By including in the American Rescue Plan (ARP) a provision to exempt up to $10,200 of last year’s unemployment benefits from federal income tax, Congress left the IRS with a very difficult task. Changing the tax code retroactively is rarely a good idea. And doing it in the middle of tax season just adds to the challenges of both the Internal Revenue Service and taxpayers.
My initial response? What an administrative nightmare! Now that the IRS has developed a solution, I give the agency a solid grade for overall implementation. But it could be more transparent about what it is doing.
A for Adaptability
When the ARP provision was first announced, I thought the IRS would have to come up with a new 1040 tax form and change its computer programming.
But neither step was necessary—at least for people who hadn’t filed their tax returns before President Biden signed the ARP on March 11. Taxpayers are instructed to report total UI benefits on Schedule 1, as they did before the law changed, and report the excluded amount on an existing line for other types of income (with a notation in the margin) on the same form. The difference between the two amounts is taxable. Surprisingly simple.
B for Limiting Burden
What about the millions of UI recipients who already filed their tax return before March 11? I first thought they would have the aggravation of filing an amended tax return. But the IRS quickly reassured them that they will receive refunds without doing anything.
The IRS, though, has not yet explained how it will pay those automatic refunds. It’s entirely feasible to do so, but the method will affect the timing of payments and the risk of errors.
The quickest way: The IRS could compute the excluded amount based only on the information on a federal income tax return. But doing so would be error prone. For example, the $10,200 cap applies to each spouse’s benefits. Thus, for a couple, up to $20,440 of 2020 UI benefits could be tax-free. But the IRS can’t determine the amount each spouse received based solely on the information on their joint tax return.
Alternatively, the IRS could wait until later in the year when it routinely checks and matches tax returns to W-2s and other information reports, including 1099-G’s sent by the state UI office to each beneficiary. That’s less risky and—because the infrastructure already exists—less costly than other options. But it would delay refunds for months.
The middle-ground: IRS could accelerate its matching of the 1099-Gs with 1040s and skip the error check. That would get refunds out faster, but it’s costlier and risker to implement than the annual matching procedures. It may be especially problematic in a year when many people received 1099-Gs for UI benefits they never collected because criminals stole their personal information and fraudulently got benefits.
C for Clarity
The IRS acted quickly to minimize its administrative costs and taxpayer burdens. But it has been slow to explain the process to taxpayers. Last week, the instructions were moved to a much more visible location on the IRS’s website, but the agency still has not fully updated all the related pages.
And an evolving interpretation of the law is another source of confusion and frustration. The exclusion is available only to those with adjusted gross income of $150,000 or less. But do jobless benefits count towards that cap? They did prior to March 23rd, but they don’t anymore.
Was the retroactive change in law worth the administrative struggle?
Unemployment insurance is a wage-replacement program, chiefly financed by payroll taxes on employers. Either all the benefits should be taxed, as they have been since 1987, or the payroll taxes should be recognized as compensation and included in workers’ taxable income.
Still, Georgetown University law professor Brian Galle has made a compelling case that the federally-funded expansions of UI benefits in 2020 were a response to a qualifying disaster and thus even under pre-ARP law should be exempt from taxes.
The challenge this year was widespread sticker shock. State agencies are supposed to alert beneficiaries that benefits are taxable and give them the opportunity to request that those taxes are withheld. But that message likely got lost in the chaos of 2020 when millions were laid-off from jobs for the first time in their lives and state agencies were overwhelmed.
Thus, many of those who were jobless last year didn’t realize they owed tax on unemployment benefits until they filed their 2020 Form 1040s over the past couple of months. And they may not have the money to pay the tax.
This mess can be avoided next time. Taxes could be automatically withheld from future benefits unless recipients opt out. Or, even better, Congress does not change the prior year’s tax law in the middle of filing season.
