Although the Internal Revenue Service still has not issued any guidance on whether the California “middle-class tax refund” is taxable on federal returns, some major tax-preparation companies are treating it as not taxable.
But other tax professionals believe it is, prolonging the confusion as tax season begins in earnest.
“Based on currently available information, and our own expertise, our understanding is that these payments are not taxable at the federal or California state level,” Lisa Greene-Lewis, a spokeswoman for TurboTax, said via email. “We are providing guidance to our customers and are hopeful for additional clarification in the near future.” TurboTax is the nation’s best-selling tax preparation software.
TurboTax software is prompting users to report the payment as a California Middle Class Tax Refund, but it then deducts the payment so the net amount is zero.
The Franchise Tax Board began sending these one-time payments, which range from $200 to $1,050, to state residents in late October. To qualify, people had to have filed a 2020 state tax return with no more than $250,000 in income for singles or $500,000 for married couples. The payments, designed to offset inflation, arrived via direct deposit or prepaid Visa debit card.
The bill that authorized the payments exempted them from state income tax. Although the bill called them refunds, it also said they “shall not be a refund of an overpayment of income taxes.”
“The problem here is the language that says it’s not a tax refund,” said Annette Nellen, a San José State University professor and director of its graduate tax program.
State income tax refunds are generally reported to the recipient and to the IRS on Form 1099-G, for government payments. The tax treatment is pretty clear: Taxpayers do not have to report the refund as income on their federal tax return if they didn’t itemize deductions on their return for the year that generated the refund, the IRS says.
If they did itemize deductions that year, and got a benefit from the state-tax deduction, then they would have to include some or all of the refund on their tax return for the year it was received. (Most people do not itemize deductions.)
The Franchise Tax Board surprised tax pros in November when it said it would send a different form - 1099-MISC for miscellaneous income - to anyone who received a payment of $600 or more because it “may be taxable income for federal purposes.” The board isn’t providing much help - instead of saying outright whether the payment is taxable, it instructs people to consult their tax professional or IRS Publication 525. But that publication doesn’t say what to do about a state tax refund that’s not a refund.
The IRS does say that in most cases, income from any source “is taxable unless it is specifically exempted by law. Income that is taxable must be reported on your return and is subject to tax. Income that is nontaxable may have to be shown on your tax return but isn’t taxable.” Income that is taxable is supposed to be reported whether you receive a 1099 form or not.
Tax professionals have been debating whether the payment would qualify for any federal tax exemption. One possible exemption is the “general welfare exclusion.”
The IRS describes it like this: “Payments made under social benefit programs for promotion of general welfare are excludable from gross income under a concept known as the general welfare doctrine. This applies only to governmental payments out of a welfare fund based upon the recipient's need, and not as compensation for services.”
Some tax pros have questioned whether payments made to joint filers making up to $500,000 would qualify for the exclusion based on need, especially when some lower-income people - mainly seniors with no income other than Social Security or disability - did not get payments because they didn't need to file a tax return.
“I interpret the payments as income that doesn't meet any exclusion under federal law,” Nellen said.
But absent any guidance from the IRS (which began accepting and processing 2022 returns on Jan. 23), some are figuring they do qualify for the general welfare exclusion.
Tom Cluster, who lives in Placer County, said that when he used TurboTax software to do his 2022 taxes, he entered his payment into the 1099-MISC section. On a page for “uncommon tax situations” he checked a circle that said, “This was a California Middle Class Tax Refund (MCTR).” At the bottom of that page the following appeared: “The California Middle Class Tax Refund (MCTR) will not be taxable on your California or Federal returns.”
So how did this show up on his federal return? It appeared on Schedule 1, line 8z. Under the words “other income” it said “CA Payment 700.” Immediately under that line it said “CA payment - general welfare exclusion (minus) 700. The amount entered in the box on line 8z was zero.
H&R Block is the second-largest seller of tax-prep software and prepares taxes for clients at storefront locations.
“Without clear IRS guidance currently, there is a reasonable basis to claim the payments are not taxable at the federal level,” Andy Phillips, director at The Tax Institute at H&R Block, said via email. “Our guidance is to report the income on the federal return (Schedule 1), and clearly indicate the payment is for the California Middle Class Tax Refund. Clearly reporting the payment should help make it clear to the IRS how the taxpayer is treating the payment and prevent possible IRS notices.”
Phillips declined to say how, if the payment is not federally taxable, it should be reported on the return. “We have a process for our own clients, but would not want to be responsible for providing that same guidance to others if the IRS were to take a different position,” he wrote.
The IRS did not respond to a question asking how its Volunteer Income Tax Assistance and Tax Counseling for the Elderly programs, which offer free basic tax return preparation to low-income and other eligible clients, are treating the California payments.
California Sens. Dianne Feinstein Alex Padilla both reached out to the IRS for clarification, their offices told The Chronicle.
At least 10 other states issued one-time payments to eligible residents last year to offset inflation or return part of their budget surpluses, according to the Tax Foundation.
But most did it in a more straightforward way.
Georgia, Virginia and South Carolina, for example, issued direct deposits or paper checks - not debit cards - to residents who had a state income tax liability in 2020 or 2021, depending on the state. (California did not require a 2020 tax liability to get a refund.)
“Most of the other state payments represent a state income tax refund,” H&R Block’s Phillips said. “If the taxpayer took the standard deduction and did not deduct state taxes on their prior federal tax return, they do not need to pay federal tax on their tax refund. However, if the taxpayer itemized and deducted state taxes, a portion of the payment may be taxable.”
Another complication: Some Californians might receive a Form 1099-MISC for a payment they never received or for a payment they got on a debit card that was depleted by online thieves after they activated it.
In the first case, “Individuals who received a 1099-MISC for MCTR, but did not receive a MCTR payment, should dial 800-852-5711 and press 1,” the Franchise Tax Voard said in an email.
And what about people who received a card but discovered the funds had been stolen by online thieves?
That happened to Elena Njemanze, a kindergarten teacher who lives in Emeryville. When she tried to use the debit card to buy baby formula at the Berkeley Bowl on Dec. 19, it was rejected for insufficient funds. She later discovered someone had used the $480 remaining on her $700 card to make purchases at Kay Jewelers and GameStop in Victorville (San Bernardino County) at 2 a.m.
She reported it to Money Network, the company hired to issue the debit cards, and after waiting on hold for 40 minutes, was told it would take 45 to 90 days to investigate. Now she’s wondering what to do about the 1099-MISC for the $700 she received.
The Franchise Tax Board said it and Money Network will work to reissue a stolen payment if the recipient promptly reports it.
Asked what they should do about taxes, the Franchise Tax Board would offer only this complicated explanation by email: “With respect to federal taxability, a taxpayer is ‘generally taxed on income that is available to [them], regardless of whether it is actually in [their] possession,’” it said, quoting IRS publication 525. “Therefore, if your MCTR payment was not received by you in 2022, it may not be considered taxable income for the 2022 tax year. If the recipient receives the reissued MCTR payment in 2023, the MCTR payment may be considered taxable income for the tax year 2023 because the payment was available to the recipient in 2023.”
It said it would not issue a corrected 1099-MISC for 2022 to theft victims.
Due to the “complexity,” it recommended they consult the IRS publication or their tax professional.
Let’s hope they can find the answer.
Kathleen Pender is a freelance writer and former columnist for The San Francisco Chronicle. Email: kathpender84@gmail.com Twitter: @KathPender
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