Late IRS guidance on state stimulus checks threatens to upend tax season

It's just over two weeks into tax filing, and many tax professionals were almost ready to call this year's season back to normal.

But guidance expected this week from the Internal Revenue Service on the taxability of state stimulus checks threatens that early assessment. The agency recommended taxpayers who received those payments last year to hold off on filing their returns until the guidance is finalized.

That means millions of taxpayers once again face a potentially complicated and frustrating tax season that, given what's happened in recent years, seems to now be routine.

"The IRS did not make any public statement about this until after the tax-filing season began, after almost 17 million returns had already been filed. That delay creates unnecessary burdens and confusion for taxpayers and tax preparers,” Jared Walczak, the Tax Foundation’s vice president of state projects, told Yahoo Finance. “It throws tax season into chaos. This was avoidable."

More of the same?

The late move on guidance by the IRS is reminiscent of recent years of disruptions and changes.

Last year included major changes from the American Rescue Plan (ARP) that introduced several enhanced tax breaks, benefiting millions of Americans' returns. In 2021, the IRS delayed the start of tax-filing season to February to issue a second round of stimulus checks. One last-minute provision in the ARP also applied to those returns even though the filing season had already started. And in 2020, the pandemic and ensuing shutdowns delayed the tax deadline by months and stretched the agency’s operations.

"The pandemic was a major issue as employees called out sick and hiring efforts were derailed. Then all those extra stimulus checks added a significant burden onto them,” said Eric Bronnenkant, head of tax at Betterment, a financial advisory company. “All of those things and being in an arguably constantly underfunded status was the perfect storm."

Even 2019, prior to the pandemic, wasn’t normal.

That year, the IRS had to implement the massive tax legislation enacted under the Trump administration. Among the many changes in it were a doubling of the standard deduction and Child Tax Credit, a $10,000 cap on the state and local deduction, the loss of some miscellaneous itemized deductions, a higher estate tax exemption, and a 20% deduction for pass-through income. The new law also called for a completely restructured tax form.

On top of that, the season began just after the longest-ever federal shutdown of the government concluded, during which the agency’s operations had been severely curbed.

‘The IRS is trying’

This year looked as though it could be calmer.

Many of the enhanced credits and deductions from the pandemic that complicated federal tax returns in the last two years have expired. And the few new tax breaks this year apply to a much smaller pool of taxpayers.

The IRS, plagued by backlogs in the previous two years, took major steps in shrinking its massive paper jam in the final months of 2022, thanks to its recruitment efforts and some technology fixes. The agency's watchdog, the Taxpayer Advocate, even said the IRS was on better footing to start this year's filing season in its annual report to Congress, though more progress was needed.

"I know the IRS is trying to work harder at improving the taxpayer experience right now,” Bronnenkant said. “They got a lot of funding, and they're trying to figure out how to hire more people, and become more efficient at what they're doing by expanding their technology."

The biggest potential hiccup, tax pros worried this year, would be smaller-than-expected refunds for many taxpayers after the loss of the temporarily enhanced tax breaks during the pandemic.

"I’ve noticed this year that many people are seeing lower refunds due to the decrease in the Child Tax credit, Dependent Care Credit, and the Earned Income Credit,” said Grant Dougherty, an enrolled agent and founder of Dougherty Tax Solutions, echoing other tax pros Yahoo Finance interviewed.

‘Unfair to taxpayers’

As for the pending guidance on the state stimulus checks, there's mixed advice on how to proceed.

While the IRS asked taxpayers to delay filing their returns until a final determination is made, two of the largest tax preparers — H&R Block and TurboTax — are reportedly continuing to file returns for residents in California, one of the 19 states that issued tax rebates last year. H&R Block told the Wall Street Journal that it expected the IRS would rule that the payments in California at least weren't taxable.

But other tax experts said it's not that clear cut.

It's possible the IRS could rule that one state's payments are taxable and another state's payments are not, depending on “the purpose and the parameters” of each state’s relief package, Walczak said. Some tax rebates came from a state revenue surplus, for example, while others were intended to provide relief from runaway inflation.

"This will be a true state-by-state analysis,” Walczak said, noting the determinations could be complicated. “The general rule is that state rebates are taxable income for federal purposes, but there are a variety of exclusions.”

Dwight Nakata, a certified financial planner and CPA at YNCPAs, who practices in California, said it “may be best to wait until additional guidance is available from the Internal Revenue Service (IRS).” He typically counsels his clients to wait until mid-February anyway, “to allow time for slow or misdirected mail.”

But that delay could be costly for many taxpayers who file early because they depend on the prompt delivery of their tax refunds, often earmarked for certain items like debt payments or even basic living expenses.

"Since refunds can make up as much as 30% of a low-income family’s annual income, tax season delays can seriously affect the financial well-being of low-income households and households of color," said Joanna Ain, associate director of policy at Prosperity Now, a nonprofit focused on economic equity. "These payments can be lifelines for households, helping families meet daily needs and be used to build emergency savings."

And for those who've already filed their returns and end up affected by the final determinations by the IRS, that may mean going back and correcting their returns, Walczak said.

“This process is unfair to taxpayers,” he said. “The reality is that some, perhaps many, of these rebates will be federally taxable and that that will be consistent with federal law. But the IRS should have gotten well ahead of this."

Rebecca is a reporter for Yahoo Finance. Follow her on Twitter at @RebeccaChenP. Gabriella is a personal finance reporter at Yahoo Finance. Follow her on Twitter @__gabriellacruz. Ronda is a personal finance senior reporter for Yahoo Finance and attorney with experience in law, insurance, education, and government. Follow her on Twitter @writesronda.

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