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Sunday, January 29, 2023

Are special state tax refunds taxable? Maybe; it depends!

For COVID relief, both the federal government and some state governments had funds for individuals/households. Congress created Economic Impact Payments (recovery credits) which were specified as not taxable and states followed that. Some states such as California had additional relief such as the Golden State Stimulus payments where were labeled as a one-time tax refund and available only to individuals below $75,000 of income or who received certain aid. California law (R&T 17131.11) was clear the funds were not taxable for California. For federal purposes, as a tax refund they were not taxable and even if not truly a tax refund, they likely fell under the general welfare exclusion to be non-taxable.

Last summer some state lawmakers created additional grants or refunds likely due to a surplus and increased gasoline prices hurting some individuals. California enacted the Better for Families Tax Refund (AB 192, Chapter 51, 6/30/22). This is also called the Middle Class Tax Refund (MCTR) on the FTB website (it's not clear where that name came from).

The preamble to the bill states that "existing law authorizes various forms of relief for low-income Californians." The relief provided though is available to married couples or head-of-household filers with 2020 income (AGI) up to $500,000 or single up to $250,000.  These are not low-income levels because those high levels represent less than 2% of the California population. In addition to being below the stated AGI levels per the 2020 return, recipients had to have filed their 2020 return by 10/15/21 (before AB 192 was enacted) and be a California resident for six or more months of 2020 and not be eligible to be claimed as a dependent.

AB 192 is very clear that the "refund" is not taxable in California (R&T 17131.12(a)). While it sounds like a non-taxable refund for federal, there is a provision in AB 192 at Welfare & Institutions §8161(d) that states that the payment "shall not be a refund of an overpayment of income taxes ..."

So, perhaps it is not a non-taxable tax refund (although some bill language makes it sound like it is a refund of various California taxes, but why deny it then to someone without a need to file a 2020 California income tax return; everyone in CA certainly pays a variety of taxes including renters who indirectly pay a lot of property taxes, as well as sales and excise taxes).

Does the general welfare exception apply to make the MCTR non-taxable? The IRS describes this income exclusion as requiring the income recipient to satisfy the following (see Information Letter 2019-0024):

1. funds paid per a government program - met

2. not a payment for services - met

3. for promotion of the general welfare meaning it is based on need - I think not met

How can funds given to about 97% of Californians be a needs-based program? How can payment given to people well above the federal poverty line be based on need? How can $400 given to a married couple with $499,000 of income or $200 if single with $249,000 of income be based on need? Well, it would appear that the general welfare exception doesn't apply - the refunds/grants are taxable for federal purposes.

The FTB must have reached the same conclusion because they have stated that they are and will be issuing 1099-MISC to anyone receiving an MCTR or $600 or more.  Of course, even if someone received a payment under $600, it is still taxable despite not receiving a 1099. Also note that these are Form 1099-MISC for miscellaneous payments rather than 1099-G for a refund of income tax paid (which makes sense because you could get the payment even if no income tax was owed in 2020).


1. Why were these funds given to people who don't need them? And it is not just the funds, but the costs of issuing so many "refunds."

2. Why were the funds not available to people who do need them, such as people with income below the filing threshold so did not file a 2020 return by 10/15/21? (these folks also lost out on the Golden State Stimulus if they did not file a 2020 return by 1015/21)

3. Why did AB 192 include a law change to say that the "refund" is not an income tax refund?

4. Why do California lawmakers want residents to give some of their payments to the federal government?

5. What about the reality that higher income individuals who get a refund under $600 won't have a 1099-MISC and may just forget to report it on their return, versus the lower-income folks getting a 1099-MISC that they must report? Now the amount might not cause a federal liability for low income taxpayers, but it is likely to result in some tax owed by many recipients.

All recipients should note what they received and put it in their tax records so all recipients report it on their 2022 or 2023 return (refunds are issued in Nov 2022 through January 2023). 

For more:

What do you think?


Anonymous said...

I think the answer to 1 and 2 is “politics”. Given that - the politics, state finance practices and budgetary issues (all complex) likely provide answers to the other questions. A lot of financial decisions at every level of government end up with politics trumping sound policy. More so in one-party dominated governments

21st century taxation (Annette Nellen) said...

News at 2/3/23 - the IRS issued a statement that by next week "We expect to provide additional clarity for as many states and taxpayers as possible."

Hopefully that will include California to allow for consistency among filers. The SF Chronicle reported on 2/1/23 that TurboTax is reporting the MCTR 1099-MISC but then backing it out so the next result is non-taxable.

As I note in the above post, it is difficult to see how payments given to people with up to $500,000 of income and no payments given to many very low income people because they did not file can be treated as a system issuing payments based on need. (Note: $500,000 for a couple is 27 times greater than the 2022 federal poverty level.)

Perhaps the CA lawmakers can retroactively fix it by making it clear in the law it is treated as a refund even if no tax was owed in 2020. It is probably too late to say the payments were only for COVID relief (which would have made them non-taxable under IRC section 139).

We'll see.

21st century taxation (Annette Nellen) said...

Usually info about the general welfare exclusion comes from the IRS. But there are at least two regular Tax Court decisions where it came up.

In Maines, 144 TC 123 (2015), the taxpayer received some refunds of various NY tax credits because the amounts were greater than what they owed to NY (the case doesn't mention the amounts). One theory on whether the "refunds" are taxable was whether the general welfare exclusion applied. The court noted that one requirement was the the payments "promote the general welfare (generally based on need)." The court noted: "Grants from welfare programs that don't require recipients to show need have not qualified for the general-welfare exclusion."

Similarly in Bailey, 88 TC 1293 (1987), the court found that payments under a facade grant program were not excludable under the general welfare exclusion. Per the court, these payments "were awarded without regard to any need of the recipients. The only requirements for participation in the facade grant program were ownership of the property and compliance with the building code." This ruling also lists lots of revenue rulings on the exclusion including their summary of Rev. Ru. 76-131: "payments made by the State of Alaska to long-term residents distinguished from general welfare payments because they were based on the recipient's age and residency requirements regardless of financial status, health, educational background, or employment status."

These interpretations and consideration of the general welfare exclusion make it difficult to apply to the Middle Class Tax Refund under AB 192 (2022) given that financial need was not considered given that the payments go to many individuals in the top 10% of income levels (who do not have a financial need) and many individuals with a dire financial need don't get anything at all (unless they filed a 2020 return by 10/15/21, which is 8 1/2 months before enactment of AB 192).

And AB 192 made a law change that the payments are not treated as income tax refunds which seems to prohibit application of a position that the payments just don't meet the definition of income.