Tax Benefit Rule
The tax benefit rule provides an exception to the general rule that a deduction (or credit) taken in a prior year must be included in gross income in the year of recovery. If and to the extent the earlier deduction (or credit) does not reduce taxes, under the tax benefit rule, the recovery is excluded from the current year’s gross income. Although it would be logical to go back and restate the original transaction, the IRS prefers certainty, closure, and “administrative convenience”: to go back and monkey with a prior year’s transaction would run counter to the Service’s long standing principle that a tax year is a closed and separate event.
For example, assume that amounts paid and deducted for medical expenses in, say, 2007, are reimbursed by the taxpayer’s insurance carrier in 2008. To the extent that the 2007 deduction bolsters the taxpayer’s itemized deductions so that they exceed the applicable standard deduction amount (no mean feat given that medical expenses are deductible only to the extent they exceed 7.5% of adjusted gross income), a tax benefit results and the taxpayer would have to include in gross income the lesser of the insurance reimbursement or the amount by which the total for 2007 itemized deductions listed on Schedule A (pdf file) exceeds the standard deduction amount. There is nothing special about the standard deduction amount and the taxpayer who chooses this option receives no tax benefit for the year in question (provided, of course, that the taxpayer doesn’t have any other deductions or credits subject to recovery in later years, e.g., above-the-line deductions in 2007 for moving expenses (pdf file) that are reimbursed by the taxpayer’s employer in 2008). Therefore, in calculating the recovery amount (pdf file) the taxpayer includes in gross income, we must first determine the amount of the 2007 tax benefit (i.e., the amount by which itemized deductions exceed the standard deduction amount) and then include in gross income the lesser of the insurance recovery or the excess of itemized deductions over the standard deduction. The topic of property tax rebates (pdf file) is another area where the tax benefit rule is commonly applied.
One more comment: The tax benefit rule focuses on the previous year’s deduction, not the actual tax paid. Put differently, it does not consider the the taxpayer’s tax bracket; the taxpayer comes out even only if the he or she stays in the same bracket. But if you move up to a higher bracket then you must include the recovery in income at a higher tax rate and therefore lose out in the deal.
Other useful articles about the tax benefit rule are listed below:
- The Tax Benefit Rule (pdf file)
- State Income Tax Refunds - Tax Benefit Rule (pdf file)
- Recovery of tax benefit items
- John Hancock Financial Services v. United States (see especially paragraph 14 of opinion)
- Gold Kist, Inc. v. Commissioner (see esp. para. 15 of opinion)
Many happy returns, Roger
Tax Avoidance
A concept appearing time and again in leading tax resources is the idea of “tax avoidance,” and I illustrate this key concept using the example of a clever and complicated tax shelter.
In my research, whether reading law school textbooks on federal income taxation or one of many helpful practitioner guides, the concept of substance over form explains decisions made in many important court cases and serves as a standard to guide practice. In a word, the lay person and the practitioner must understand the “meat” or substance of controversial tax issues in order to structure transactions so they meet not only the letter but also the spirit of the law. If a transaction serves no other purpose than that of tax avoidance you can expect the Commissioner of the Internal Revenue Service and courts of law to reject your claim for favorable tax treatment.
One area where the doctrine of substance over form is commonly applied is litigation examining the economic substance and business purpose of tax shelters (and the very label of “tax shelter” is a clue that the writer of the opinion or law school textbook is a most unsympathetic critic of the taxpayer’s argument).
For example, in ACM Partnership v. Commissioner, a case in the Third Circuit of Appeals (1998), Colgate-Palmolive sells (in 1988) a wholly-owned subsidiary for a long-term capital gain of approximately $104 million. In order to create a tax loss to offset its large gain, Colgate enters into partnership with ACM (owned 94% by Colgate) and makes an installment sale of property to a nontaxable foreign entity. In the first year of the installment sales contract, the foreign entity has a large interest in the partnership and reports a large nontaxable gain, “owning” over 90% of that gain. In year two, after adjustment of ownership interests so that ACM now owns most of the partnership with the foreign entity, the property is sold at a loss, and presto!, ACM (i.e., Colgate) is the beneficiary of a large tax loss it uses to offset Colgate’s $104 million gain.
In the majority opinion, the court looks to the economic substance (pdf file) of this complicated transaction and finds little substantial economic effect other than the conjuring up of a tax loss to offset Colgate’s earlier taxable gain. Moreover, it finds a glaring absence of a sound business purpose and rules the real purpose of the transaction is a scheme to avoid federal income taxes.
Here are some additional resources on tax avoidance:
Many happy returns, Roger