Delaware, Florida, Hawaii, Idaho, Illinois, Indiana, Maine, New Jersey, New Mexico, New York, Oregon, Pennsylvania and Rhode Island. The IRS said payments in these states are related to “general welfare and disaster relief.”

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The same’s true in Alaska — which would make 17 states — but the IRS noted that taxpayers need to look for “more nuanced” guidelines there. When it comes to Alaska, the IRS specified that payments that aren’t taxable involve only the “supplemental Energy Relief Payment received in addition to the annual Permanent Fund Dividend.”

Taxpayers in four other states — Georgia, Massachusetts, South Carolina and Virginia — face more complex rules. Most people won’t likely see their state payments taxed at the federal level — but others will.

The IRS said many people in those four states “will not include state payments in income for federal tax purposes if they meet certain requirements.” That’s true 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. A taxpayer, for example, might not have received a benefit if they itemized but ran into a $10,000 cap per year on state and local income tax deductions.

The state payment in 2022, the IRS said, would be included in income in those four states if the taxpayer received “a tax benefit in the year the taxes were deducted.”

Many taxpayers and tax professionals had been waiting for this guidance before filing a federal return and risking making a mistake in the process before they knew where the IRS stood.

The IRS acknowledged in its statement that exceptions can apply to many of the special payments made by the states in 2022, even though typically payments made by states would often be included in income for federal tax purposes.

The IRS, according to the release, determined that its guidance is in “the best interest of sound tax administration” and reflects that the pandemic emergency declaration ends in May, making the issue involving “general welfare and disaster relief payments” only an issue in the 2022 tax year.

The IRS noted: “Other payments that may have been made by states are generally includable in income for federal income tax purposes. This includes the annual payment of Alaska’s Permanent Fund Dividend and any payments from states provided as compensation to workers.”

IRS tells 21 states how to handle last year’s special payments

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