2009 Tax Strategy I - Sales Tax and State Tax Refund

With the beginning of 2010, it is time to start thinking about our 2009 taxes, as painful as that might be. To help out, I am going to be posting a daily tax tip from now until April 15. Please feel free to call me if you have any questions.

Sales Tax and State Tax Refund

Under the tax benefit rule, the recovery of an amount deducted or credited in an earlier tax year is included in a taxpayer's income in the current (recovery) year, except to the extent the deduction or credit didn't reduce federal income tax (or alternative minimum tax). (IRC §111(a))

For tax years 2004 through 2007, a taxpayer has the option to deduct as an itemized deduction either the state (and local) income tax paid during the year or state and local sales tax. On first examination would assume that (1) if the client chooses to deduct state income tax and subsequently receives a refund from the state, then that refund is taxable. However, (2) if they choose to deduct sales tax instead of state income tax and receive a state refund for that year that refund is not taxable! Actually, the IRS has taken a much more liberal approach to this issue. Their position is that for purposes of the tax benefit rule the amount of refund includable in income is limited to the excess of the tax the taxpayer chose to deduct over the tax they did not choose to deduct.

Example – Assume the taxpayer can choose an $11,000 state income tax deduction or a $10,000 state general sales tax deduction. Since the state income tax deduction is the largest, he chooses to deduct the state income tax. In the subsequent, he receives a $2,500 state income tax refund. Using the IRS’s more liberal approach the tax benefit derived from by deducting the $11,000 state income tax was only $1,000 more than, if the $10,000 sales tax deduction was used. Thus, the benefit from only $1,000 of the state tax deduction and as a result only $1,000 of the $2,500 refund is taxable the next year.

Strategy – In order to benefit from the IRS’ liberal tax benefit rule position you must be able to compute the difference between sales tax deduction and state tax deduction. Thus it is important (when there is a state tax refund and the state tax deduction exceeds the sales tax deduction) to determine the allowable sales tax deduction for the client and record it in your file. Otherwise, there is no way of computing the tax benefit rule. Be Sure To Look Back – And take advantage of this tax benefit rule.