Monday, December 31, 2012

Fiscal cliff' debate may delay state tax refunds

Almost every tax cut enacted since 2001 will expire, including the Bush-era tax cuts, the 2009 stimulus tax cuts, a short-term fix to protect taxpayers from the Alternative Minimum Tax, and a tax package that includes popular tax provisions to encourage things such as charitable giving. The Social Security payroll tax will also expire, as will a law that affects how doctors who treat seniors through Medicare are paid. Congress is also negotiating an extension of long-term unemployment benefits for 2 million Americans.

Federal and state tax systems are so intertwined that taxpayers will find it nearly impossible to file a state tax return — or get a timely refund — until Congress resolves the current fight over tax policy.

Most of the fiscal cliff fight involves tax rates for 2013. That doesn't affect your ability to file this year's return. But Congress also needs to retroactively settle a few 2012 tax issues — deductions, credits and the Alternative Minimum Tax (AMT). Until this is done, it will be hard to file either a federal or state tax return.

Forty-one states and Washington, D.C., have income taxes, collecting $300 billion in 2012. All of these governments have finished their rules, set rates and are ready for taxpayers to file.

About two-thirds of state income tax filers get a refund. The amounts are smaller than the average federal refund of $2,707 last year, but still substantial: an average of $1,146 in Maryland, $831 in California and $314 in Ohio.

For simplicity reasons, nearly every state uses "federal adjusted gross income" as the starting point for computing state tax liability. With federal tax law up in the air, how to compute that crucial number — what goes on Line 37 of the federal 1040 form — will remain a mystery to many taxpayers.

"Theoretically, you can file state and federal returns separately. In reality, the two systems work in concert with each other, so it's hard to separate them," says Harley Duncan, managing director of state tax issues at KPMG, a tax advisory firm.

Tax preparer H&R Block is encouraging clients to wait to file state and federal returns together, says Mimi Nolan, director of the company's Tax Institute. TurboTax has created a "red light/green light" system in its software to tell users if, in the estimation of TurboTax's 150 tax analysts, it's OK to file a state return before federal law is set.

"Tax refunds are the biggest payday of the year, bar none, for 60 million people living paycheck to paycheck," says TurboTax Vice President Bob Meighan. "This money is critically important to people paying rent, paying down debt and other expenses."

But tax law is so complicated that even the 96% of taxpayers who don't use the deductions currently being debated can get tripped up on unsettled issues, such as whether the sales tax can be an itemized deduction and the AMT.

Some examples of state returns and refunds thwarted by the current debate:

• Many states require attaching completed federal tax forms to state returns. Example: North Dakota requires the federal 1040. New Mexico wants Schedule A. New Jersey wants Schedule B. New York wants Schedules C, D, E and F.

• The IRS runs the electronic filing system used by states and 80% of taxpayers. The IRS is supposed to start accepting federal and state electronic returns on Jan. 22. If Congress doesn't act soon on the AMT, the IRS will need until March to reprogram its e-file computers — a delay that would block millions of state returns.

"The AMT is the bug-a-boo," says Verenda Smith, deputy director of the Federation of Tax Administrators, a coalition of state tax collectors. States don't use the federal AMT to compute taxes, but they rely on the federal electronic filing system to be at full speed during the peak filing period in mid-February.

"Our state return is indivisible from the federal return," says Gary Gudmundson of the Ohio Department of Taxation. "It's not like you can do one without the other."

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