DEDUCTION FOR STATE TAXES DISALLOWED UNDER ITEMIZED DEDUCTION CEILING, BUT LATER REFUNDED, IS INCLUDABLE IN INCOME.

Rev. Rul. 93-75

ISSUE

If a taxpayer's itemized deductions in a prior taxable year were reduced by the overall deduction limitation in section 68(a) of the Internal Revenue Code and the taxpayer subsequently recovers all or a portion of these previously deducted amounts (for example, state income taxes), what portion of the recovery or refund is includible in gross income under the tax benefit rule?

FACTS

In Situations 1, 2, and 3 below, A, B, and C are unmarried individuals who itemized their deductions on their federal income tax returns for 1991 and use the cash receipts and disbursements method of accounting. For 1991, none of these individuals was subject to alternative minimum tax under section 55 of the Code and none was entitled to any credit against income tax.

The allowable deductions of A, B, and C for 1991 consisted entirely of state income taxes that were deducted under section 164(a)(3) of the Code, reduced by an amount determined under section 68(a) of the Code because each taxpayer's adjusted gross income for 1991 exceeded $100,000. In 1992, each individual received a partial refund of the previously deducted state income taxes.

The following chart shows each taxpayer's adjusted gross income (AGI) for 1991, the state income taxes each paid in 1991, the reduction under section 68(a)(1) that applied for 1991, the greater reduction under section 68(a)(2) that was not applied, the amount of the deduction for 1991 taking into account the section 68(a)(1) reduction, the amount of the refund received in 1992 of state income taxes deducted in 1991, and the "proper amount" of state taxes, which is the amount of state taxes paid in 1991 reduced by the refund received in 1992.

                             Situation 1    Situation 2    Situation 3

Section 68(a) of the Code provides that if an individual's adjusted gross income exceeds the applicable amount, the amount of the itemized deductions otherwise allowable for the taxable year is reduced by the lesser of (1) 3 percent of the excess of adjusted gross income over the applicable amount, or (2) 80 percent of the itemized deductions otherwise allowable for the taxable year. Under section 68(b)(1), the applicable amount is $100,000 ($50,000 in the case of a separate return filed by a married taxpayer), increased for years after 1991 by a cost-of-living adjustment under section 68(b)(2).

Section 111(a) of the Code excludes from gross income amounts attributable to the recovery during the taxable year of any amount deducted in any prior year to the extent that the amount did not reduce the amount of tax imposed by chapter 1 (sections 1 through 1399) of subtitle A (income taxes) of the Code.

Section 111 of the Code is a partial codification of the tax benefit rule, which generally requires the inclusion in income of amounts that were deducted by a taxpayer in a prior taxable year to the extent those amounts generated a tax benefit to the taxpayer through a reduction in the amount of tax liability in the prior year. The purpose of the rule is to achieve rough transactional parity within the framework of a tax system requiring annual calculations. Rev. Rul. 92-91, 1992-2 C.B. 49. Rough transactional parity is achieved if the taxpayer is "put in more or less the same after-tax position as if only the proper amount had been deducted." See S. Print 98-169, Vol. I, 98th Cong., 2d Sess. 472 (1984), concerning the amendments to section 111 of the Code made by section 171 of the Tax Reform Act of 1984, Pub. L. No. 98-369, 1984-3 C.B. (Vol. 1) 206.

Thus, a refund of state income tax that was previously deducted is includible in gross income in the year of receipt to the extent of the difference between the taxpayer's itemized deductions in the prior year (after the application of section 68 of the Code) and the deductions the taxpayer would have claimed (the greater of (1) the itemized deductions after the application of section 68 or (2) the standard deduction) had the taxpayer paid the proper amount of state income tax in the prior year and not received a state income tax refund in a subsequent year.

In Situation 1, A deducted $9,000 in 1991 because A's otherwise allowable deductions of $12,000 were reduced under section 68(a)(1) of the Code by $3,000 (3 percent of the excess of $200,000 over $100,000). In 1992, A received a refund of $2,000 with respect to the state income taxes deducted in 1991. If A had paid only $10,000 in state income taxes in 1991 (the proper amount of state income taxes for 1991 after the 1992 refund ($12,000 - $2,000)), A's otherwise allowable itemized deductions of $10,000 would have been reduced by $3,000 under section 68(a)(1) to $7,000. A derived a tax benefit to the extent of the $2,000 difference between A's deduction for 1991 ($9,000) and the deduction for 1991 that A would have claimed ($7,000) had A paid the proper amount of state income taxes in 1991 and not received a state income tax refund in 1992. Thus, the $2,000 state income tax refund that A received in 1992 is fully includible in A's gross income in 1992.

In Situation 2, B deducted $9,000 in 1991 because B's otherwise allowable deductions of $12,000 were reduced under section 68(a)(1) of the Code by $3,000 (3 percent of the excess of $200,000 over $100,000). In 1992, B received a refund of $7,000 with respect to the state income taxes deducted in 1991. If B had paid only $5,000 in state income taxes in 1991 (the proper amount of state income taxes for 1991 after the 1992 refund ($12,000 - $7,000)), B's otherwise allowable itemized deductions of $5,000 would have been reduced by $3,000 under section 68(a)(1) to $2,000, which is less than the standard deduction of $3,400 that B would have claimed for 1991. B derived a tax benefit to the extent of the $5,600 difference between B's deduction for 1991 ($9,000) and the standard deduction for 1991 ($3,400) that B would have claimed had B paid the proper amount of state income taxes in 1991 and not received a state income tax refund in 1992. Thus, $5,600 ($9,000 - $3,400) of the $7,000 state income tax refund that B received in 1992 is includible in B's gross income in 1992, and $1,400 of that $7,000 refund is excludable from B's gross income under section 111.

In Situation 3, C deducted $10,000 in 1991 because C's otherwise allowable deductions of $40,000 were reduced under section 68(a)(1) of the Code by $30,000 (3 percent of the excess of $1,100,000 over $100,000). In 1992, C received a refund of $5,000 with respect to the state taxes deducted in 1991. If C had paid only $35,000 in state income taxes in 1991 (the proper amount of state income taxes for 1991 after the 1992 refund ($40,000 - $5,000)), C's otherwise allowable itemized deductions of $35,000 would have been reduced by $28,000 (80 percent of $35,000 = $28,000) under section 68(a)(2) because that reduction is less than the $30,000 reduction determined under section 68(a)(1). Thus, C would have claimed a deduction in 1991 of $7,000 ($35,000 - $28,000). C derived a tax benefit to the extent of the $3,000 difference between C's deduction for 1991 ($10,000) and the deduction for 1991 that C would have claimed ($7,000) had C paid the proper amount of state income taxes in 1991 and not received a state income tax refund in 1992. Thus, $3,000 ($10,000 - $7,000) of the $5,000 state income tax refund that C received in 1992 is includible in C's gross income in 1992, and $2,000 of that $5,000 refund is excludable from C's gross income under section 111.

HOLDING

If a taxpayer's itemized deductions in a prior taxable year were reduced by the overall deduction limitation in section 68(a) of the Code and the taxpayer subsequently recovers all or a portion of these previously deducted amounts (for example, state income taxes), the recovery or refund is, in general, fully includible in gross income under the tax benefit rule. More specifically, the portion of the recovery or refund that is includible in gross income in the year of receipt equals the difference between the prior year's itemized deductions (after the application of section 68) and the deductions that would have been claimed (the greater of (1) the itemized deductions after the application of section 68 or (2) the standard deduction) had the taxpayer paid the proper amount in the prior year and not received a recovery or refund in a subsequent year.

EFFECTIVE DATE

The Internal Revenue Service will not challenge a taxpayer's treatment of state income tax refunds (or similar recoveries) on income tax returns (including amended returns) filed on or before December 31, 1993, if the portion of the state income tax refund (or similar recovery) included in gross income on the return is determined in accordance with the method provided by the worksheet on page 18 in Publication 525, Taxable and Nontaxable Income (1992).

EFFECT ON OTHER REVENUE RULINGS

Rev. Rul. 79-15, 1979-1 C.B. 80, which addresses the portion of a state income tax refund that is excludable from gross income under the tax benefit rule as applied under prior law, is obsolete.

DRAFTING INFORMATION

The principal author of this revenue ruling is Michael L. Gompertz of the Office of Assistant Chief Counsel (Income Tax and Accounting). For further information regarding this revenue ruling, contact Mr. Gompertz on (202) 622-4910 (not a toll-free call).