taxability of state refund

[Lin150]

Client itemized in 2011 and deducted state and local tax on Schedule A. State refund was $2000. $990 of refund was due to credits given by the state - the rest of the refund was from excess tax withheld.
How much of the refund is taxed in 2012?

[FEDUKE404]

Gotta crunch those numbers!

Client itemized in 2011 and deducted state and local tax on Schedule A. State refund was $2000. $990 of refund was due to credits given by the state - the rest of the refund was from excess tax withheld.
How much of the refund is taxed in 2012?

Your software should handle it....

IIRC, in some/most instances the part of a "refund" that comes from something other than a refund of taxes paid is treated differently. I have seen a Form 1099-G which shows a "refund" that differs from the amount of the "refund" that was shown on the relevant tax return. Of course, now that some states are not even issuing Forms 1099-G for state refunds. . . . . . .

You also should look into what the sales tax table amounts would have been for the year in question. That amount can frequently reduce the amount of otherwise taxable state refund.

From the facts presented, and since the state was not disclosed, you may only have a potential taxable refund of ~$1k...or less...

BOTTOM LINE: Get last year's Schedule A and look around!!

FE

[taxea]

the 1099g usually is the total of refund credits and possibly interest if paid to TP. Your program will transfer the actual amount of refund and will show the correct amount as taxable.

[S T]

Should be a worksheet in your Tax Software - if you changed software from 2011 to 2012 filings and you will have to more than likely enter the information . If you didn't change Software - then the 2011 Software might have carried the amount forward -- or possibly should have - I always check from year to year - 1099 G from the State will provide the amount of the refund, but not necessarily the correct amount to be included on the State Refund Line.

Outside Source that I sometimes use is CFS - Tax Tools - they also have a worksheet to complete.

But as FE states, you need a copy of the 2011 tax return for certain schedules and information to "plug in"

Sandy

[Koss]

State Refund

The portion of the state refund that flows from credits, as opposed to a refund of tax withheld, is irrelevant. That has no bearing on how much of the state refund is taxable.

This has become one of most complicated areas of the tax return. And in many cases, tax software does not handle it very well.

I will readily concede that here in Ohio, and in many other states, the state tax refunds are relatively small. At some point, and this is very subjective, it is simply not worth the time and effort to determine whether some portion of the state refund might not be taxable, and you simply report the entire amount.

It may sound crass or lazy. But if the state refund is $107, is it appropriate for me to spend 25 minutes performing manual calculations, only to determine that the taxable portion of the refund is $78? If the taxpayer is in the 28% tax bracket, I have just reduced their tax liability by about eight dollars. But the extra work could arguably increase the professional fee by $15 or $20.

That may be a more extreme example. I know that some taxpayers routinely get relatively large state tax refunds, in the range of two to three thousand dollars, in states like New York and California. If a state refund is $2000, and only two thirds of it is taxable, then we certainly want to know that.

If you really want to understand how to determine the taxable portion of the refund, you have to study the worksheet in the instructions for line 10 of Form 1040.

The problem is that there are about a dozen exceptions in the instructions. Sometimes you can't use the regular worksheet. Sometimes you have to use a special worksheet that is found in Publication 525.

And some of the exceptions seem to be remarkably common scenarios. Situations in which you cannot use the regular worksheet include...

- You could be claimed as a dependent by someone else in 2011.

- You owed AMT on your 2011 tax return.

- You filed MFJ in 2011, but you are not filing MFJ in 2012.

- In early 2012, you made an estimated payment of state income tax for 2011.

Think about that last one. Almost everyone who makes estimated payments makes a payment in January that is applied to the previous year. That's an awful lot of people who cannot use the regular worksheet for line 10.

But, wait! There's more... You also have to use the worksheet in Pub. 525 if--

your 2011 state and local income tax refund is more than your state and local income tax deduction minus the amount you could have deducted as your 2011 state and local general sales taxes.

Okaaaaaay.

My software has a subroutine that addresses this issue, but you have to manually enter the amount of the prior year general sales tax deduction. That amount is based on the prior year income, and you have to look it up in the prior year's general sales tax table.

The decision tree for this particular question is absolutely mind-bending.

For those that are interested, the worksheet for line 10, along with a list of the exceptions, is available here:

http://www.sgaweb.net/cbllc/wksln10.pdf

And the worksheet from Pub. 525 is available here:

http://sgaweb.net/cbllc/wksp525.pdf

BMK

[dtlee]

Refundable credits from the state generally will not affect the state tax liability and will not be considered part of the refund. Nonrefundable credits, on the other hand, will.

Likewise, use tax payments and charitable contributions paid through the state return should not reduce the refund.

If the fourth estimated state tax payment is made in January 2012, the refund is apportioned between the 4th estimate and the payments made during 2011, reducing the taxable refund reportable (and the amount carried to the 2012 return).

I posted the results of a test of 5 software packages a couple of years ago. Four of them made some kind of error.

[S T]

And Koss as always is giving us the best information and reminding us of earlier days while we were learning how to prepare taxes - a short cut if the State refund was not much - but might I add the correct way for those t/p clients that did receive a large state tax refund --- Now the State refund calculation has become more complex

I am having to revisit due to change of software and the conversion not calculating. Great fun!

Sandy

[FEDUKE404]

Amounts on 1099-G do not match state refund amount

And Koss as always is giving us the best information and reminding us of earlier days while we were learning how to prepare taxes - a short cut if the State refund was not much - but might I add the correct way for those t/p clients that did receive a large state tax refund --- Now the State refund calculation has become more complex

I am having to revisit due to change of software and the conversion not calculating. Great fun!

Sandy

The comments made by Koss are, of course, quite correct. The permutations behind figuring a "correct" taxable state refund amount can be mind-boggling and time-consuming. And in those scenarios if you do not have the 2011 tax return available, you are grasping at straws.

However, I have found that software WILL take much, if not all, of the grunt work out of determining what is taxable. Even the cheapest software should be able to handle scenarios where the #4 state estimated payment is made "early" in December or "on time" in January. I have also found (after the fact!) that merely taking the less than a minute to fill in the state/days/local sales tax rate associated with line 5b of Schedule A will frequently make a difference "down the line," even though often not on the current tax return. I can fill in that information in perhaps 20 seconds maximum...no burden on my part. (I now routinely do it for ALL tax returns where a Schedule A is involved!) After that, the worksheet for your software should be able to handle (without any further effort on your part except perhaps clicking "use worksheet" in lieu of selecting "fully taxable" or "not taxable") the relevant calculations.

Where things get burdensome is if you have a new client and/or your tax software has changed. Then you face an uphill struggle, and may say "tax it and be gone!"

Of course, it was not that long ago that I remember the "simple" approach for taxing state refunds: Did you itemize last year? If yes, fully taxable and if no, onward we go. But "the rules" were always out there, although perhaps the motivation to get a smaller taxable amount was not.

FWIW: I first noted this "TAX refund or not" issue a couple of years ago with a continuing client at the time. I think it was VA, although perhaps NY or PA? In any case, the number shown of the Form 1099-G for that state's refund differed from the actual state refund amount (transferred by my software) as the starting point for the prior state tax return. The client confirmed he HAD received the actual state refund shown on the tax return, and after some comparison of numbers the difference was found to be due to some state-specific credits that increased his "tax" refund.

So much fun. . . .

FE

[Gary2]

The portion of the state refund that flows from credits, as opposed to a refund of tax withheld, is irrelevant. That has no bearing on how much of the state refund is taxable.

Everything else in your post is absolutely correct. And I'm betting you even understand this part perfectly, but it doesn't say (unambiguously) what I think you wanted to say. The problem being that the check received from the state (which is what some people will call the "refund" is not the same as "refund of income taxes." But it is true that the computation of "how much received from the state is actually a refund of state income tax" is a totally separate calculation from "how much of the refund of state income tax is taxable on the federal return."

A simple example: Taxpayer's state return shows $1000 in withholding, a state tax liability of $1100, and a state EITC of $200. That person will receive $100 from the state based on that return. Not only is that not potentially taxable (without even looking at the Sch. A or other numbers for the applicable year), but I would venture there's an additional $100 of taxes paid with that return that can be included as state income taxes paid for the following year.

Do you trust every single state to get this right when they prepare the 1099-Gs? I don't.

Do you trust every piece of software on the market (even if just limited to the professional software) to get this right, for every single state, year after year? I don't.

And this is before we throw in additional complexities: What about use tax paid on the state return? What about interest paid by the state on the refund (which I believe are always taxable on the federal, even if there was no itemizing). What about refundable business credits? dtlee said that refundable credits won't affect the state tax liability, and that's true, as far as it goes. But does that mean that all refundable credits issued by a state are non-taxable? I'm pretty sure all state EITCs are non-taxable. But some states have a variety of refundable business credits, some of which can even be sold to other businesses. While these would not be taxable recoveries, they may be taxable for other reasons. Again, do you really trust all the states and all the software to get it right?

This doesn't mean I expect everyone to start scanning last year's returns for tricky cases and then double checking this year's software calculations and 1099-Gs. But it's a subtle area, worth understanding at a general level.

[Burke]

- In early 2012, you made an estimated payment of state income tax for 2011.

Think about that last one. Almost everyone who makes estimated payments makes a payment in January that is applied to the previous year. That's an awful lot of people who cannot use the regular worksheet for line 10. BMK

My clients better not, if they itemize. I have them all pay that last installment by 12/31 of the current tax year in order to deduct it! Some learned that lesson the hard way.

[dtlee]

There is a big difference between state refundable credits and state nonrefundable credits. In many cases the payments from the states in the form of refundable credits do not even require the filing of a tax return to receive them and are included in the tax return for convenience.

The starting point for the computation of a taxable state refund begins with the amount deemed to be a refund of taxes previously paid and reported on Form 1099-G. None of the states who offer refundable credits include these refundable credits in the 1099-G amount and all of those states do include the impact of nonrefundable credits in the same 1099-Gs. The point of this is that a refundable credit is not a return of taxes previously deducted whether paid to a taxpayer who itemized in the prior year or not. At least a few states have requested letter rulings from the federal government to identify whether or not their payments from refundable credits are or are not part of the refund of a previously deductible amount. Those who have, have been told that they are not considered a refund of taxes previously paid (since they have no impact on the tax liability).

Here are some states which insist that refundable credits do not go on the 1099-G:

http://www.michigan.gov/taxes/0,4676,7-238-43715-154102--F,00.html

http://www.revenue.state.mn.us/individuals/individ_income/Pages/Form_1099-G_Record_of_Income_Tax_Refund.aspx

http://www.revenue.wi.gov/faqs/pcs/1099g.html

https://www.ftb.ca.gov/individuals/faq/net/908.shtml

http://www.tax.ny.gov/pit/file/1099moreinfo.htm

I know of no valid reason for claiming these to be part of a taxable refund of previously paid taxes.

On another note, I have seen nothing that documents that a refundable credit paid by a state should be considered as tax-free income. I asked here once before and no one seemed willing to cite anything which allows a refundable child care credit or EIC from a state to be treated as tax-free income to the recipient regardless of whether or not that taxpayer itemized in the prior year. In other words, if a taxpayer has never itemized and receives a child care credit from their state, what section of the code allows this refundable credit payment to be treated nontaxable income under any circumstances?

Why does this matter?

If a refundable credit is considered part of a refund of taxes previously paid, it is only taxable to the extent that a deduction was claimed. If it is considered income (whether taxable or nontaxable) any part of it which offsets an existing liability should be considered a payment of state taxes. In other words, if a taxpayer would have a $200 balance due on the 2012 return, but receives a $330 Empire State Child Credit resulting in a refund of $130 received in 2013, $200 of the $330 was actually a payment of the $200 tax liability and if it was paid in 2013 (as would normally be the case) it wil be eligible to be claimed as part of the 2013 itemized deductions.

[Roland Slugg]

My clients better not, if they itemize. I have them all pay that last installment by 12/31 of the current tax year in order to deduct it!

Wow! You have more authority over your clients than I have over most of mine. But even if you do, it's not always wise to urge a client to pay the #4 state estimated tax installment in December. The AMT might render it useless in one year but not the next. In fact it might be wise to not pay ANY state estimated tax in certain years because of the AMT. Another possibility: The taxpayer might want to bunch all his itemized deductions into every OTHER year, taking the standard deduction in the alternating years.

The posts above about tax software not always getting the taxable portion of a state refund right are very valid. The portion of a refund that consists of an estimate payment made in the subsequent year ... i.e. the same year as the refund ... is a good case in point.

[FEDUKE404]

Being inflexible for dubious reasons

My clients better not, if they itemize. I have them all pay that last installment by 12/31 of the current tax year in order to deduct it! Some learned that lesson the hard way.

That approach is dangerously close to not having the best interests of the clients in mind.

As alluded to by Roland Slugg, there can be valid "tax reasons" NOT to pay the #4 state payment before the new year. Things that quickly come to mind include a lower income/tax rate in the old year versus a higher same in the new year. AMT can come into play. What about looking at standard deduction in the old year and itemizing in the new year, to include something as simple as an apartment renter who is contracting for a new home?

I have several clients who like to "fine tune" their tax situation, as much as possible, toward the end of the calendar year. I can virtually predict which ones will call me in late November or early December to discuss their year-end issues. Depending on their own circumstances, to include issues as stated above, they may defer/advance funds for such things as #4 estimated state payments, contributions, property tax payments, certain medical bills, and even consider an "extra" late-December mortgage payment.

It takes minimal effort to change (within your software) the payment date for state payment #4 from the "automatic" 01/15/2013 to something like 12/21/2012. After that, the tax software can easily handle things from there on. This would include the following year, with an automatically carried over entry along the lines of "prior year state and local estimates paid after 12/31/20xx" for Schedule A.

While there are times to pursue Thoreau's "Simplify, simplify" approach to things, I don't consider that to be the proper approach for my clients. That definitely applies in a situation as simple as making a sound decision for my client's best interest and then having to do a bit, but not a lot, of extra work to implement that decision.

Hope I did not squash any toes here.

FE

[dtlee]

When I posted this question a couple of years ago, I included a snippet from Letter Ruling 8445062 (Aug. 9, 1984). I will try to include the entire text here (emphasis added):

This is in reply to your letter dated April 18, 1984, and subsequent correspondence concerning the reporting requirements under Section 6050E of the Internal Revenue Code for State income tax refunds that are paid in 1984 which are reportable in January of 1985.

The State income tax laws do not permit joint return filing for State income tax purposes. Instead, a married couple files a combined return on which each spouse independently reports his or her income and deductions and independently computes his or her tax. Any tax due by one spouse may be offset by any refund due the other spouse.

The State income tax law provides for refunds based on A Credits and B Credits. These are refundable credits and are allowable in addition to any State income tax refund otherwise allowable.

Taxpayers are allowed to designate on their State income tax return amounts they wish to donate to the C Fund. These donations either decrease the amount of the refund or increase the amount of tax due on the return.

Section 6050E of the Code provides that every person who, with respect to any individual, during any calendar year makes payments or refunds of State or local income taxes (or allows credits or offsets with respect to such taxes) aggregating $10 or more shall make a return setting forth the amount of such payments, credits or offsets and the name and address of the individual with respect to whom such payment, credit or offset was made.

Section 5f.6050E-1(b)(4) of the Temporary Income Tax Regulations under the Tax Equity and Fiscal Responsibility Act of 1982, provides that the term “credit or offset” means an overpayment of tax which, in lieu of being refunded to the taxpayer is applied against an existing liability of the taxpayer or available for application against some future liability of the taxpayer or otherwise used or available for use for the taxpayer’s benefit.

Section 164 of the Code allows a deduction for Federal income tax purposes of state and local income taxes for the taxable year within which paid or accrued.

Under section 111 of the Code, gross income for Federal income tax purposes includes recoveries of previously deducted bad debts, prior taxes or “delinquency amounts” to the extent that prior deductions resulted in an income tax benefit for the year of deduction. The term “prior taxes” includes previously deducted state or local income taxes.

The explanation given in the Committee Reports for enacting section 6050E was that “[u]nder present law, the refund, credit or offset of State or local income taxes that were deducted (with a resulting tax benefit) in a prior year is includible in a taxpayer’s gross income. [However] There is no requirement that information returns with respect to such refunds be filed with the United States or that a statement regarding the refunds be furnished to the recipient.” See H.R.Rep. No. 97-760 (Conf.Rep.) 97th Cong. 2nd Sess. 467 (1982), 1982-2 C.B. 600, 646.

The purposes of section 6050E of the Code is to require reporting of state income tax refunds that would be includible in the individual’s gross income under section 111 because he or she had previously claimed a deduction under section 164 for those state income taxes paid or accrued in a prior year. The reporting requirement of section 6050E of the Code covers only refunds, credits or offsets of state or local income taxes.

In the instant case, refundable A and B Credits are allowable in addition to any State income tax refund or credit otherwise allowable. However, the credits themselves do not constitute overpayments of tax; rather, they are allowable as credits or are refundable whether or not there has been any State income tax paid. Consequently, only refunds representing the excess of State income tax withheld or paid over the amount of the actual state income tax liability are reportable under section 6050E.

Accordingly, based on the above cited law and rationale, the following answers are provided in reply to your specific questions. Also, there is attached and made part of this ruling letter a copy of Form 1099-G for 1984.

1. How is the year (Box 3) on Form 1099-G to be determined?

The year designation to be entered in Box 3 is the taxable year for which the refund was made. As indicated in the instructions for Form 1099-G, if no entry is made in Box 3, the refund will be considered to be the refund for the taxable year 1983.

2. How is the refund (Box 2) on Form 1099-G to be determined?

In general--

The amount of the refund to be reported in Box 2 does not include any State A Credit or any State B Credit. It does, however, include any amount designated as a donation to the C Fund.

The amount of refund to be entered in Box 2 is determined before any reduction for:

(a) amounts applied to 1984 estimated tax,

(b) amounts applied against delinquent taxes owed to the State, or

(c) amounts applied against debts owed to another state agency (e.g. delinquent support payments, etc.).

Specifically--

(a) Where one spouse’s refund for tax year 1983 is applied against the 1983 tax owed by the other spouse, the amount of refund to be reported in Box 2 is the amount of the refund before reduction for the other spouse’s tax due. The gross amount of refund rather than the net amount is reportable.

(b) Where husband and wife file on the same return and each receives a refund, a separate Form 1099-G is required for each spouse showing that spouse’s respective refund.

(c) Where the amount of the refund claimed on the return is adjusted (increased or decreased) by the State Department of Revenue, the corrected amount is the amount required to be reported in Box 2 of Form 1099-G.

(d) Where a person files both an original and amended 1983 State income tax returns during the calendar year 1984, the amount of the refund to be reported in Box 2 is the net total refunds from both returns filed.

Where a person files State income tax returns for two or more different taxable years during the same calendar year, a separate Form 1099-G is required for each different taxable year.

(e) As previously stated, that amount of refund reportable in Box 2 of Form 1099-G does not include amounts allowed as A or B Credits.

(f) Where an audit by the State of multiple years tax returns results in overpayments for one or more taxable years and underpayments for one or more taxable years, a separate Form 1099-G is required for each taxable year for which an overpayment was determined, reporting in Box 2 the full amount of the refund determined as a result of the audit, before offset of the refund against the tax deficiencies determined to be also due. Also, the taxable year to which the refund relates must be shown in Box 3 of Form 1099-G.

This ruling is directed only to the taxpayer who requested it. Section 6110(j)(3) of the Internal Revenue Code provides that it may not be used or cited as precedent.

E.L. Kennedy

Chief, Specialty Tax Branch

This has been used by several states to guide them in reporting refund recoveries.

As I indicated in the forum a couple of years back, I remain unconvinced that state refundable credits are considered tax-free income to the recipients (including those who never deducted any itemized deductions), but I am very convinced they are not a recovery of a previously deducted amount.

I was also looking for this.

In this item from an IRS field attorney advice memorandum from 2005 (released in 2006), the IRS commented on the taxability of distributions from a particular state fund that had been set up to provide refundable credits.

They conclude that these refundable credits are gross income even though not reportable on Form 1099-G:

http://www.irs.gov/pub/irs-lafa/060901f.pdf