Recovery of Previously Deducted Amounts
(THE TAX BENEFIT RULE)
Recovery (refund) of previously deducted amounts in a subsequent year may
cause income recognition (i.e. Tax Benefit Rule).
Taxpayer receives a state tax refund of $600 dollars in 2014 after
filing her 2013 state tax return.
Taxpayer had originally paid $3,000 of state
income taxes in 2013.
Whether the above refund is taxable or not depends upon what the taxpayer did on
her US 1040 for year 2013.
If she itemized and deducted those state income taxes
for the full amount paid, then she deducted too much and the refund will be
taxable to the extent of the tax benefit received from the deduction.
taxpayer did not itemize, the state taxes couldn’t be deducted so there was no tax
benefit from the deduction and no taxable income on the refund.
The Tax Benefit Rule is an important concept that can guide you in determining
whether a refund of an item is taxable.
If the person deducted the cost of the item
in a previous year, the refund is taxable.
If no previous deduction was taken, the
refund is not taxable.
Claim of right
A taxpayer may receive funds normally constituting income but the right
to keep all of it is contingent upon future events.
Under the claim of right
doctrine, the taxpayer must report the amounts received as income, unless
taxpayer does not have control of the funds.
An example of this would be
someone who sells property but the full price is contingent upon a future event
(for example, the purchaser must obtain zoning or licensing approval).
may have to refund some of the sales price if the future contingency fails to occur.
If the taxpayer is subsequently required to repay the disputed amount, a
deduction is available in the year of repayment.
Original Issue Discount (OID) Rules
These rules apply to debt instruments (with exceptions
notably US savings bonds, debt
instruments with terms less than one year, and loans between individuals of less than
$10,000) that are issued at a discount (purchase price less than face value) and mature at
the face value.
An accrual based borrower would deduct the interest as accrued while a
cash based lender would normally recognize the interest income at maturity.
rules place both on the accrual basis for purposes of recognizing the discount element of
So, a cash basis taxpayer must amortize the discount as interest income (usually
using the effective interest method) each year just like an accrual basis taxpayer.