Introduction
During the COVID-19 pandemic the world witnessed three direct payments by the US federal government to approximately 165 million Americans for economic relief. These payments were enhanced by legislation specifically exempting them from the federal income tax. Many states followed the federal practice and issued similar stimulus payments in 2022. The IRS waited until after the filing season and then issued clarification that those state payments would not be taxed and started to exempt most state payments. The guidance released was specific to 2022 and did not then apply to any future payments that could theoretically be made. The IRS then issued Notice 2023-56 over six months later to provide guidance for 2023 and subsequent years, but the guidance contained in Notice 2023-56 has yet to be finalized. Comments are invited with a submission preference of before October 17, 2023.
Notice 2023-56 began its analysis talking about “gross income” which “means all income from whatever source derived” including every “undeniable accession to wealth, clearly realized, over which a taxpayer has complete dominion.”[1] This includes state payments with three notable exceptions:
State Tax Refunds
The classification of a payment from a state as a tax refund turns on substance, not form. To be more specific, the payment must be the amount of “taxes actually paid by the taxpayer.”[2] This is not restricted to a state income tax.[3] A refund is usually “not an accession to wealth,”[4] however it can be through the “tax benefit rule” which requires income inclusion for recouped deductions.[5] Therefore, state tax deductions must be balanced by including refunds as income to the extent that they reflect deductions that reduced the taxpayer’s tax liability. The above does not apply to the standard deduction.
General Welfare Exclusion
The second exception to a state payment being included in gross income is referred to as the general welfare exclusion. Specifically, “payments made to, or on behalf of, individuals by governmental units under legislatively provided social benefit programs for the promotion of the general welfare are not includible in an individual recipient’s Federal gross income.”[6] This exclusion has three prerequisites:
Disaster Relief Payments
The third exclusion is the disaster relief payment exclusion, and of the three contemplated exceptions, only the disaster relief exclusion is expressly statutory. “Section 139(a) provides that Federal gross income does not include any amount received by an individual as a qualified disaster relief payment.”[10] A “qualified disaster relieve payment” includes, “among other things, any amount paid to, or for the benefit of, an individual 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.”[11] Thus, there are three elements:
A disaster may be “qualified” through a presidential declaration that the event “warrant[s] assistance by the Federal Government under the Robert T. Stafford Disaster Relief and Emergency Assistance Act” codified in 42 U.S.C. §§ 5121-5207.[12] The second factor was not analyzed by the IRS, but it is likely based on the language used that payments made “in connection with” a “qualified disaster” would be explicit in their association. Once the first two criteria are met, the third is “presumed” to be met as well, meaning the taxpayer would not need to show anything beyond the applicability of the first two elements in order to have a payment qualify as a disaster relief payment.
If you have questions or concerns about how these news reports may affect you or your business, please contact The Burton Law Firm at: 916-822-8700 or email info@lawburton.com for a consultation.
[1] Notice 2023-56 § 3.01(quoting IRC § 61(a) and Commissioner v. Glenshaw Glass Co., 348 U.S.
426, 431 (1955)).
[2] Notice 2023-56 § 3.02.
[3] Notice 2023-56 § 4.02.
[4] Notice 2023-56 § 3.02.
[5] “The tax benefit rule generally requires a taxpayer to include in Federal gross income an amount recovered during a taxable year that the taxpayer deducted for Federal income tax purposes in a prior taxable year to the extent the Federal income tax deduction reduced the taxpayer’s Federal income tax liability in the prior taxable year.” Notice 2023-56 § 3.02.
[6] Notice 2023-56 § 3.03.
[7] Notice 2023-56 § 3.03.
[8] Notice 2023-56 § 3.03.
[9] Notice 2023-56 § 3.03.
[10] Notice 2023-56 § 3.04.
[11] Notice 2023-56 § 3.04.
[12] Notice 2023-56 § 3.04.
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California has required employers to “indemnify” employees for “necessary expenditures or losses incurred by the employee in direct consequence of the discharge of his or her duties, or of his or her obedience to the directions of the employer” in substantially the same terms since 1937 under Labor Code § 2802.
