Why the IRS could tax state inflation relief payments

People who received state tax rebates or inflation relief payments last year should hold off on filing their taxes while the federal government decides if the payments count as taxable income, the Internal Revenue Service said last week. The agency said more guidance will be coming as soon as this week. 

More than 20 states issued a rebate or inflation relief payment last year, according to the Tax Foundation, a Washington, D.C.-based think tank. Governors and lawmakers in at least eight states have proposed sending residents additional cash this year as they seek to spend down huge revenue surpluses.

State tax rebates generally count as taxable income, Jared Walczak, vice president of state projects for the Tax Foundation, wrote Wednesday in a blog post. 

But disaster relief payments, such as those made to help people cope with the Covid-19 pandemic, are tax-exempt. So are rebates intended to help specific groups, such as low-income people. It also matters whether taxpayers itemize or take the standard federal tax deduction, he wrote. 

Many states issued Covid-19 relief payments in 2021. But policymakers generally framed last year’s round of checks differently: as income tax relief and an effort to help state residents cope with rising prices. Governors and lawmakers are making the same case for additional payments this year.

Rebates framed as inflation relief could face scrutiny from the IRS, tax experts say. Take Maine, where the state government sent $850 checks to income tax payers last year to offer relief from “pandemic-driven inflation.”

Maine Revenue Services spokesperson Sharon Huntley told the Portland Press Herald that the payments shouldn’t be taxed.

“The IRS has indicated that it is in the process of reaching its own determination, and we believe that the agency should conclude, too, that the payments are exempt,” she said. “We encourage them to reach this conclusion swiftly so that Maine people, and others across the nation, may have certainty.”

There’s no guarantee the IRS reaches that conclusion, tax experts told the Press Herald. Maine Gov. Janet Mills (D) ended the state’s Covid-19 state of emergency in June 2021, long before the $850 payments were issued.

“A word to state lawmakers,” Walczak tweeted on Wednesday. “If you’re thinking about offering a rebate this year, keep federal taxability in mind.”