States often provide tax credits to encourage individuals and businesses to purchase and develop property, pay wages, or engage in other forms of economic stimulus and socially beneficial activities. Some such credits can be used only to reduce or to eliminate actual state tax liabilities of the person who is engaged in the “creditable” activity, or, if the credits are earned by a pass-through entity, actual state tax liabilities of the entity’s owners. Other credits, however—often referred to as “refundable credits”—may be used to claim a tax “refund” even if the available credits exceed the relevant persons’ state tax liabilities, or the relevant persons have no state tax liabilities at all.
One aspect of refundable state tax credits that may be given little thought by the state legislatures that authorize them is the federal income tax treatment of such credits once obtained. Credits that are not refundable have been held not to result in income for federal tax purposes, although they may indirectly increase federal tax liabilities by reducing state taxes for which deductions would otherwise be allowable and/or by resulting in a refund of a tax payment for which a deduction was already claimed with respect to a prior period (thereby resulting in an income inclusion under tax benefit principles).1
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