Federal Tax Treatment of Proposed NY Inflation Refunds

12/9/24 news release

Per a December 9, 2024 story at the New York State website, Governor Hochul has proposed "sending 8.6 million New Yorkers an Inflation Refund Check as first proposal of 2025 State of the State."

The rationale is that inflation increased the price of taxable goods and services on which sales tax was charged. So, the state collected more sales tax than it would have without inflation's affect on prices. Governor Hochul proposes giving "everyday New Yorkers":

   $500 for families making under $300,000

   $300 for individuals making under $150,000

Big question ... Will these "tax refunds" be subject to federal income taxes (must the recipients include them in their federal income tax)?

I think the answer is yes.

Income is broadly defined at IRC §61 and case law as being derived from any source and something that is an accession to wealth. In Notice 2023-56 suggested how the tax law applies to various payments received from a state and sought public comments for the IRS's final guidance (which has not yet been issued).

In Notice 2023-56, the IRS noted that the name given to a payment is not controlling but instead, the substance of the payment arrangement controls. If a tax "refund" is limited to how much tax the individual actually paid, the payment is likely to be a non-taxable tax refund (taxable though if the taxpayer claimed a deduction (tax benefit) for the tax later refunded).

The NY proposal is the same for everyone at a specified income level or marital status. It appears to have no relation to how much sales tax the recipient actually paid.

Notice 2023-56 also explains the general welfare exclusion where payments are made based on need. This also won't apply to the NY "refunds" as the income levels at which they can be issued is well beyond "needs" and the median income level.

Is there anyway to avoid the federal tax hit so that 100% of the refunds can stay in New York?  Well, they could be changed to be, for example, 10% of the actual sales tax paid. But people won't have these records. It could be achieved by temporarily lowering the sales tax rate to give buyers back some portion of sales tax by paying less today than they otherwise would. They could use the additional sales tax collected to provide funding for services available to low-income individuals.

I think they could significantly lower the income level for these payments, so that they are truly only provided to those in need making them excludable under the general welfare exclusion.

What do you think?