COVID-19 did a number on the U.S. economy, prompting federal and state lawmakers to offer a variety of relief programs. At the state level the most notable government help came via stimulus payments.
Those payments helped the recipients cover living expenses. They also raised tax issues, specifically whether federal taxes would be due on the money.
The Internal Revenue Service answered that question back February, when the agency announced that most special state-issued tax or inflation relief payments were tax-exempt.
Today, the IRS updated that prior guidance, which dealt only with the taxability of state payments made during 2022.
IRS issued Notice 2023-56 because of so-called spillover payments that some states made in early 2023. These payments technically were part of the 2022 state program amounts that were distributed in 2023, so they remain federally tax free this year.
"To the extent that the [Feb. 10, 2023] news release provided that taxpayers can exclude the state payment received in 2022 from federal income, this treatment also applies in 2023," said the IRS. "This [Notice 2023-56] means taxpayers who did not get a payment under the program during 2022 may exclude from federal income a state payment provided under the 2022 program but actually received in 2023."
General welfare exemption remains: But what about continuing state payments? A handful of states are still issuing tax rebates to their residents.
Today's IRS notice reiterated the agency's earlier stance that state general welfare payments do not count as taxable income on recipients' federal tax returns.
As the IRS noted in its first guidance on the state payments back in February, to qualify for the general welfare exclusion, the payments must be paid from a governmental fund, be based on the need of the individual or family receiving such payments, and not represent compensation for services.
Payments that are based on some criteria other than individual or family need do not qualify for the general welfare exclusion, says the IRS.
However, the IRS also noted that determining whether payments qualify as federally tax-exempt general welfare amounts "is a complex, fact-intensive inquiry that depends on a number of considerations." Notice 2023-56 offers the following example of a general welfare situation.
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 taxable 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 taxable year 2021. Individual H filed a State G income tax return for taxable year 2021 as a single filer. State G paid a $650 State payment to H in 2023.
State 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, H may exclude the $650 State payment from Federal gross income for taxable year 2023 under the general welfare exclusion.
Itemizers only are affected: While the IRS clarification is welcome, it won't apply to most taxpayers, even those who get a regular state tax refund.
That's because filers don't have to worry about taxes on state refunds if they claim the standard deduction. The federal tax implications of a state refund only come into play when the associated state taxes are used to claim a federal itemized tax deduction on Schedule A.
Most taxpayers, however, take the standard amount rather than itemizing. The IRS says that in tax year 2021, 90 percent of individual filers claimed the standard deduction.
Finally, the IRS also asks in today's notice for public comments regarding the application of the rules described in the guidance, as well as on specific aspects of state payment programs or other situations where the agency's guidance would help.
You also might find these items of interest:
- State tax department online links
- State relief payments issued in 2022 are federally tax free
- Watch out for continuing COVID-19 tax (and more) scams
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