Rev. Rul. 56-447

Advice has been requested with respect to the taxability, for Federal income tax purposes, of a refund of state income taxes received by an individual taxpayer who uses the cash receipts and disbursements method of accounting and files his Federal and state income tax returns on the calendar year basis.

In Mimeograph 6444, C. B. 1949-2, 11, as modified by Mimeograph 6597, C. B. 1951-1, 20, relating to the taxable status of refunds of taxes, it is held that all refunds of taxes, the deduction of which in prior years resulted in tax benefits, should be included in gross income for the taxable year in which such refunds are received by the taxpayer unless, under the taxpayer's method of accounting, such refund is properly accounted for as of a different period, and except as otherwise provided by Federal statute. Conversely, if the taxpayer derived no tax benefit from the deduction of such taxes in the prior taxable year, the tax refunded would be excluded from gross income in the year it was received, to the extent provided in section 111 of the Internal Revenue Code of 1954.

In general, section 111 of the Code excludes from gross income recoveries during the taxable year of previously deducted (or credited) bad debts, prior taxes, or delinquency amounts, to the extent that the prior deduction or credit did not result in a reduction of the taxpayer's Federal income tax (i. e., a tax benefit) for the year of deduction. If there were recoveries in more than one year, the nontaxable amount which did not result in a tax benefit would be reduced by any amount which had been excluded in a previous taxable year. A "prior tax" is defined as a tax on account of which a deduction or credit was allowed for a prior taxable year.

If, for example, an individual (cash method) taxpayer had, for Federal income tax purposes, an adjusted gross income in 1954 of $10,000, allowable itemized deductions from adjusted gross income of $1,200, including $200 state income taxes paid in 1954, and was entitled only to one $600 personal exemption deduction for himself, the taxpayer's taxable income, as defined in section 63 of the Code, would be $8,200. The inclusion of the state income tax in his itemized deductions for 1954 clearly reflects a tax benefit to him. Accordingly, if, in 1955, the taxpayer received a $50 refund from the state because of an overpayment of his 1954 state income taxes, the $50 would be includible in his gross income for 1955.

However, if the taxpayer's adjusted gross income for 1954 was $1,700 and all other facts were the same, he would have received a tax benefit of $100 by deducting the $200 state income tax, because without such deduction he would still have taxable income of $100. Under these latter circumstances and assuming that the entire amount of $200 of state income tax paid in 1954 was refunded to the taxpayer in 1955, $100 would be includible in gross income for that year and $100 would be excludable therefrom under section 111 of the Code.

If the taxpayer had used the U. S. Individual Income Tax Return, Form 1040A in filing his return and had his tax computed from the tax table by the District Director of Internal Revenue, or had used the Form 1040 return and elected to use the tax table or the standard deduction in computing his tax liability for the taxable year 1954, when the state income tax was paid, the refund of all or any part thereof would not be includible in his gross income in the year received. In such cases, it is considered that the allowance of the use of the tax table or the standard deduction does not constitute a deduction for any of the specific items, such as state income tax, which a taxpayer may be entitled to deduct from adjusted gross income in computing taxable income for Federal income tax purposes.

The above principles would be equally applicable to any (cash method) taxpayers who file their returns on a fiscal year basis.