December 17, 2020
Did You Know That Unemployment Compensation Is Taxable and Could Impact a Taxpayer’s Earned Income Tax Credit (EITC)?
In January of 2021, a record high number of taxpayers will receive a Form 1099-G, Certain Government Payments, indicating the amount of unemployment compensation (UC) paid to them during 2020 that must be reported on their 2020 federal income tax return. 2020 has been a difficult year, particularly for those experiencing unemployment. Taxpayers who received UC, including any of the special unemployment compensation authorized under the Coronavirus Aid, Relief, and Economic Security (CARES) Act, may be unaware that generally, unemployment benefits are included in gross income, like a regular paycheck, and can be taxed. For taxpayers expecting to receive the EITC, it’s important to remember that UC can reduce the amount of EITC, even to zero.
Taxability of UC: UC is not subject to certain payroll taxes, for example, Social Security and Medicare taxes, and withholding is not required. However, taxpayers may still have to pay federal and state income taxes on that income. The federal income tax treatment of UC depends on the type of program paying the benefits. The IRS provides a tool to help taxpayers determine if payments received for being unemployed are taxable.
The amount of UC shown in box 1 on the Form 1099-G is taxable and must be reported on a federal income tax return for the tax year it was received. UC generally includes any amount received under an unemployment compensation law of the United States or of a state. For example, it includes benefits paid by a state or the District of Columbia from the Federal Unemployment Trust Fund, state unemployment insurance benefits, railroad unemployment compensation benefits, disability payments from a government program paid as a substitute for unemployment compensation, unemployment assistance under the Disaster Relief and Emergency Assistance Act of 1974, etc. For more information, see IRS Publication 525, Taxable and Nontaxable Income.
Taxpayers should also consider potential state tax requirements, because UC may be taxable in some states. With over 65 million initial jobless claims filed during 2020, many taxpayers will be reporting UC on their tax returns for the first time.
Increased UC under the CARES Act: The CARES Act, signed into law on March 27, 2020, just as U.S. unemployment reached a record high of 14.7 percent in April, increased UC for many unemployed taxpayers and further expanded benefits to certain categories of workers not ordinarily eligible to receive these benefits, such as self-employed workers and independent contractors. The Department of Labor reported that during the week ending November 21, 2020, 33 states were still offering extended benefits to unemployed workers.
UC Impact on EITC: In addition to reporting UC on their income tax returns for the first time, taxpayers may receive a significantly lower EITC because their 2020 earned income was less than expected. The amount of EITC fluctuates based on the taxpayer’s earned income and adjusted gross income. The EITC is a complex area of law and most low income taxpayers require specialized assistance in order to claim the credit successfully. The IRS provides a helpful tool to help taxpayers determine eligibility for the EITC and an estimated credit amount. However, not all taxpayers can avail themselves of the tool — a 2018 Taxpayer Advocate Service (TAS) study found that more than 11 percent of low income taxpayers and over 28 percent of seniors never use the internet.
Taxpayers living paycheck to paycheck or from one unemployment check to the next may be anticipating the EITC based on last year’s earned income. However, earned income does not include amounts received as UC. Thus, a taxpayer receiving UC may report less earned income for the purpose of computing the EITC, resulting in a reduction or elimination of the credit. In addition, taxpayers who did not opt for voluntary withholding may see reduced refunds or have a tax due as a result.
To address the negative tax consequences of UC not constituting earned income, I am recommending that Congress allow UC to be included as qualifying income in computing the EITC during national disasters. This legislative recommendation has special meaning in the year of the coronavirus pandemic, with so many jobless taxpayers reliant on UC as a primary source of income. The recommendation will be included in the 2021 Purple Book issued in conjunction with my 2020 Annual Report to Congress.
Collection Alternatives: Some taxpayers may be reluctant to file balance due tax returns if they are unable to pay the tax by the due date. Taxpayers who owe tax and fail to file and pay on time will most likely owe interest and penalties on the tax they pay late. Two penalties may apply – for filing late and for paying late. Interest accrues on top of penalties. The penalty for late filing can be as much as five percent of the unpaid taxes each month up to a maximum of 25 percent, while the penalty for late payment is generally 0.5 percent of the taxpayer’s unpaid taxes per month up to a maximum of 25 percent of unpaid taxes. If both penalties apply, the maximum amount charged for the two penalties is five percent per month. Taxpayers can avoid incurring the failure-to-file-penalty by timely filing their return. Where taxpayers have a balance due on their returns and are unable to pay that balance in full, the IRS offers collection alternatives, such as installment agreements and offers in compromise. Some taxpayers may qualify to be placed in currently not collectible status. During 2020, the IRS expanded collection alternatives for individuals experiencing COVID-19-related financial difficulties. The IRS website contains information on these alternatives. Eligible taxpayers may contact a Low Income Taxpayer Clinic (LITC) for assistance with understanding their filing obligations and collection alternatives.
Communication with Taxpayers: Millions of taxpayers will receive Form 1099-G for the first time and may not appreciate the effect UC will have on their tax returns, including the amount of the EITC. Taxpayers may receive the form in the mail or may receive instructions to retrieve an electronic version of Form 1099-G from their state’s website. We encourage the IRS to continue educating taxpayers about the taxability of UC. In addition to posting information on IRS.gov, I recommend the IRS engage stakeholders, such as Volunteer Income Tax Assistance (VITA) and Tax Counseling for the Elderly (TCE) partners, and community organizations to spread the word to potential EITC recipients that the amount of their 2020 credit may be less than they are expecting. TAS will also collaborate with the IRS on including UC information in its EITC outreach materials at the beginning of the filing season.
Tax Return Preparation Assistance: If taxpayers have received UC during 2020 and are unsure what to do, VITA and TCE programs provide free income tax return preparation assistance to eligible taxpayers. VITA offers free basic tax return preparation to people who generally make $57,000 or less, persons with disabilities, and limited English-speaking taxpayers, while TCE provides tax return assistance to taxpayers over 60 years of age. Some VITA and TCE sites will offer virtual help to taxpayers in place of face-to-face assistance. Taxpayers can also access the Free File Alliance which is a nonprofit coalition of industry-leading tax software companies, partnered with the IRS to help Americans prepare and e-file their federal tax returns quickly, safely and for free.
As many taxpayers continue to navigate an uncertain economic future amid the pandemic, TAS stands ready to help and direct taxpayers to the resources they need.
The views expressed in this blog are solely those of the National Taxpayer Advocate. The National Taxpayer Advocate presents an independent taxpayer perspective that does not necessarily reflect the position of the IRS, the Treasury Department, or the Office of Management and Budget.