IRS was late in publishing guidance on how to treat state pandemic payments for federal income tax purposes.
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In 2022, many states responded to the pandemic by sending their residents special tax refunds or other payments. Taxpayers, and the professionals preparing their returns, needed to know whether these payments have to be reported on federal income tax returns. Unfortunately, we did not get guidance from the IRS until after the start of the tax season.
Hurry up and wait
Normally the IRS wants us to get our returns in as quickly as possible. They needed time to prepare guidance on this issue, however. Their initial recommendation to anyone with questions was to wait:
For taxpayers uncertain about the taxability of their state payments, the IRS recommends they wait until additional guidance is available or consult with a reputable tax professional.
Of course, no reputable tax professional would be so foolish as to offer an answer before the IRS provided additional guidance.
That guidance arrived a week later, and was generally favorable. It appears that at least some of the IRS tax experts thought it would be technically correct to tax the payments. We gather as much from the somewhat grudging manner of granting relief. Rather than say the agency finds the payments nontaxable, the guidance says the IRS has determined “it will not challenge the taxability of” the payments. They seemed to be saying, what the hell, we’ll let you get away with it this time.
Special pandemic payments from most states do not have to be reported on federal income tax returns. However, residents of Georgia, Massachusetts, South Carolina and Virginia may have received payments in the form of refunds of state tax they previously paid. Those individuals may have to report and pay tax on some or all of the amount they received, but only if they claimed the previous payment as an itemized deduction and received a benefit (reduction in their federal tax) from claiming that deduction. Here the IRS is applying the rule that applies to tax refunds in general. Relatively few individuals should be affected, because only a small fraction of federal taxpayers itemize.
If you paid tax on the payment
Many taxpayers who anticipate refunds file their returns as soon as tax season opens. No doubt some who filed before the IRS issued its guidance assumed they had to report, and paid tax on, their state pandemic payments. The IRS is aware of this and suggests that any taxpayer who overpaid for this reason should file an amended return.