I have written frequently about the burdens the complexity of the Internal Revenue Code imposes on taxpayers and the IRS alike. One of the burdens it imposes on the IRS and its Office of Chief Counsel is the responsibility to clarify ambiguities in the law and make reporting requirements workable so that taxpayers, tax professionals, and tax return software developers know how to report items of income, deduction, and credit on federal income tax returns.
The IRS must issue guidance and provide education in a proactive and timely manner. Timely guidance is vital to taxpayers, tax professionals, and industry, and it is just good tax administration. It is key to eliminating confusion and frustration for taxpayers and tax professionals, earning the trust of the American people, and providing quality service. Sometimes, timing is everything.
While the IRS deserves credit for the volume of guidance it provides, there are times when it delays or fails to issue timely guidance and thereby creates serious problems, including uncertainty and confusion, for taxpayers, tax professionals, and tax software developers. Two recent, well-publicized examples stand out as instances where the IRS missed the boat.
Special State Tax Refunds or Payments
The first example relates to the federal tax treatment of special state tax refunds or payments to residents of more than 20 states. Among these states are California, Massachusetts, and Virginia. In California, taxpayers who filed 2020 California tax returns reporting adjusted gross incomes up to $500,000 for a joint return or $250,000 for a single return were eligible for Middle Class Tax Relief benefits worth up to $1,050. To date, nearly 17 million payments have been made.
Are they taxable for federal income tax purposes?
The State of California thinks the answer may be yes. The California Franchise Tax Board website says: “Individuals who received a California Middle Class Tax Refund (MCTR) of $600 or more will receive a 1099-MISC for this payment… The MCTR payment may be considered federal income. You should consult IRS Publication 525, Taxable and Nontaxable Income, or your tax professional regarding the federal tax treatment of this payment.”
The Commonwealth of Virginia largely agrees. It provided a one-time tax rebate, and its Department of Taxation’s website says: “If you itemized your deductions, you may be required to report the rebate amount you received as income on your federal return. You’ll receive a Form 1099G in the mail, just like you would if you received a state tax refund.”
While the details of these special tax refunds or payments vary somewhat among the states, they share general characteristics. Yet there is ample reason to believe many of these payments are not taxable for federal income tax purposes – either if the taxpayer did not receive a tax benefit in an earlier year or under the “general welfare exclusion.” We understand that at least some tax software developers have concluded that some state payments are not taxable and have programmed their software so that these payments are not reported.
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. Yet to date, it has issued no specific guidance whatsoever.
Last Friday, after news stories began to appear in the press, the IRS issued a statement indicating an intent to provide “additional clarity for as many states and taxpayers as possible next week.” Meaning this week. While this is welcome news, the commitment to provide “additional” clarity implies the IRS had provided clarity earlier (it had not), and the reference to “as many states and taxpayers as possible” implies some taxpayers will have to wait for additional guidance or be left to decide how to report the refunds or payments themselves, at least for now, without knowing whether the IRS ultimately will consider them taxable. 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 impact of the delay in providing timely information and guidance is hard to overstate. Tax software developers had to devote resources to decide how to treat these amounts (knowing the IRS might later take a different view) and program their software accordingly. Taxpayers and tax professionals needed to make decisions before filing returns. For taxpayers who have already filed returns that reported the payments as taxable, they likely will need to file amended returns to exclude the payments if the IRS determines they are not taxable. That means they will need to spend time and money to file amended returns and then wait for their refunds, and it means the IRS will have to devote resources to processing amended returns and issue refunds.
Conversely, if taxpayers excluded the payments and the IRS later determines the payments are taxable, the taxpayers will be subject to additional tax, interest, and potentially penalties. The delay in providing guidance also means the IRS is likely to receive a significant number of telephone calls and some correspondence from taxpayers and tax professionals – something timely guidance would have prevented.
This was a known issue, with ramifications for tens of millions of taxpayers, tax return preparers (who still prepare most federal income tax returns) and tax software developers. The failure to have identified and resolved this issue before the filing season suggests that someone, or everyone, was asleep at the switch.
The second recent example of the IRS’s failure to provide timely guidance relates to implementation of 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. In general, Forms 1099‑K are issued to freelancers or small business owners to promote tax compliance. Prior to 2022, Forms 1099-K were required to be issued to payees only if (1) total payments exceeded $20,000 and (2) the number of transactions involving that payee exceeded 200. Congress reduced the threshold as part of the American Rescue Plan Act of 2021, effective for payments made after 2021. That meant that Form 1099-K information returns would have to be filed beginning early in 2023 with respect to payments made in 2022.
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. 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.
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. On December 23, 2022, largely because of the lack of guidance, the IRS effectively pulled the plug. It issued a notice that created a “transition period” of one year, postponing implementation of the $600 reporting threshold for third-party settlement organizations 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. 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. The good news is that on December 28, 2022, the IRS finally provided guidance that included instructions on how to report payments received for personal use and not for goods or services. (See Q&A #8.) But it came far too late. 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.
As the IRS develops its plans to transform the taxpayer experience in light of the Inflation Reduction Act, it is examining a wide range of taxpayer service and information technology issues. In my view, making sure it issues timely guidance to resolve legal ambiguities and to make tax reporting practical should be high on its priority list. The IRS could task a small number of employees on its operations side and in its Office of Chief Counsel to identify emerging, time-sensitive needs and make sure they receive the priority attention they deserve.
If the IRS or Office of Chief Counsel do not have sufficient staff to work through the full range of emerging issues on a timely basis, the additional funding provided by the Inflation Reduction Act should be used for this purpose. My primary concern is that the failure to address issues like these proactively is harmful to taxpayers, but it is also worth noting that it creates re-work for the IRS that timely guidance would have avoided. The IRS is still trying to work through its paper processing backlog, get current with pending refunds and returns, and improve telephone service. Apart from other consequences, delayed or inadequate guidance may cause an increase in telephone calls, amended returns, or IRS adjustments and thereby disrupt the filing season.