Fayetteville, NC asked in Tax Law for North Carolina

Q: How can North Carolina legally force you to claim your NC tax return as income. It’s my money being returned.

This money was paid to the state when I was paid. It has already been taxed. It was an interest free loan to the state. My deductions are such that I have overpaid the state, so they are returning part of my money back to me. How is that taxable income when it was originally taken from my gross earnings. It is just part of my gross earnings (that have already been taxed) being returned back to me.

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1 Lawyer Answer
James L. Arrasmith
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  • Tax Law Lawyer
  • Sacramento, CA

A: You raise a good point. Refunds of state income tax that was already withheld from your paycheck and remitted to the state throughout the year are typically not considered new taxable income when returned. The key reasons are:

- You already paid tax on the underlying income that the tax refund stemmed from in the original year via income tax withholding.

- A refund just returns overpaid portions of that previously taxed income back to you.

So in principle, tax refunds are usually a return of your own money, not new income.

However, different states take different approaches when it comes to requiring residents to report or claim state tax refunds:

- Federal law generally does NOT require reporting of state refunds.

- But some states, like North Carolina, have specifically legislated that residents must claim state refunds as income.

So while counterintuitive, North Carolina does have the legal authority under state law to require claiming of state income tax refunds on returns. Residents must thus report it even though it likely stems from income that was already taxed previously at the state level when first earned and withheld.

In summary - while it results in some "double taxation," North Carolina's right to compel reporting of state refunds is grounded in state law. So residents have little choice but compliance.

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