IRS urged to offer clearer guidance on state tax rebates, 1099-Ks

The Internal Revenue Service is planning to issue guidance as soon as today on whether special state tax refunds, rebates and payments from states like California, Virginia and others are taxable.

National Taxpayer Advocate Erin Collins took the IRS to task Thursday for its failure to provide more timely guidance to resolve taxpayer confusion over the taxability of state tax refunds and payments and the lower $600 threshold on Form 1099-K reporting.

In a new blog post Thursday, she called out the IRS for its failure to provide clarity about what taxpayers in more than 20 states should do if they receive special tax refunds or payments, and the implementation of the requirement for third-party payment entities like Venmo, PayPal or Cash App to report payments over $600 on Forms 1099-K.

Tasos Katopodis/Bloomberg

"The IRS has known for months that there is uncertainty about the tax treatment of these special state tax refunds or payments, and it has also known the answers may affect tens of millions of taxpayers," Collins said about the special state tax refund payments. "Yet to date, it has issued no specific guidance whatsoever. … Giving taxpayers a choice between waiting to file their returns and receive their refunds or filing returns now that the IRS may later determine to be inaccurate is not acceptable. … The failure to have identified and resolved this issue before the filing season suggests that someone, or everyone, was asleep at the switch."

Last Friday, the IRS posted a notice on its website saying, "The IRS is aware of questions involving special tax refunds or payments made by states in 2022; we are working with state tax officials as quickly as possible to provide additional information and clarity for taxpayers. ... We expect to provide additional clarity for as many states and taxpayers as possible next week." 

The guidance is expected to be issued Thursday or Friday, perhaps with a state-by-state table.

Approximately 22 states, including Alaska, Arkansas, California, Colorado, Connecticut, Delaware, Florida, Georgia, Hawaii, Idaho, Illinois, Indiana, Maine, Massachusetts, Minnesota, New Jersey, New Mexico, New York, Oregon, Rhode Island, South Carolina and Virginia, sent rebates or special refunds or payments to taxpayers after reporting budget surpluses (see story). California issued more than 7.1 million direct deposits and 9.4 million debit cards, totaling over $9 billion, according to the California Franchise Tax Board, later sending millions of Form 1099-MISC information returns to taxpayers in the state as well as the IRS. The state also sent rebates to offset high gasoline prices for its residents.

The move by the IRS has added an extra element of chaos during the first weeks of tax season (see story).

"They're asking taxpayers to delay the filing of their returns," said Karla Dennis, an enrolled agent at Karla Dennis and Associates in La Palma, California. "But several clients have already filed their returns. Now they are concerned that they are going to owe back money. The IRS is asking them not to amend but to hold tight until they provide guidance, but people want their refunds in this era of inflation when everything's a little bit higher. People are in need of their dollars now."

Form 1099-K confusion

Collins also criticized the IRS for not providing more timely guidance on the requirement that third-party payment entities like Venmo, PayPal or Cash App issue Forms 1099-K to report payments that total more than $600. The American Rescue Plan Act of 2021 had lowered the dollar threshold for reporting from its previous $20,000 and removed entirely the minimum threshold of 200 transactions. Gig economy businesses and the tax community were worried that would unleash a flood of 1099-K forms in January on unsuspecting taxpayers, but the IRS temporarily delayed the reporting requirement in late December (see story). However, Collins believes the IRS still has to clear up the confusion there as well, given the limited amount of guidance it has issued so far.

"The new requirement created practical challenges. Probably the most significant came about because many people use these payment apps to transfer funds for non-business purposes — to reimburse a friend for dinner or concert tickets, send funds to college-age children, give a birthday gift, and the like," she wrote. "While payments for business purposes using these apps are taxable, personal payments are not. As it turns out, taxpayers may not have understood how to distinguish personal payments from business payments, and users were not always accurate in how they characterized their payments. Third-party settlement organizations and users repeatedly asked the IRS to provide useful guidance, and the IRS's response was largely to tell taxpayers that if a Form 1099-K is erroneous, they needed to go back to the third-party provider and convince the provider to issue a corrected Form 1099-K. Given the anticipated volume of Forms 1099-K — which likely is in the tens of millions — that was not a realistic solution."

She noted that the IRS could have provided guidance advising taxpayers who received 1099-Ks for personal payments to report the amounts as income and back them out on a separate return line. Instead, despite nearly two years of lead time, the IRS failed to provide useful guidance to taxpayers and tax professionals. She acknowledged that in December, due to the lack of guidance, the IRS "effectively pulled the plug" by issuing a notice that created a "transition period" of one year, delaying implementation of the $600 reporting threshold until the 2024 filing season.

"Had the IRS provided guidance on how to back out personal payments earlier, the reporting requirement probably could have been timely implemented," said Collins. "Given where things stood in late December, I believe the IRS made the right decision to postpone implementation of the new Form 1099-K threshold. But this is another example of how the IRS had ample time to work with industry and inform and educate taxpayers to implement a legal requirement, yet it did not do so early and proactively."

She pointed out, however, that on Dec. 28, the IRS finally provided guidance that included instructions in Question 8 on a frequently asked questions page on how to report payments received for personal use and not for goods or services.

"But it came far too late," Collins added. "Given where we are, the IRS should now prioritize working with industry and educating taxpayers to prevent the issuance of Forms 1099‑K for personal payments received in 2023."