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Will the Federal Government Tax Your State Tax Rebate?

By: Jared Walczak

February 13th update: On Friday evening, the IRS announced that rebates in most states would not be taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. ed, but that payments from Georgia, Massachusetts, South Carolina, and Virginia are taxable if the payment was a refund of state taxes and the individual itemized and received a tax benefit.

The distinction the IRS is leaning upon is that, since these four payments are characterized as refunds of state taxes, they reduce state taxes paid and make an itemizing taxpayer’s state and local tax deductionA tax deduction is a provision that reduces taxable income. A standard deduction is a single deduction at a fixed amount. Itemized deductions are popular among higher-income taxpayers who often have significant deductible expenses, such as state/local taxes paid, mortgage interest, and charitable contributions. an overstatement of the amount they paid in state and local taxes, unless the full difference was above the $10,000 cap. But this potential double benefit, of course, accrues to taxpayers in every affected state, not just these four. The IRS is taking a formalistic approach in determining that a rebate check processed as a “tax refundA tax refund is a reimbursement to taxpayers who have overpaid their taxes, often due to having employers withhold too much from paychecks. The U.S. Treasury estimates that nearly three-fourths of taxpayers are over-withheld, resulting in a tax refund for millions. Overpaying taxes can be viewed as an interest-free loan to the government. On the other hand, approximately one-fifth of taxpayers underwithhold; this can occur if a person works multiple jobs and does not appropriately adjust their W-4 to account for additional income, or if spousal income is not appropriately accounted for on W-4s. ” reduces tax liability, but a rebate check issued in any other way is not a net reduction in state tax liability.

This conclusion is defensible, but it is notable that the IRS was not similarly formalistic elsewhere. They concluded that the remaining payments were not refunds and met the standards of “general welfare” or “disaster relief” payments. Here, the IRS appears to have bent the rules to reach these conclusions, because the payments are inconsistent with standard definitions of those terms. Taxpayers in these states will not complain that the IRS opted for flexibility in a pro-taxpayer direction—the right call after throwing filing season into chaos with a late announcement of potential taxability—but it makes the singling out of four states harder to justify.

A formalistic focus on refunds versus rebates is in contrast with an approach in which the IRS admits that they balanced the need for certainty over the need to apply the general welfare doctrine and qualified disaster relief payment rule accurately. The IRS was right to take a sweeping pro-taxpayer view here, but it is unfortunate for the residents of Georgia, Massachusetts, South Carolina, and Virginia that their generosity of interpretation met with such an arbitrary limit.

If your state issued tax rebates last year, you might have to pay federal income tax on the rebate you received. Maybe. Who knows? Unfortunately, not the IRS—at least not yet.

This uncertainty is unfair to taxpayers. Tax experts have long known that the taxability of state rebate payments would be an issue, but the IRS remained silent until February 3rd, at which point it basically said we’ll get back to you soon. By the time the agency commented, nearly 17 million tax returns had already been received. This belated acknowledgment of the uncertainty surrounding the federal taxability of state tax rebates—after filing is well underway—throws tax season into chaos.

It puts filers in as many as 22 states in limbo. At least some taxpayers received rebate checks in Alaska, Arkansas, California, Colorado, Connecticut, Delaware, Florida, Georgia, Hawaii, Idaho, Illinois, Indiana, Maine, Massachusetts, Minnesota, New Jersey, New Mexico, New York, Oregon, Rhode Island, South Carolina, and Virginia. The IRS has yet to say what that does to their federal tax liability.

(Lists of states providing tax rebates vary, mostly as a matter of definitions. Minnesota’s rebate, for instance, only went to a small subset of the population, so Minnesota is often excluded. Alaska’s was an expansion of the Permanent Fund Dividend that residents receive every year. Some of these distinctions can matter for analysis of federal taxability.)

The federal Internal Revenue Code begins with a definition of income that includes “all income from whatever source derived,” including from state governments, but there are exceptions. Three are potentially relevant in determining the taxability of state rebate checks:

  1. Qualified disaster relief payments are not taxable, even if made through the tax code. The COVID-19 pandemic qualifies; an emergency declaration was issued for the pandemic in March 2020 and is still in effect. If the IRS construes a state’s tax rebates as a pandemic response, those rebates would not be subject to federal income tax.
  2. The general welfare doctrine establishes that social benefit programs are excluded from definitions of gross income. From an economist’s point of view, food and housing assistance for low-income families are income. But from a tax collector’s point of view, they are not. This applies to social benefit programs run through the tax code as well, so a rebate narrowly tailored to assist specific populations may be excluded from federal taxation under this doctrine.
  3. If a taxpayer received no federal tax benefit because of the transfer, then the rebate may not be taxable.

Back in 2021, when a handful of states offered rebates, it was easier to frame them as pandemic aid. In 2022, however, few of these rebates were framed as assistance to mitigate pandemic-era disruptions, at least directly. More often they were tied to inflation relief, or simply offered as a way to return some of states’ large surpluses to taxpayers. What states said, moreover, is not the end of the story: the framing might factor into the IRS’s determinations, but ultimately federal officials will have to weigh the facts and circumstances in each state.

Two rebates—in Florida and Rhode Island—were specifically targeted to families with children, and Minnesota’s was only available to front-line workers, but most states provided rebates to most or all taxpayers, regardless of income, circumstance, or household characteristics, making it difficult to characterize the rebates as social benefit programs. If a rebate does not constitute pandemic relief, the general welfare doctrine may be of little help.

But it may make a difference whether a taxpayer itemizes or takes the standard deductionThe standard deduction reduces a taxpayer’s taxable income by a set amount determined by the government. It was nearly doubled for all classes of filers by the 2017 Tax Cuts and Jobs Act as an incentive for taxpayers not to itemize deductions when filing their federal income taxes. . Itemizing taxpayers receive a deduction for state and local taxes paid (capped at $10,000). Imagine a household with $3,500 in state tax liability, but which subsequently received a $500 rebate check. On net, their tax payments to state government ran $3,000, not $3,500—so if the taxpayer deducts $3,500 in state taxes within the state and local tax deduction, the IRS is likely to expect them to offset it by including the $500 rebate as income. It may not constitute income for someone who took the standard deduction.

The word “may” appears frequently here; that’s intentional and unavoidable. Ultimately, these determinations lay with the IRS, and the agency is pleading for more time to decide. In a February 3 statement, the IRS said to anticipate “additional clarity for as many states and taxpayers as possible” this week. One hopes they will keep to that schedule. In the meantime, taxpayers are urged to wait for additional guidance, and those who have already filed are asked not to amend their returns yet. No one knows exactly what the IRS will determine, and you certainly don’t want to have to file three times.

Potential federal tax liability is just one of many reasons why one-time rebates are economically inferior to permanent rate reductions. States’ revenue gains are a mix of recurring and one-time increases, and there are certainly worse things states can do with the temporary share than to give it back to taxpayers. But there are better options, like reducing unfunded liabilities to avoid future tax increases. Moreover, to the extent that states have recurring revenue gains, permanent tax changes influence future economic decision-making, whereas retroactively applied rebates do little to improve a state’s economic outlook.

Nevertheless, in almost half of states, many residents received a check. The IRS was aware of this fact, and of the federal income tax confusion it would engender. It’s unfair to taxpayers that we’re more than a week into February and still don’t know what millions of them are supposed to put on their federal tax returns. This could have—and should have—been avoided.