The Internal Revenue Service (IRS) will soon start accepting federal tax returns for fiscal year 2020. The coronavirus pandemic and the many pandemic-related relief measures passed last year make this a unique tax season for taxpayers and the IRS.
Congress made several tax policy changes in 2020 that will affect the next fiscal season, including the CARES Act passed in March 2020 and the coronavirus package passed in December as part of the Consolidated Appropriations Act of 2021. Because of these changes, there are some special considerations that must be taken into account during this fiscal reporting period: Economic impact: adjustments to tax returns, taxation of unemployment insurance (UI) benefits, and changes to income tax refunds.
Under normal circumstances, the IRS generally begins tax season in late January. The IRS is expected to open the tax season on the 12th. February opens, which is later than the usual tax season start date. The agency is encouraging taxpayers to file tax returns electronically this year to speed up the processing of tax returns.
Economic Impact Payments
The IRS and the Treasury Department sent two sets of Economic Impact Payments to individuals in 2020 as part of the broader coronavirus control measures. Payments, sometimes called incentive payments, were made by direct deposit, paper check, or prepaid debit card. Technically, the payments are tax credits awarded to individuals based on their adjusted gross income (AGR) for 2018 or 2019. In anticipation of the claim period, the IRS updated Form 1040 for 2020 to finalize payments when individuals are entitled to an additional amount.
Individuals can receive the surcharge (in the form of a refundable tax credit on their 2020 tax return) in one of two ways. Firstly, applicants who have not received payments due to delays or errors in processing may apply for reimbursement.
Second, applicants will use the 2020 IGA to calculate the credit owed. If a claimant received a partial payment (or no payment) because their IGA in 2018 or 2019 was higher than the phase-out threshold, they can apply for a top-up payment if they had an IGA that was lower than the 2020 IGA that entitles them to a top-up payment. Taxpayers who have not received payments for a dependent may also receive a credit on their tax return. In addition, applicants who were originally ineligible for CARES payments because they did not have a Social Security number may be eligible if they are members of a mixed-status family.
Corrections are made for the sole benefit of taxpayers, so that they do not see their tax liability increase as a result of the payments. Since the payments themselves are tax benefits, they are not subject to income tax.
Lawmakers have responded to the unprecedented rise in unemployment in 2020 by significantly increasing unemployment benefits (UI). These increases include the Federal Pandemic Unemployment Benefit (FPEB), which will be paid between December 28 and December 31. March and 30. Additional compensation of $600 per week in July (with the benefit of $300 per week available under Executive Action until CUPEF payments resume at the end of December); an extended compensation period of an additional 13 weeks after state benefits under the Pandemic Unemployment Compensation Program (PEUC) expire; and an extension of eligibility for Pandemic Unemployment Assistance Benefits (PUA), making contract workers and workers in major industries eligible for benefits in the event of a pandemic.
UI benefits helped support Americans’ income during the year and are considered taxable income. According to the U.S. Department of Labor, approximately $6.4 billion in unemployment benefits were paid in the fourth quarter of 2019. By the second quarter of 2020, this figure had risen to $64.2 billion and by the third quarter of 2020, $48.7 billion had been paid in unemployment insurance. The increase in disability benefits follows a rise in unemployment from 3.5% in February 2020 to a peak of 14.8% in April 2020. The unemployment rate remained at a high level of about 6.7% in December.
To avoid an unexpected tax bill on their tax return, taxpayers must correctly deduct taxes from their PA benefits. For federal income tax purposes, taxpayers may, but need not, opt for a 10% withholding tax rate. Taxpayers may also pay estimated taxes quarterly during the year. Many taxpayers likely did not properly withhold or deduct the amount of tax for unemployment benefits, which can lead to unexpected tax liabilities when they file their 2020 tax returns.
Refundable Tax Credits
As part of the recent coronavirus package, policymakers made changes to the calculation of the ISCED and Child Tax Credit (CTC) for fiscal year 2020. Generally, both loan amounts are calculated based on earned income and on time scales for low-income people. The sliding scale with income means that the economic downturn can reduce the cost of a loan for those who have lost income due to the pandemic.
The latest coronavirus package addresses this problem by allowing claimants to use 2019 income instead of 2020 income to determine eligibility for a credit when filing their tax returns. The revolving provision will increase the total amount of repayable loans for low-income borrowers. It will be important for tax filers to compare the income earned for the two tax years to see which is most appropriate for their tax situation. The Joint Committee on Taxation (JCT) estimates that federal revenues will fall by about $4.1 billion in 2021.
Many tax preparers worry about tax refunds at the beginning of tax season. A combination of unique economic conditions and specific tax policies can affect refunds, both for individual taxpayers and for the tax system as a whole.
Economic downturns often affect refunds because taxpayers have lower incomes and tax policy creates incentives that affect the amount of refunds. During the Great Recession, for example, total repayments exceeded the trend, rising from about $250 billion in 2007 to $335 billion in 2009 before remaining flat in subsequent years (see the following chart). However, the percentage of returns with tax refunds has remained stable, between 75 and 80% of the returns filed in those years. The average tax credit also increased from about $2,200 in 2007 to about $2,600 in 2009 and then decreased to about $2,200 in 2016.
It is unclear where tax refunds will end up in fiscal year 2020, although trends indicate higher refund levels than in recent tax seasons. Many taxpayers have not yet made their economic arguments. As of mid-September 2020, up to nine million eligible people had not yet received their benefits. In addition, individuals who have not previously received a second-round incentive payment must report it on their tax return to take advantage of this credit. Taxpayers should ensure that these payments are not claimed twice if the second payment is received after the tax return is filed, which may require an amendment to the tax return.
The payments will tend to increase returns, although it is not known how many people who do not normally file tax returns will do so this year to take advantage of the payments.
Adjusting refunds for tax credits may also help preserve the amount of refunds available to low-income taxpayers. The cost of the adjustment, estimated at $4 billion, represents about 1 percent of tax refunds generated in 2019, although the loss of revenue is unlikely to result in an immediate increase in the amount of tax refunds.
An increase in unemployment insurance claims could be a devaluing factor for tax refunds, as some claimants may have additional tax arrears if they did not properly withhold taxes during the tax year. However, this problem was not so important during the Great Recession that it offset other trends toward tax cuts in general. However, it remains to be seen whether the tax due on higher benefit amounts compared to the current economic downturn (including CUPF payments of $600 per week) will significantly reduce the refund.
While tax refunds are an area of interest for taxpayers, it is important to remember that tax refunds are not an accurate means of analyzing tax liabilities or assessing how tax changes will affect the taxpayer’s after-tax income.
The 2021 tax season will be difficult for taxpayers, the IRS, and state tax departments due to last year’s tax changes and the logistical challenges presented by the current pandemic. The IRS should provide flexibility for individuals and businesses to meet and understand their tax obligations for the year, while seeking ways to simplify tax compliance and reporting procedures.