Taxability of Refundable State Tax Credits

[dtlee]

From time to time on this board, I have posed comments/questions regarding the taxability of refundable state tax credits. New York State has many of these. Some software treats such credits identically to the way they handle nonrefundable credits such that their taxability is determined as if refunds of a previously taxed amount. Other software treats these as totally nontaxable distributions from the state. I have found no authority that supports either situation and would like the opinions of others on the recent decision of Maines v. Commissioner:

https://www.ustaxcourt.gov/InOpHistoric/MainesDiv.Holmes.TC.WPD.pdf

where they apparently disregarded the comments in Office of Chief Counsel Internal Memorandum Number: 200842002:

https://www.irs.gov/pub/irs-wd/0842002.pdf

and determined that part of this refundable credit is creates a taxable event.

I have not gone through this in detail, but it appears that they are taking the position that anything reducing the current year liability is not taxable, but anything that creates a refund, will create a taxable refund.

My interpretation of this is that something like the NYC School Tax Credit which is given to all NYC Residents would be taxable to the extent of the refund eligible taxpayers receive. Something like the NYS and NYC Earned Income Credit might be more protected if they are considered gifts as described in this earlier memorandum:

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

where they state:

If the payments constitute a gift to a class of recipients rather than refunds of taxes previously paid, then the payments
are excluded from gross income under I.R.C. § 102. Based on the available information, it does not appear that the payments constitute excludable gifts, as they appear prompted by the State’s moral obligation to its taxpayers and/or by an anticipated benefit, rather than out of disinterested generosity.

I am looking for other opinions on these matters since I have been trying to decipher the taxability of refundable state tax credits since one of my peers brought this up at a meeting a dozen years ago.

[Stringbean]

No State Deduction Taken

The link to the Tax Court decision brings out the taxpayers' case, namely that the taxpayer never deducted NY state tax as a Sch A deduction.

The entire purpose (or so I thought) of taxing a state refund was to offset the previous years' deduction for state income taxes that were overwithheld and resulted in a deduction that was too much. Most software (and even instructions) treat this line as ZERO INCOME if the taxpayer did not deduct state income taxes as an itemized deduction the previous year.

The tax court, it would seem, was too aggressive in creating an item of taxable item when the taxpayer had not even deducted on the previous year. There may be some support if the taxpayer's refundable credit exceeded their total NY tax.

[dtlee]

The tax court is saying that there is a difference between something used to derive the state tax liability (i.e., a nonrefundable credit) and something which constitutes a payment from the state to which a taxpayer would be entitled even if no liability existed (i.e., a refundable credit). For example, the Alaska Fund payment is a taxable payment from the state. If they had an income tax return, it would likely be included there as a convenience (as some states include political contributions, wildlife contributions, or sales tax payments). Just because it is on the tax return does not mean if affects the deductible amount of state income tax nor the amount considered to be a recovery of a previously deducted amount.

An example is the NYC School Tax credit which can be claimed on a separate form or incorporated into the State Tax Return. It has no relation to the State or City tax liability.

I actually feel that the court's position could have been more aggressive since it allowed the payment from the state to be reduced by the amount of income tax it offset in the return. I would have expected the full amount to be taxable with the amount of tax paid with it allowed as a deduction in the tax year during which the return was filed (thus lost if not able to itemize that year).

[Roland Slugg]

I read the "Maines" case several months ago ... summaries/comments about it, actually ... and remember thinking that the court's conclusion made perfect sense. The court did not view the matter as a "tax refund" issue but rather as a "taxable income" issue. Accordingly, it ruled that Code §61 was the operable law, and that since there is no exception provided for the credits in question, that their receipt did indeed constitute taxable income.

I noted, too, that the Maines case involved a business entity, or a couple of them as I recall, furthering my belief that the court's decision was correct. If the refundable payments had gone to individuals, the decision might have been different. However, I believe the credits giving rise to the refund ... of which there are three ... are only available to business entities, so their treatment by individuals is probably moot.

In concluding that only the net refundable portion of the credits was taxable I, too, believe the court erred. It basically took the "net" view instead of the "broad" view of what were really two separate matters. The end result, however, will be the same, for if the gross credits amount was reported as income in the year received, then the same taxpayer's deduction for state taxes paid would be correspondingly higher.

[dtlee]

You could be right, Roland.

However, the return under discussion was a personal tax return since they were taking the credits on a personal tax return even though they had some origin in a business situation.

I believe that they are saying that if you have a nonrefundable credit related to a deductible item, that credit is potentially a recovery of a previously deducted amount or tax free if you previously derived no tax benefit, but if you have a refundable credit unrelated to any deduction, it will potentially create taxable income if it creates a refund relative to the tax liability in the year you were eligible for it.

I find the latter piece to be problematic since two unrelated partners with identical tax credits will show a different amount of taxable income from the credit totally unrelated to anything other than the how much of their state tax liability was covered prior to the completion of their state tax return.

[DonPriebe]

Nys 1099-g

New York state does not include the refundable credits on the 1099-G that is prepared for the taxpayer. Instead, it only includes that part of the refund that is due to excess withholding.

According to the NYS website ... <quote>

The Form 1099-G amount may also differ [from your refund amount] because it doesn’t include:

certain refundable credits, such as the empire state child credit, real property tax credit,
earned income credit, child and dependent care credit, farmer’s school tax credit, and the
New York City school tax credit [,or]
interest paid by New York State on an overpayment </quote>

Most taxpayers don't notice this because NYS does not mail out the 1099-Gs; you have to download the info from the web.

[dtlee]

Thanks, Don.

Over the years I have found only one preparer who ever treated refundable New York State Tax Credits as taxable income. That individual claimed that the New York City School Tax Credit was taxable to all recipients regardless of whether or not they ever itemized deductions. I think this court decision supports that statement.

I knew other preparers who treated refundable credits as tax free, but allowed recipients to deduct any state taxes paid with them. Thus, if a tax liability was paid with the NYS Earned Income credit on their 2014 return, the amount of state liability before the credit would be allowed as a state and local tax payment in the following year. I think this court decision does not support either perspective (that they are tax free or that you can deduct the tax liability you offset with them in the following year).

I know of no software companies who treat state refundable tax credits as even partially taxable and I know of one tax software vendor who insists that there is absolutely no difference between the taxability of a refundable state tax credit and a nonrefundable one (in other words, the NYS Earned Income Credit and other taxes like it are a recovery of your previously deducted state taxes and thus never taxable if you never itemized). I think this decision contradicts both perspectives.