Tax Benefit Rule
Posted on May 19, 2008
Filed Under Federal Income Tax, Key Concepts
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
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