Rev. Rul. 74-140

Advice has been requested concerning the deductibility of State income taxes paid by an individual under the circumstances described below.

A civilian employee of the Government of the United States was stationed in Hawaii and received a cost-of-living allowance that was exempt from Federal income tax under section 912 of the Internal Revenue Code of 1954. However, the cost-of-living allowance was subject to the income tax imposed by the State of Hawaii.

Section 164 of the Code provides, in part, for the deduction of State and local income taxes paid or accrued during the taxable year.

Section 265 of the Code provides, in part, as follows:

No deduction shall be allowed for--

(1) Expenses.--Any amount otherwise allowable as a deduction which is allocable to one or more classes of income other than interest (whether or not any amount of income of that class or classes is received or accrued) wholly exempt from the taxes imposed by this subtitle, or any amount otherwise allowable under section 212 (relating to expenses for production of income) which is allocable to interest (whether or not any amount of such interest is received or accrued) wholly exempt from the taxes imposed by this subtitle.

Accordingly, it is held in the instant case that the portion of the State income taxes paid by the taxpayer that is allocable to the cost-of-living allowance, a class of income wholly exempt under section 912 of the Code, is non-deductible under section 265. Rinehart v. United States, 68-2 U.S.T.C. 87, 937 (W. D. Okla. 1968), aff'd 429 F. 2d 1286 (10th Cir. 1970); Mary A. Marsman, 18 T.C. 1 (1952), aff'd in part and rev'd in part, 205 F. 2d 335 (4th Cir. 1953), aff'd after remand, 216 F. 2d 77 (4th Cir. 1954), cert. denied, 348 U.S. 943 (1955); George W. P. Heffelfinger, 5 T.C. 985 (1945); James F. Curtis, 3 T.C. 648 (1944).

For a similar conclusion see Rev. Rul. 61-86, 1961-1 C.B. 41, which provides that in the case of an estate or trust, that portion of its State income taxes that is allocable to exempt income other than exempt interest income is nondeductible under section 265 of the Code.