Latest Democrat deal would give Americans a tax waiver on the first $10,200 of their 2020 unemployment benefits

Senate Democrats reached a compromise on Friday to narrow the scope of the enhanced unemployment benefits in the $1.9 trillion Covid-19 relief package, cutting the benefit from $400 to $300 a week but allowing the enhanced benefits to run through early October.

As part of that compromise, Democrats added language to the bill that would provide a tax waiver on up to $10,200 of unemployment insurance benefits for 2020, staff for Sen. Ron Wyden, D-Ore., confirmed Friday to CNBC Make It.

"We've found a way to…ensure that the millions of Americans who are still struggling to find work will see an immediate benefit before Tax Day this year," Sen. Tom Carper, D-Del., said in a statement emailed to CNBC Make It.

The amendment, which is expected to hit the Senate floor Friday afternoon, ensures that unemployed workers will not face a surprise bill on their 2020 taxes, according to a spokeswoman for Sen. Carper.

About 40 million Americans received unemployment insurance benefits last year, according to a recent report from the left-leaning Century Foundation, authored by Brian Galle and Elizabeth Pancotti. 

That amounted to over $580 billion in benefits that are considered taxable income, including the extra weekly $600 payments made under the Federal Pandemic Unemployment Compensation (FPUC) program and the $300 weekly boost provided through the Lost Wages Assistance (LWA) program. 

Yet researchers estimate that only 40% of unemployment payments in 2020 had taxes withheld. That's due, in part, to the fact that while state unemployment agencies are supposed to offer the option to withhold 10% of benefits for income taxes, some states failed to do so.

California resident Gale Nichols opted to have the state withhold 10% of her unemployment payments for taxes. But when her 1099-G arrived in the mail earlier this year, she discovered she's on the hook for taxes on $23,076 of her unemployment benefits. "It was a complete surprise to me," she says.

California did not withhold taxes on the enhanced $600 benefits made available through the FPUC program. "I think it would have been a safe assumption if you check a box to withhold taxes, that you withhold taxes from all the money that they're going to be sending you," Nichols says.

California's Employment Development Department said in an emailed statement to CNBC Make It that the state did withhold taxes on standard state-issued unemployment insurance and federal pandemic unemployment assistance benefits, but the option to withhold taxes was not available for the $600 pandemic additional compensation payments.

Similarly, Hawaii and Minnesota reportedly did not withhold taxes from all or some of the federal employment programs. Ohio, meanwhile, did not withhold state taxes on any of the federal unemployment programs, including the Pandemic Unemployment Assistance (PUA) program designed for gig workers, independent contractors, the self-employed and those who would normally not be eligible for unemployment. 

Additionally, many out-of-work Americans could not afford a 10% reduction in their benefits or did not realize that their unemployment payments were taxable. All said, that means millions of workers could owe "thousands of dollars per family" in unemployment benefits on their 2020 taxes, according to Galle and Pancotti.

Friday's amendment could provide some much-needed relief to Americans. The tax waiver would dramatically reduce or even eliminate many unemployed workers' federal tax burden. And some states are stepping in as well.

Maryland and Delaware both recently passed legislation that waives state income tax on unemployment benefits for 2020. Additionally, a bill that would exempt unemployment benefits from taxes in 2020 and 2021 is awaiting a signature from Arkansas Governor Asa Hutchinson.

Meanwhile, states like California, Montana, New Jersey, Pennsylvania and Virginia, exempt taxes on unemployment and seven states — Alaska, Florida, Nevada, South Dakota, Texas, Washington and Wyoming — do not levy any state income taxes.

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