Federal income tax on state income tax refund


P

pomegranate-man

TP paid too much state estimated tax for 2008, all during 2008.

So on the 2008 federal return, there's a large deduction in Schedule A. But
for 2009 there'll be a state income tax refund.

The refund would typically be taxed as income for 2009, which seems fair
since to balance tax benefit on 2008 Schedule A.

But TP is subject to AMT for 2008. There, state taxes are added back into
income. So there wasn't a real tax benefit in 2008. (This was checked using
TurboTax; if the 2008 state estimated tax was reduced to produce no refund,
the federal tax remained the same and schedule A line 5 didn't switch to
sales tax.)

On the 2009 return next year, will there be a calculation that sorts all
this out, so the refund isn't really taxed? Is there some pitfall to be
avoided about taxes on the refund?

Thanks.
 
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P

Phil Marti

pomegranate-man said:
TP paid too much state estimated tax for 2008, all during 2008.

But TP is subject to AMT for 2008. There, state taxes are added back into
income. So there wasn't a real tax benefit in 2008. (This was checked
using
TurboTax; if the 2008 state estimated tax was reduced to produce no
refund,
the federal tax remained the same and schedule A line 5 didn't switch to
sales tax.)

On the 2009 return next year, will there be a calculation that sorts all
this out,
Yes. See Publication 525.
 
M

Mark Bole

pomegranate-man said:
TP paid too much state estimated tax for 2008, all during 2008.
Was it an unreasonable amount based on income during the year? There's
probably some leeway, but an extreme overpayment could attract unwanted
attention.

Since estimated payments are required quarterly but refunds are only
issued annually, there is some opportunity for gaming the system, but I
don't think the rate of return is all that impressive.

But TP is subject to AMT for 2008. There, state taxes are added back into
income. So there wasn't a real tax benefit in 2008. (This was checked using
TurboTax; if the 2008 state estimated tax was reduced to produce no refund,
the federal tax remained the same and schedule A line 5 didn't switch to
sales tax.)

On the 2009 return next year, will there be a calculation that sorts all
this out, so the refund isn't really taxed?
If subject to AMT again in 2009, the refund will be excluded from the
AMT calculation. If not, you could probably perform such a calculation.

-Mark Bole
 
D

D. Stussy

Phil Marti said:
all this out,

Yes. See Publication 525.
Not necessary. AMT means no deduction, so its refund in 2009 is not
recognized.
 
F

Frank S. Duke, Jr.

TP paid too much state estimated tax for 2008, all during 2008.

So on the 2008 federal return, there's a large deduction in Schedule A. But
for 2009 there'll be a state income tax refund.

The refund would typically be taxed as income for 2009, which seems fair
since to balance tax benefit on 2008 Schedule A.

But TP is subject to AMT for 2008. There, state taxes are added back into
income. So there wasn't a real tax benefit in 2008. (This was checked using
TurboTax; if the 2008 state estimated tax was reduced to produce no refund,
the federal tax remained the same and schedule A line 5 didn't switch to
sales tax.)

On the 2009 return next year, will there be a calculation that sorts all
this out, so the refund isn't really taxed? Is there some pitfall to be
avoided about taxes on the refund?

Thanks.
Actually most tax software, including Turbotax has a state tax refund
worksheet and a carryover worksheet to bring over data from the prior year.
In 2009, this worksheet will know that the taxpayer was subject to AMT from
the carryover worksheet. The state tax refund worksheet will ask you if you
want to "recalculate AMT" but does not really say how to do it. I go back to
the prior year return, find a W-2 where most of the state tax was withheld
and put a negative entry in the amount of the state refund on the W-2, right
under the original state tax withholding. The software will scream about
the negative entry but it works. I print page 2 of the form 1040 before and
after. The adjusted tax and AMT are the 2 numbers you need for the 2009
state tax worksheet. Be sure you don't save the adjusted prior year return.

Of course, if you did not prepare the prior year, finding all the
information you need to fill in the state tax worksheet is probably not
worth the trouble.

Uncompensated advice guaranteed correct or double your money back

Frank S. Duke, Jr. CPA
Cincinnati, OH USA
 
F

Frank S. Duke, Jr.

Not necessary. AMT means no deduction, so its refund in 2009 is not
recognized.
Disagree. This is not always true, although it is most of the time. If you
actually do the calculations, sometimes you find that the refund is still
taxable. I am consistently surprised, when I actually go back and adjust
the prior year AMT calculation.

Uncompensated advice guaranteed correct or double your money back

Frank S. Duke, Jr. CPA
Cincinnati, OH USA
 
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D

D. Stussy

Frank S. Duke said:
wrote on 3/13/09 9:27 PM:

Disagree. This is not always true, although it is most of the time. If you
actually do the calculations, sometimes you find that the refund is still
taxable. I am consistently surprised, when I actually go back and adjust
the prior year AMT calculation.

Uncompensated advice guaranteed correct or double your money back
Please provide an example.

Comapring a return with AMT and a deduction for any schedule A tax to the
equivalent return without that schedule A tax yields no difference in the
total tax (although the amount allocated between regular tax and AMT will
change - but the TMT line will not), so where's the tax benefit that says
that the refund is taxable?
 
F

Frank S. Duke, Jr.

Please provide an example.
Taxpayer is filing MFS in 2007 and 2008. AGI in 2007 is $225,805 with
itemized deductions of $24,128. Tax is $56,005 and AMT $2615 for a total of
$58,620. Recalculating the return by reducing the deductions by the $1391
state refund yields deductions of $22,737, regular tax of $56,492 and AMT of
$2,146 for a total of $58,638, $18 more so there was a slight savings from
the state tax deduction. ProSeries makes the whole refund taxable.
Comapring a return with AMT and a deduction for any schedule A tax to the
equivalent return without that schedule A tax yields no difference in the
total tax (although the amount allocated between regular tax and AMT will
change - but the TMT line will not), so where's the tax benefit that says
that the refund is taxable?
Uncompensated advice guaranteed correct or double your money back

Frank S. Duke, Jr. CPA
Cincinnati, OH USA
 
R

removeps-groups

Taxpayer is filing MFS in 2007 and 2008. AGI in 2007 is $225,805 with
itemized deductions of $24,128. Tax is $56,005 and AMT $2615 for a total of
$58,620. Recalculating the return by reducing the deductions by the $1391
state refund yields deductions of $22,737, regular tax of $56,492 and AMT of
$2,146 for a total of $58,638, $18 more so there was a slight savings from
the state tax deduction. ProSeries makes the whole refund taxable.
The change in tax after removing 1391 of state deductions is 487 more,
which is precisely 35% of 1391, subject to rounding error, which makes
sense as the client is in the 35% tax bracket.
However, the increase in AMT is less than $487, which is something I
can't repro on my program.

Here's what I did:

MFS
W2 income of 225,805
Mortgage interest of 10,000 which is allowed under AMT
State tax of 14,128.
Tax is 56,068 and 2,671 for a total of 58,739.

Now with state tax reduced by 1,391, so it is 12737.
Tax is 56,555 and 2,184 for a total of 58,739 (same as before).
Regular tax increased by $487, AMT increased by that same amount.

So something else special must be going on in your return.
 
P

pomegranate-man

Thanks to all who replied.

I found the relevant part of Publication 525:

Subject to alternative minimum tax. If you
were subject to the alternative minimum tax in
the year of the deduction, you will have to
recompute your tax for the earlier year to deter-
mine if the recovery must be included in your
income. This will require a recomputation of
your regular tax, as shown in the preceding
example, and a recomputation of your alterna-
tive minimum tax. If inclusion of the recovery
does not change your total tax, you do not
include the recovery in your income. However,
if your total tax increases by any amount, you
received a tax benefit from the deduction and
you must include the recovery in your income
up to the amount of the deduction that reduced
your tax in the earlier year.
 
D

D. Stussy

The change in tax after removing 1391 of state deductions is 487 more,
which is precisely 35% of 1391, subject to rounding error, which makes
sense as the client is in the 35% tax bracket.
However, the increase in AMT is less than $487, which is something I
can't repro on my program.
Increase? TMT and AMTI should remain the same, so the only "change" to AMT
should be exactly balanced by a change to regular tax.
Here's what I did:

MFS
W2 income of 225,805
Mortgage interest of 10,000 which is allowed under AMT
State tax of 14,128.
Tax is 56,068 and 2,671 for a total of 58,739.

Now with state tax reduced by 1,391, so it is 12737.
Tax is 56,555 and 2,184 for a total of 58,739 (same as before).
Regular tax increased by $487, AMT increased by that same amount.
No. AMT DECREASED by the same amount.
 
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F

Frank S. Duke, Jr.

Increase? TMT and AMTI should remain the same, so the only "change" to AMT
should be exactly balanced by a change to regular tax.


No. AMT DECREASED by the same amount.
I appreciate all the simulating that people have done but to make it correct
you have to have all the data. The ProSeries worksheets associated with the
State Refund calculation go on for 3 pages and ask for more than 20 items of
date from the prior year return, automatically carried forward in all my
returns. I'm sorry but at this time of the year, I just don't have the time
to give you all the details. What I can tell you is that most of the time,
prior year AMT protects the current year refund but it is not always the
case so I always do the prior year recalculation and judiciously check the
numbers if it does not. I have seen the same effect in TurboTax and in
TaxWise.

Uncompensated advice guaranteed correct or double your money back

Frank S. Duke, Jr. CPA
Cincinnati, OH USA
 
R

removeps-groups

No. AMT DECREASED by the same amount.
Oops, I made a typo. Yeah, the AMT is decreased by the same amount so
that the total tax is the same, when we remove a state tax deduction.
But in the OP's situation, the change in AMT is not balanced by a
change to the regular tax. What might the reasons for this be (that
was the point of my post)?

I'm trying to figure out the worksheet in
http://www.irs.gov/publications/p525/ar02.html#en_US_publink100098400.
But if when we remove a state tax deduction, the regular tax increases
by 487 and the AMT tax decreases by 469, then it seems logical that
the benefit from the deduction was (487-469)/487 which is 3.6961%, so
only 3.6961% of the recovery should be taxable.
 
D

D. Stussy

Oops, I made a typo. Yeah, the AMT is decreased by the same amount so
that the total tax is the same, when we remove a state tax deduction.
But in the OP's situation, the change in AMT is not balanced by a
change to the regular tax. What might the reasons for this be (that
was the point of my post)?

I'm trying to figure out the worksheet in
http://www.irs.gov/publications/p525/ar02.html#en_US_publink100098400.
But if when we remove a state tax deduction, the regular tax increases
by 487 and the AMT tax decreases by 469, then it seems logical that
the benefit from the deduction was (487-469)/487 which is 3.6961%, so
only 3.6961% of the recovery should be taxable.
I suggest that you've made a math error. The sum of the digits of the
difference is divisible by 9, so that means that possibly you've transposed
two digits in one of the numbers involved in the computation. What you say
is not possible, as the TMT remains the same. As AMT = TMT - Regular Tax
(where TMT > Regular), any change in the regular tax MUST have a change of
equal magnitude in AMT.
 
K

KEBSCHULLW

pomegranate-man said:
TP paid too much state estimated tax for 2008, all during 2008.
But TP is subject to AMT for 2008. There, state taxes are added back into
income. So there wasn't a real tax benefit in 2008. (This was checked
using > TurboTax; if the 2008 state estimated tax was reduced to produce no
refund, > the federal tax remained the same and schedule A line 5 didn't switch to
sales tax.)
On the 2009 return next year, will there be a calculation that sorts all
this out,
Phil Marti said:
Yes. See Publication 525.
arc.ampr.org
wrote on 3/13/09 9:27 PM:
Not necessary. AMT means no deduction, so its refund in 2009 is not
recognized.
Frank S. Duke said:
Disagree. This is not always true, although it is most of the time. If you
actually do the calculations, sometimes you find that the refund is still
taxable. I am consistently surprised, when I actually go back and adjust
the prior year AMT calculation.
D. Stussy said:
Please provide an example.
arc.ampr.org
wrote on 3/14/09 4:39 PM:
Comparing a return with AMT and a deduction for any schedule A tax to the
equivalent return without that schedule A tax yields no difference in the
total tax (although the amount allocated between regular tax and AMT will
change - but the TMT line will not), so where's the tax benefit that says
that the refund is taxable?
pomegranate-man said:
Thanks to all who replied.
I found the relevant part of Publication 525:
Subject to alternative minimum tax. If you
were subject to the alternative minimum tax in
the year of the deduction, you will have to
recompute your tax for the earlier year to deter-
mine if the recovery must be included in your
income. This will require a recomputation of
your regular tax, as shown in the preceding
example, and a recomputation of your alterna-
tive minimum tax. If inclusion of the recovery
does not change your total tax, you do not
include the recovery in your income. However,
if your total tax increases by any amount, you
received a tax benefit from the deduction and
you must include the recovery in your income
up to the amount of the deduction that reduced
your tax in the earlier year.
To all:

There are two circumstances where a state income tax overpayment in a
year the AMT is paid can produce a tax benefit:

1. The state income tax overpayment causes more of the capital gains
to be taxed at the lower tax rate and fewer of the capital gains to
be
taxed at the higher rate. See page 2 of Form 6251. For tax years 1997
through 2007 the tax
benefit would equal 10% of the overpayment. In 2008, the tax benefit
would be 15% of the overpayment.


2. The state income tax overpayment causes a transition from paying
the only the regular tax to paying the AMT. In this situation a
portion of the refund would be taxable when the AMT is paid.

Cheers,

WDK
 
R

removeps-groups

What does "up to the amount of the deduction that reduced your tax in
the earlier year" mean?
To all:

There are two circumstances where a state income tax overpayment in a
year the AMT is paid can produce a tax benefit:

1. The state income tax overpayment causes more of the capital gains
to be taxed at the lower tax rate and fewer of the capital gains to
be
taxed at the higher rate. See page 2 of Form 6251. Fortaxyears 1997
through 2007 thetax
benefit would equal 10% of the overpayment. In 2008, thetaxbenefit
would be 15% of the overpayment.
Sorry, I'm not following.
 
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K

KEBSCHULLW

What does "up to the amount of the deduction that reduced your tax in
the earlier year" mean?




Sorry, I'm not following.
Look at page 2 of Form 6251 for 2007. There you will find that capital
gains may be taxed at either 5 or 15 percent.

For a taxpayer whose regular taxble income is taxed at a rate below 25
percent, the portion of long-term capital gains that constitute the
difference between the threshold for the 25 percent tax rate and the
taxpayer's regular taxable income, excluding capital gains, are taxed
at 5 percent and the remainder are taxed at 15 percent.

Because state income taxes reduce regular taxable income, excluding
capital gains, and thereby increase the portion of capital gains taxed
at 5 percent and reduce the portion taxed at 15 percent, there is a
tax benefit equal to 10 percent a state income tax overpayment that
reduced the portion of capital gains taxed at 15 percent.

The tax benefit will be revealed by the instructions in Publication
525 that were cited above.

Cheers,

WDK
 
D

D. Stussy

What does "up to the amount of the deduction that reduced your tax in
the earlier year" mean?
Zero, since the tax isn't deductible under AMT. The tax benefit rule
applies in full.
 
K

KEBSCHULLW

Zero, since the tax isn't deductible under AMT. The tax benefit rule
applies in full.


Sorry, I'm not following.

Stussy:

You are right, the tax benefit rule does apply, but zero is not the
answer under the scenario that I described. Here is why.

State income taxes are deductible in determining regular taxable
income.

Regular taxable income is used to determine the long-term capital
gains portion of the AMT.

When the regular taxable income (excluding long term capital gains)
was below the threshold for the 25 percent tax rate, about $63,700
for
MFJ for 2007, the long-term capital gains rate was 5 percent. When
regular income plus capital gains exceeded the threshold for the 25
percent tax rate, the excess capital gains were taxed at 15 percent.

Thus, a state income tax overpayment in a year the AMT is paid can
produce a tax benefit because it can cause more of the long-term
capital gains to be taxed at the lower rate and fewer of the capital
gains to be taxed at the higher rate since itemized deductions impact
regular taxable income and regular taxable income determines the
portions of capital gains taxed at the higher and lower rates.

Hence, there is a tax benefit equal to 10 percent of the portion of
long-term capital gains that was shifted from being taxed at the 15
percent rate to being taxed at the 5 percent rate by a state income
tax
overpayment.

In 2008, the benefit will be 15 percent of the portion of long-term
capital gains that was shifted from being taxed at the 15 percent
rate
to being taxed at the 0 percent rate.

It may be helpful if you construct a dummy return that has regular
taxable income excluding capital gains well below the threshold for
the 25 percent regular tax and with several hundred thousands of
dollars of capital gains so that payment of the AMT is required and
then play around with the amount of state income taxes deducted. I
learned about this a few years ago, after the fact, and the return
was
not a dummy return.

When you understand that a state income tax overpayment can produce a
tax benefit when the AMT is paid, I will tell you about my experience
at
the "Closing the Tax Gap" symposium at Stanford Law School on
November 8, 2008, when I raised the issue of IRS's treatment of state
income tax refunds when the AMT is paid.

Cheers,

WDK
 
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R

removeps-groups

It may be helpful if you construct a dummy return that has regular
taxable income excluding capital gains well below the threshold for
the 25 percent regular tax and with several hundred thousands of
dollars of capital gains so that payment of the AMT is required and
then play around with the amount of state income taxes deducted. I
learned about this a few years ago, after the fact, and the return
was not a dummy return.
Name = AMT State
Filing Status = Single, 1 exemption
State of residence = CA
W2 = 50,000
Long term capital gain = 300,000
Federal tax withheld = 0
State tax withheld on W2 = 2,000
State tax estimated payments = 30,000

Itemized deduction after phaseout = 30,099
Exemption after phaseout = 2,333
Taxable income = 317,568
Tax = 44,988
AMT tax = 10,765
Net tax = 55,753

Now reduce the state tax by 1000 (make the estimated payment 29,000).

Itemized deduction after phaseout = 29,099 (less by 1000)
Exemption after phaseout = 2,333 (same as before)
Taxable income = 318,568 (more by 1000)
Tax = 45,288 (more by 300)
AMT tax = 10,615 (less by 150)
Net tax = 55,903 (more by 150)

So the extra deduction $1000 for state tax did make a difference.
Amazing!

So if you get a refund of $1000, how much of the refund is taxable?

It seems reasonable to me that because the $1000 took $300 off the
regular tax but added $150 back through AMT, the benefit from AMT was
50%, so only 50% of the refund should be taxable. Say someone
deducted $10000 of state tax and got a mere $1 benefit, then if they
get a refund of $5000, does it seem right that the full $5000 is
taxable? Maybe I'm stretching it, but "to the extent" below seems to
support my ratio idea :). The OP said that his tax program claimed
the entire refund was 100% taxable.

<Quote source="http://www.law.cornell.edu/uscode/uscode26/
usc_sec_26_00000111----000-.html">

(a) Deductions
Gross income does not include income attributable to the recovery
during the taxable year of any amount deducted in any prior taxable
year to the extent such amount did not reduce the amount of tax
imposed by this chapter.

</Quote>
 
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