IRS Orders States: No Tax on Rebates

There are eight states that allow federal income taxes paid as a deduction on the state tax returns: Iowa, Oklahoma, Louisiana, Missouri, Montana, North Dakota, Oregon, and Utah. Because the impending federal income tax rebates will reduce the amount of tax paid for 2001, these states stand to make money [1] on the fact that residents will have less federal income tax to deduct.

Tax rebates will reduce the total amount of tax paid by most taxpayers during 2001, thus the deduction for income taxes on state returns that allow such a deduction will also be reduced, thereby increasing the income tax in the state.

The Federation of Tax Administrators has successfully lobbied the IRS to prevent the states from what amounts to taxing the federal rebates. As a result, the IRS has agreed to exempt the rebate amounts from state taxation.

However, the IRS decision does not carry the weight of a Congressional action or a court order, so this issue may continue to raise controversy. States that want the extra tax money may take the matter to court. Stay tuned for further developments.