Unemployment Compensation Taxation

Unemployment compensation is taxable income under Section 85. This guide explains what unemployment compensation is, how it is taxed, and special rules that may apply.

What is Unemployment Compensation?

Unemployment Compensation refers to payments made to individuals who are temporarily out of work through no fault of their own. These payments can come from federal or state programs designed to assist unemployed workers. According to Section 85 of the IRC, unemployment compensation is defined as any amount received under a law of the United States or of a state that is in the nature of unemployment compensation.

Types of Unemployment Compensation

1. State Unemployment Benefits: Most unemployment benefits come from state programs that provide temporary financial assistance to workers who have lost their jobs. Each state has its own eligibility requirements and benefit amounts.

2. Federal Unemployment Benefits: In times of economic crisis, the federal government may provide additional unemployment benefits. For example, during the COVID-19 pandemic, programs like the Pandemic Unemployment Assistance (PUA) were available to help those who were not traditionally eligible for state unemployment benefits.

3. Extended Benefits: These are benefits provided during periods of high unemployment, extending the duration of assistance beyond the standard state benefit period.

How is Unemployment Compensation Taxed?

General Rule

Under Section 85(a), any unemployment compensation received by an individual must be included in their gross income. This means that unemployment benefits are taxable just like regular income. Taxpayers must report these benefits when they file their federal income tax returns, and they may be subject to federal income tax based on their overall income level.

Reporting Unemployment Compensation

When you receive unemployment benefits, you should receive a Form 1099-G from your state unemployment agency. This form reports the total amount of unemployment compensation you received throughout the year. Include this amount when you file your taxes.

Example of Reporting

Suppose you received $12,000 in unemployment benefits during the year. You would receive a Form 1099-G indicating this amount. When you file your tax return, you would list this $12,000 as part of your gross income, potentially affecting your overall tax liability.

Special Rules for the 2020 Tax Year

In response to the economic impact of the COVID-19 pandemic, the federal government instituted some temporary changes regarding the taxation of unemployment compensation for the tax year 2020.

Exclusion of Unemployment Compensation

For the tax year beginning in 2020, if your adjusted gross income (AGI) was less than $150,000, you could exclude up to $10,200 of unemployment compensation from your gross income. This exclusion applies separately to each spouse in the case of a joint return. The key points to remember are:

1. Eligibility: Only applicable for individuals whose AGI is below $150,000.
2. Amount: Up to $10,200 of unemployment compensation could be excluded from taxable income.

Calculating Adjusted Gross Income

To determine if you qualify for this exclusion, your AGI must be calculated after applying certain tax provisions but without considering the unemployment compensation itself. This calculation can be complex, especially if you have other sources of income, deductions, or credits, so it may be beneficial to consult a tax professional.

Example of the Special Rule

Let’s say you and your spouse received a total of $25,000 in unemployment benefits in 2020. If your combined AGI is $140,000, you can exclude $20,400 from your gross income for tax purposes—$10,200 for you and $10,200 for your spouse. Thus, only $4,800 of your unemployment benefits would be subject to taxation.

Who is Affected by Section 85?

Section 85 applies to all individuals who receive unemployment compensation. This includes:

• Former Employees: Individuals who were laid off or terminated due to no fault of their own.
• Part-Time Workers: Those who may have been employed part-time and lost their job.
• Gig Workers: Individuals who may qualify for unemployment benefits under special federal programs.
• Self-Employed Individuals: Those who may qualify for unemployment assistance during extraordinary circumstances like the pandemic.

Common Scenarios and Considerations

Scenario 1: Multiple Sources of Income

If you are receiving unemployment benefits while also working part-time, you still need to report all income, including the unemployment benefits. It’s essential to assess how both income streams impact your overall tax bracket.

Scenario 2: Filing with a Spouse

When filing jointly, both partners can benefit from the unemployment compensation exclusion up to the specified limit. It's advisable to assess both partners' income to maximize tax benefits.

Scenario 3: State-Specific Benefits

Many states have their own tax rules regarding unemployment compensation. For instance, some states may not tax unemployment benefits at all, while others may have different thresholds. It’s critical to check your state’s tax regulations to understand your tax obligations fully.

Practical Tips for Taxpayers

1. Keep Records: Maintain all documentation related to your unemployment benefits, including Form 1099-G, as this will be essential for tax filing.

2. Consult Tax Software or Professionals: Given the complexities of tax laws, especially with the additional rules during special circumstances like the pandemic, consider using reputable tax software or consulting a tax professional.

3. Consider Impact on Other Benefits: Be aware that unemployment compensation may affect your eligibility for other benefits, such as income-based programs or credits.

4. Plan for Taxes: Since unemployment benefits are taxable, consider setting aside a portion of these funds for potential tax liabilities to avoid surprises when filing taxes.

Conclusion

Understanding the tax implications of unemployment compensation under Section 85 helps taxpayers manage their tax liability and ensure compliance. Stay informed about changes in tax law, particularly during extraordinary circumstances. Consult a tax professional if you have specific questions or unique financial situations.