Tim has state income taxes of $4,500 withheld from his salary during
On his 2008 federal income tax return, Tim properly deducts
the $4,500 as state taxes paid. Upon filing his 2008 state income tax
return, he determines that his actual state income tax for 2008 is only
$3,900, and the state sends him a $600 refund.
What are the tax
consequences of the refund?
Explain in terms of the concepts
presented in the chapter.
This is a classic example of the tax benefit rule that taxes any
amount deducted in a previous year as income in the year of
recovery to the extent that a tax benefit was received from the
Because Tim took a deduction for the entire
$4,500 withheld, any refund of the state taxes must be included
in income in the year of the refund.
In this case, the $600 refund
is taxable in 2009.
Note that the annual accounting period
concept does not allow Tim to go back and amend his 2008
return for the refund, because the events of each tax year are
deemed to stand apart from each other.
In working this problem, you may want to note that if, under the
administrative convenience concept, Tim had not itemized his
deductions (i.e., he used the standard deduction in 2008) he
would not have to claim the $600 refund as income in 2009
because he did not take an actual deduction for the state income
In addition, if Tim's itemized deductions did not exceed
his standard deduction by more than $600, then only the excess
of Tim's actual deductions over the standard deduction would
be income under the tax benefit rule.
For example, if Tim's 2008
total itemized deductions were $5,650, then only $200 of the
refund would be income.
This is the excess of total deductions
over the 2008 standard deduction for a single individual ($5,650
How would your answer change if Tim's actual state income tax is
$4,900 and he has to pay $400 with his state return?
Because Tim is a cash basis taxpayer, he must take deductions
in the year in which the allowable expense is paid.
In this case,
the additional $400 in 2008 state tax is paid in 2009.
annual accounting period concept, Tim cannot go back and
amend his 2008 state tax deduction for taxes paid in 2009.
must deduct the taxes in 2009, the year that he pays the taxes.