Stumbling Start to Tax Season

The 2023 tax season kicked off January 23. IRS began accepting returns, and many taxpayers anticipating refunds rushed to get their forms in early. Then a slight problem. Our friends at the IRS realized there was a unique problem affecting millions of taxpayers.

State pandemic payments. In 2022, many states responded to the pandemic by sending their residents special tax refunds or other payments. Somehow, the IRS didn’t realize until after the tax season started that recipients would need to know whether they have to report these payments as taxable income on their federal tax returns. What’s worse, when the issue fell into their laps, they realized it wasn’t an easy question.

Hurry up and wait. The IRS fell into a quandary. I know, the irony. They didn’t know what to do, so they couldn’t tell us what to do. In a statement released February 3, the agency said it was working on this complicated issue as quickly as possible, and offered the following recommendation:

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.

Blessed relief. 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.