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Tuesday, March 07, 2006


A mini-fracas is unfolding in Florida, as Governor Bush would like to return a part of the state budget surplus to Florida residents, while others in Florida prefer that the budget surplus be applied to various spending initiatives. The tax lawyer in us does not question whether the refund will arise, but instead ponders the question whether such a refund is taxable to the recipients for federal income tax purposes. I mean, that is what you were wondering when you heard about this, weren't you?

Interestingly, an IRS field attorney advice memorandum recently made available under a Freedom of Information Act request, addresses this very issue in regard to such a refund in another state.

The F.A.A. indicates that the first issue in determining taxability is whether the refund can be considered a gift - since gifts are not taxable to recipients for federal income tax purposes. While a "gift" is not defined under the Internal Revenue Code, the Supreme Court has provided that a gift proceeds from a “detached and disinterested generosity,” and is made “out of affection, respect, admiration, charity or like impulses.” Duberstein v. Commissioner, 363 U.S. 278, 285 (1960). If a payment proceeds primarily from “any moral or legal duty,” or from “the incentive of anticipated benefit” of an economic nature, it is not a gift. The F.A.A. notes that in general, payments made by a state government do not qualify as non-taxable gifts because it is not the purpose of governments to make gifts to its citizens. While there are some special circumstances where a gift will arise, it did not find one in the facts of the F.A.A. Thus, it is unlikely that Florida's refund program will be nontaxable as a gift.

The next level of analysis is whether the amount being paid to state residents is a "refund" of taxes paid by the particular recipients. If a refund, the recipients will be subject to federal income tax only to the extent the taxpayer claimed a federal deduction for the payment in the preceding year (applying the "tax benefit rule") - otherwise as a refund of paid taxes the payment will not be taxable. If the payments are not a tax refund, they will be taxable to the recipients.

In the F.S.A., the IRS found that the refund under the particular facts of that state refund program was not a "tax refund" for purposes of these rules, and would thus be taxable to the recipients. The F.S.A. provided:
...the payments in this case appear to be made to a designated class of recipients without regard to whether the recipieents made prior payments of tax, rather than payments made to persons entitled to “refunds” of taxes previously paid. While individuals eligible to receive the payments are those individuals who filed a State income tax return for the preceding year, the payment is not based upon State or local tax that an individual taxpayer reported and paid, but on whether the taxpayer claimed a personal exemption. This eligibility requirement appears to simply be a method for designating a class of individuals to whom the State desires to make a payment of surplus funds.
Therefore, if Governor Bush is successful in getting through his refund program, he may need to target the refund only to taxpayers who previously paid Florida taxes and be able to characterize the payments as a refund of those taxes, if he is concerned about the taxability of such refunds to the recipients.

Source: LAFA 20060901F

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