IRS expands unemployment tax exclusion to more taxpayers

The Internal Revenue Service has changed the calculation for determining the $10,200 exclusion on unemployment benefits in the new pandemic relief package, allowing more taxpayers to qualify, but forcing tax software developers to update their programs.

The IRS updated the instructions Tuesday on how to figure the amount of modified adjusted gross income to use for deciding how much of a taxpayer’s unemployment benefits from 2020 qualify for the $10,200 exclusion on taxes. Prior to Tuesday, the IRS instructed taxpayers to include the unemployment income in modified AGI, but now they can exclude unemployment benefits from modified AGI.

The American Rescue Plan Act, which President Biden signed into law this month, allows taxpayers who earned under $150,000 in 2020 to qualify for the $10,200 exclusion. The change will allow more taxpayers to qualify now. But it does complicate matters for tax software companies and tax preparers.

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“As a tax adviser, you may have recently installed a tax software update to take into account the unemployment compensation exclusion for 2020 passed as part of the American Rescue Plan Act of 2021 and found at IRC §85(c),” wrote Ed Zollars, a partner at Thomas, Zollars & Lynch, in his Current Federal Tax Developments blog for Kaplan Financial Education. “Now it turns out that, due to an IRS change of heart on how to read IRC §85(c)(2)(B), your software may now be subjecting unemployment to tax the IRS has now decided is not to be subject to such tax.”

He noted that the IRS’s original instructions had taxpayers include the unemployment compensation in determining the modified AGI (reading “without regard to this section” in section 85(c)(2)(B) to mean without regard to the exclusion in section 85(c)) but the new instructions imply without regard to any unemployment compensation covered by section 85.

“In the interim, many (but not all) tax software providers updated their product to calculate the exclusion, presumably using the original March 12 instructions,” Zollars wrote. “Advisers will need to carefully review returns run under that software that determined the unemployment was taxable to determine if that remains correct under the March 23 worksheet.”

The IRS has been rushing to provide guidance on the American Rescue Plan Act in the midst of tax season along with the tax provisions of the other stimulus packages that Congress approved this past year in response to the economic fallout from the COVID-19 pandemic, including the CARES Act, the Families First Coronavirus Response Act and the Consolidated Appropriations Act. The unemployment provision has proven to be especially thorny since it was passed after most tax software began to be distributed this year for 2020 taxes. Some tax preparers had worried they might need to file amended returns for clients who filed early this tax season who received unemployment benefits last year, but the IRS has asked taxpayers to avoid filing amended tax returns (see story). IRS Commissioner Chuck Rettig reiterated that advice to lawmakers during a congressional hearing last week and said the IRS would handle the change on its end (see story).

Nevertheless, the latest twist is sure to add more uncertainty for some tax professionals, even though it does offer the possibility of extra tax relief for some clients. “I think the change that’s been going on in terms of the guidance with the 150 AGI including any unemployment benefit and the reversal yesterday when they came back to the idea of 150 of AGI after you deduct out your $10,200 per filer of unemployment benefit, that’s just more chaos,” said Edward Renn, a partner in Withers’ private client and tax team. “I’m sure they think they can do it, but I don’t understand how they know everybody that filed a return with unemployment compensation that they owe a refund to, and I’m still waiting for TurboTax to update their software because I’ve got a kid who’s a musician and he spent most of 2020 unemployed. I assume they’re going to change their software so that’s easy, but that remains to be seen.”

Intuit did not immediately reply to a request for comment.