Many states issued payments to taxpayers throughout the pandemic period, including during tax year 2022. Most notable is California’s Middle Class Tax Refund, for which the California Franchise Tax Board issued Form 1099-MISC, Miscellaneous Income, because it determined they may be federally taxable.
Receipt of a Form 1099 or other information return does not mean the amount it reports is taxable income to the taxpayer in that tax year or has the character ascribed to it by the information return. We need to ask questions and make that determination for the taxpayer. The issuer does not know the recipient’s tax situation.
§61 states that gross income means all income from whatever source derived, so a state payment to a taxpayer will generally be taxable unless there is an applicable exclusion from income tax.
When determining the taxation of a government payment to a taxpayer, here are the three questions that should be asked concerning that payment:
Is it a tax refund? If so, it is generally excluded from tax under §111 unless the taxpayer received a tax benefit from deducting it in a prior tax year. If the taxpayer did not itemize deductions in the tax year of payment, it would be excluded from income tax.
If the taxpayer did itemize deductions in the tax year of payment, it might only be partially included in income if they only received a partial tax benefit from the payment. For example, with respect to a $1,000 refund, if the taxpayer paid $10,800 in state income tax in the prior year, then only $200 of the refund is taxable because $800 of that refund amount was non-deductible due to the $10,000 deduction cap on state and local taxes. See Rev. Rul. 2019-11 for additional information.
The same analysis applies to state business income taxes deducted for federal purposes; any refund will generally be included in the taxpayer’s business income. This particularly applies to the state-level pass-through entity tax (PTET) systems recently enacted in most states.
If the payment is not a tax refund, it must fall under another exclusion in the tax law not to be taxable income to the taxpayer. Whether or not it is a tax refund depends on the facts and circumstances of the payments. Issuance by a state of Form 1099-G, Certain Government Payments, with the amount reported in box 2, indicates that the state takes the position it is a tax refund.
For example, in 2022, New Mexico issued “refundable tax rebates” based on filing a 2021 tax return; however, its website guidance states, “The Department cannot comment on any federal tax consequences of the rebates and relief payments.” A refundable tax credit is treated as a payment for tax purposes and is issued regardless of tax liability. I believe there is a reasonable basis for the position that this payment is a tax refund and excluded from federal income tax (as no tax benefit was claimed from it in a prior tax year).
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Does it qualify for the general welfare exclusion? The general welfare exclusion, while not generally codified, is a principle of federal tax law stating that government payments to promote the general welfare are excluded from tax, as taxing them would defeat the government's intent to provide financial assistance to individuals in need.
Congress partially codified the exclusion concerning Indian general welfare benefits in §139E; however, this exclusion only applies to Indian general welfare benefits as defined in §139E(b) and is not generally applicable to state and local programs.
Rev. Rul. 2005-46 provides a clear definition of the general welfare exclusion. To qualify under the general welfare exclusion, payments must
Be made from a governmental fund,
Be for the promotion of the general welfare (i.e., generally based on individual or family needs), and
Not represent compensation for services.
The IRS typically applies the exclusion’s three-prong test to various state, local, or tribal payments and issues formal guidance on whether the payments meet the exclusion requirements. Two examples include:
Rev. Rul. 74-205 for certain federal housing assistance payments, and
Rev. Rul. 2003-12 for grants individuals receive under a state’s program to pay or reimburse certain reasonable and necessary medical, temporary housing, or transportation expenses they incur as a result of a flood.
Even if the IRS does not issue guidance with respect to a specific state and local payment, a taxpayer can always take a position on a tax return that the payment is excluded from federal taxable income under the general welfare exclusion.
Concerning the California Middle Class Tax Refund, I believe there is a reasonable basis for the position that they are excluded from federal taxable income under the general welfare exclusion. I fully agree with this analysis from David Fogel, EA, CPA, USTCP on the issue, including how to address it on the federal tax return. The IRS should make it a priority to issue guidance for this payment and end the uncertainty.
Does it qualify for the qualified disaster relief payment exclusion? §139 provides a general exclusion for qualified disaster relief payments received by an individual. Any organization can issue the payment, including businesses and state and local governments.
A qualified disaster relief payment means any amount paid to or for the benefit of an individual:
To reimburse or pay reasonable and necessary personal, family, living, or funeral expenses incurred as a result of a qualified disaster,
To reimburse or pay reasonable and necessary expenses incurred for the repair or rehabilitation of a personal residence or repair or replacement of its contents to the extent that the need for such repair, rehabilitation, or replacement is attributable to a qualified disaster,
By a person engaged in the furnishing or sale of transportation as a common carrier by reason of the death or personal physical injuries incurred as a result of a qualified disaster, or
If such amount is paid by a Federal, State, or local government, or agency or instrumentality thereof, in connection with a qualified disaster in order to promote the general welfare.
Note that §139(b)(4) (the last bullet above) partially codified the general welfare exclusion, but only concerning certain payments due to qualified disasters.
Under §139(c), a qualified disaster means
A disaster which results from a terroristic or military action (as defined in §692(c)(2)),
A federally declared disaster (as defined by §165(i)(5)(A)),
A disaster which results from an accident involving a common carrier, or from any other event, which is determined by the Secretary to be of a catastrophic nature, or
With respect to amounts described in subsection (b)(4), a disaster which is determined by an applicable Federal, State, or local authority (as determined by the Secretary) to warrant assistance from the Federal, State, or local government or agency or instrumentality thereof.
As an example, in Rev. Rul. 2003-12, the IRS ruled the following payments to individuals were excluded under §139:
Grants individuals receive under a state's program to pay or reimburse certain reasonable and necessary medical, temporary housing, or transportation expenses they incur as a result of a flood that was a Presidentially declared disaster, and
Grants employees receive under an employer's program to pay or reimburse certain reasonable and necessary medical, temporary housing, or transportation expenses they incur as a result of a flood that was a Presidentially declared disaster.
The COVID-19 pandemic is a §139 qualifying disaster. President Trump declared a disaster nationwide on March 13, 2020, and it has continued to this day; however, President Biden stated the disaster declaration would not be renewed on May 11, 2023. Many payments issued by states over the last several years could be excluded under §139 if the legislation authorizing such payments invoked relief due to the COVID-19 pandemic. As expected, it will depend on the facts and circumstances of the payment and the legislative intent behind it.
In summary, a tax professional should analyze each state program and determine whether or not they believe there is at least a reasonable basis to exclude the payment from federal taxable income. Specific guidance from the IRS is not required to claim a tax benefit to which the taxpayer may be entitled. Use of Form 8275, Disclosure Statement, may be appropriate depending on the magnitude of the payment and the level of comfort with the position taken on the tax return.
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Thank you for this excellent analysis. Fortunately the IRS indicated that they will be issuing guidance for as many state payment programs as they can in the next week, and one would assume that addressing the payments from CA is a high priority among those given how many taxpayers are impacted.