In News Release IR-2021-71[1] the IRS announced that it plans to begin issuing automatic refunds to taxpayers who filed returns that included 2020 unemployment compensation as taxable if the changes made by the American Rescue Plan Act (ARPA) of 2021 make the unemployment not taxable in 2020.

ARPA added IRC §85(c) which rendered a limited amount of unemployment received in 2020 nontaxable for taxpayers with a modified adjusted gross income of less than $150,000. But as the law was enacted on March 11, 2021, many taxpayers had already filed returns that treated their unemployment as taxable. But, as the release notes, now the law may exclude those benefits from tax:

The legislation, signed on March 11, allows taxpayers who earned less than $150,000 in modified adjusted gross income to exclude unemployment compensation up to $20,400 if married filing jointly and $10,200 for all other eligible taxpayers. The legislation excludes only 2020 unemployment benefits from taxes.[2]

Refund Program

The IRS notes that the program will begin in May and run into the summer:

Because the change occurred after some people filed their taxes, the IRS will take steps in the spring and summer to make the appropriate change to their return, which may result in a refund. The first refunds are expected to be made in May and will continue into the summer.[3]

The IRS outlines what the agency will do as follows:

For those taxpayers who already have filed and figured their tax based on the full amount of unemployment compensation, the IRS will determine the correct taxable amount of unemployment compensation and tax. Any resulting overpayment of tax will be either refunded or applied to other outstanding taxes owed.

For those who have already filed, the IRS will do these recalculations in two phases, starting with those taxpayers eligible for the up to $10,200 exclusion. The IRS will then adjust returns for those married filing jointly taxpayers who are eligible for the up to $20,400 exclusion and others with more complex returns.[4]

But Taxpayers May Still Need/Want to Amend Their Returns

While the IRS discourages taxpayers generally from filing amended returns, the news release conceded that some taxpayers are going to need to do just that:

There is no need for taxpayers to file an amended return unless the calculations make the taxpayer newly eligible for additional federal credits and deductions not already included on the original tax return.

For example, the IRS can adjust returns for those taxpayers who claimed the Earned Income Tax Credit (EITC) and, because the exclusion changed the income level, may now be eligible for an increase in the EITC amount which may result in a larger refund. However, taxpayers would have to file an amended return if they did not originally claim the EITC or other credits but now are eligible because the exclusion changed their income.[5]

So, as a practical matter, advisers will likely want to verify that the IRS refund represents the entire reduction in tax the taxpayer is entitled to.

And Then There’s the States

While the IRS may be automating the process for most taxpayers at the federal level, state returns are another issue entirely. The IRS does note the state issue, but gives no details:

These taxpayers may want to review their state tax returns as well.[6]

State issues will include:

Will the state follow the federal law? While some states have rolling conformity statutes that will automatically follow this law change without legislative action, many others have static conformity rules requiring the state legislature to take action if the state wishes to retroactively conform to these rules.
Even if a state does decide it will not tax such unemployment, there’s no guarantee that the state revenue departments will follow the lead of the IRS and issue automatic refunds to affected taxpayers.

[1] “IRS to recalculate taxes on unemployment benefits; refunds to start in May,” IR-2021-71, IRS website, March 31, 2021, (https://www.irs.gov/newsroom/irs-to-recalculate-taxes-on-unemployment-benefits-refunds-to-start-in-may, retrieved March 31, 2021)

[2] “IRS to recalculate taxes on unemployment benefits; refunds to start in May,” IR-2021-71, IRS website, March 31, 2021

[3] “IRS to recalculate taxes on unemployment benefits; refunds to start in May,” IR-2021-71, IRS website, March 31, 2021

[4] “IRS to recalculate taxes on unemployment benefits; refunds to start in May,” IR-2021-71, IRS website, March 31, 2021

[5] “IRS to recalculate taxes on unemployment benefits; refunds to start in May,” IR-2021-71, IRS website, March 31, 2021

[6] “IRS to recalculate taxes on unemployment benefits; refunds to start in May,” IR-2021-71, IRS website, March 31, 2021