Calculation of Taxable State Tax Refund

[S T]

Is there an update on the amount to report for the taxable portion of the state income tax refund? TB page 3-20 is calculating differently than my Tax Software. Also received an
e-notice from CFS saying the IRS worksheets have modified the caluclation. "Taxable portion of he state income tax refund is limited to the difference between the amount of state income tax deducted and the amount of state and local sales tax that could have been deducted."

Sandy

[JJ EA]

state income tax refund and TBR

There are now 8 questions to ask when your client has a state income tax refund.

1. I think we all ask this one: Did they itemize last year?

2. The new one you mentioned: Is the refund more than the difference between the state income tax deducted and the amount of sales tax that could have been deducted?

3. Is the difference between the standard deduction that could have been deducted and the total itemized deductions actually deducted at least as much as the refund?

4. Did the prior year show a negative taxable income?

5. Is the refund based on payments made in two different years? Such as 4th qtr estimate made in January.

6. Were itemized deductions limited on the prior year's return?

7. Was the taxpayer subject to AMT tax in the prior year?

8.Did the taxpayer have unused tax credits in the prior year?

The good news is that your tax software handles most of these scenarios automatically if you have all of last year's tax return info entered into your program. The bad news is that the software I was using last year did not handle all of the scenarios and when we called the software company they said that none of their competitors software handled all the scenarios either.

It looks like the worksheet on TB 3-20 will answer no. 3 above and your software has probably calculated based on one of the other scenarios that apply.

[S T]

Tax Software Calc

Yes, that is what drew my attention to this issue. My Tax software is calculating based on the difference between the Tax Refund and the scenario as if the taxpayer would have used the Sales Tax Calculation.
CFS sent an email also to this effect last week.
What is confusing me is I can not find the modified worksheets. What is in TB 3-20 and also Pub 525 instructions as well as 1040 instructions, does not take into account for the State Income Deduction and the Sales Tax Deduction and only limiting the state tax refund subject to tax to the difference between the figures.
Where can we find the modified worksheets?
Sandy

[S T]

Doesn't seem like it

No JG, based on my tax software and what CFS just sent over there is a modified worksheet.
Line 1 is the amount of 2004 state refund
Line 2 is the amount of state tax paid in 2004 relating to this refund
Line 3 is the amount of state tax paid in 2005 relating to this refund
Line 4 is the Total (line 2+3)
Line 5 is Line 3/by line 4, round to 4 decimals
Line 6 is Line 5 x line 1, this is the portion of refund relating to 2005
Line 7 is Line 1 less line 6, this is the potential taxable portion of refund

Line 8 is 2004 state income tax paid (amount from line 2)
Line 9 is 2004 state and local SALES TAX that COULD have been deducted on 2004

Line 10 is Line * less Line 9

Line 11 is Lesser of line 7 or line 10

Line 12 is Total Allowable itemized from 2004 "A" line 28
Line 13 is Allowable Standard for 2004 based on 2004 filing status
Line 14 is Extra Standard for blind or over 65 based on 2004 filing
Line 15 is add line 13 and 14

Line 16 is Line 12 less line 15, but not less than zero
Line 17 is Smaller of line 16 or line 11
Line 18 is Adjustment due to 2004 Schedule A phaseout, if any
Line 19 is Adjustment due to 2004 AMT if any
Line 20 is Other adjustment

Line 21, NET TAXABLE 2004 STATE TAX REFUND, line 17 less lines 18,19,20, Enter on line 10 of form 1040.

Based on the above, all of mine state tax refunds are being limited to the difference of what the refund from State received less the sales tax deduction that the taxpayer could have taken. Example had one that calculated as follows: $626 State refund, however based on the above, don't claim $626 as a refund only claim $21 which was the difference between line 8 and line 9.

Have you seen the modified worksheet??? Was probably just released this last week.

Sandy

[S T]

Copy of CFS email received

Heres is a copy of the CFS email that I received

Recent IRS Clarification Affects Tax Benefit Rule

Modified tax benefit rule and state income vs. sales tax deduction

Recent IRS worksheets have modified the calculation of the taxable portion of the state income tax refund to be reported in 2005 & 2006. The taxable portion of the state income tax refund is limited to the difference between the amount of state income tax deducted and the amount of state and local sales tax that could have been deducted.

This changes the initial analysis in the TaxTools worksheet State/Local Sales Tax Deduction Calculation and Comparison to State Income Tax Deduction. Before these clarifications it wasn't clear that the following year's taxable state income tax refund was limited to the difference between the state income tax and state sales tax deduction. Recent IRS instructions for 1040 line 10 and Pub 525 clarify that the taxable portion is limited.

Some taxpayers would have been penalized for choosing to deduct state income tax and not looking at the net two-year tax benefit. Example: For 2004 taxpayer can choose a $9,000 state income tax deduction or an $8,000 state sales tax deduction. Taxpayer chooses to deduct the state income tax. In 2005, taxpayer receives a $2,500 state income tax refund. Before the new clarifications, taxpayer would have included the entire $2,500 refund in his 2005 income. This may have resulted in a lower two-year tax benefit for the taxpayer than if he would have chosen to deduct state sales tax. The new clarifications state that the taxpayer only needs to include $1,000 of the refund since he could have deducted $8,000 in state sales tax.

Because of these changes, we have restored last year's module to TaxTools 2006. This will allow tax preparers that did not calculate the allowable state sales tax deduction for 2004 to limit the taxable portion of the 2005 state income tax refund to the difference between the deductible state income tax and state sales tax. The 2006 module also displays a message stating that the 2006 taxable state income tax refund to be entered is limited to the difference between the amount of the state income tax deduction and the amount of the state and local sales tax deduction.

Sandy

[JG EA]

Sandy,

I reread your post and realized that you were saying it was not sufficient and so deleted my post. I will print out your information because it will help me. No I'm afraid I haven't, at this point ,seen a new and better worksheet. I looked it up in 1040 instructions and was basing my question on that.

Actually you've provided more information by asking your question!
JG

Good Idea about subscribing to TT - I'll do that, but isn't it hard keeping up with everything!

[S T]

TB Editors

Actually I am hoping that TB will provide an update here on the board. Just seemed weird when I was processing returns and double checking, so started to investigate and found the CFS email. All of my state tax refunds are minimal (difference between the two) rather than the usual full amount of the refund that we expect as as stated in TB and 1040 instructions.

By the way JG I think you subscribe to TT so you can go to their website and subscribe to emails and updates, much the same as TB.

Sandy

[Bees Knees]

TheTaxBook, page 3-19, says do not use the worksheet on page 3-20 if any of the following apply:

"The 2004 state and local income tax refund is more than the 2004 state and local income tax deduction minus the amount that could have been deducted as 2004 state and local general sales tax."

TTB says to see Itemized Deduction Recoveries in IRS Pub 525 if the above applies.

[Bees Knees]

The discussion is on page 20 of IRS Pub 525

http://www.irs.gov/pub/irs-pdf/p525.pdf

It doesn't look like the IRS is providing a worksheet for this situation, but it does provide two examples:

"For 2005, the refund that you must include in
income is limited to the excess of the tax you
chose to deduct over the tax you did not choose
to deduct.

Example 1. For 2004 you can choose an
$11,000 state income tax deduction or a
$10,000 state general sales tax deduction. You
choose to deduct the state income tax. In 2005
you receive a $2,500 state income tax refund.
You must include $1,000 of the refund in your
income since you could have deducted $10,000
in state sales tax.

Example 2. For 2004 you can choose an
$11,500 state general sales tax deduction
based on actual expenses or an $11,200 state
income tax deduction. You choose to deduct the
general sales tax deduction. In 2005 you return
an item you had purchased and receive a $500
sales tax refund. In 2005 you also receive a
$1,500 state income tax refund. You must in-
clude the $500 sales tax refund in your income
since it is less than the excess of the tax de-
ducted ($11,500) over the tax you did not
choose to deduct ($11,200 - $1,500 = $9,700).
Since you did not choose to deduct the state
income tax, you do not include the state income
tax refund in income.

[S T]

Muddled Through It

Thanks Bees,
Sometimes things just don't seem right, but after going through the Tax Software Calc, TB, and Pub 525 finally got there and it started to make some sense.

Sometimes it is just so difficult to understand things without a worksheet.

Sandy

[Bees Knees]

To modify the worksheet on page 3-20, I would simply change the wording for line 7 to say: "Taxable part of refudnd. Enter the smaller of line 1, or line 6, or the excess of the state income tax you chose to deduct over the state sales tax you did not choose to deduct."

[Snaggletooth]

IRS "Matching" Program

Can you imagine what is happening to the IRS "Matching" Process for Information Returns on this subject?

In this case, the 1099-G from the various states. Used to be as easy as falling off a log. But now with the advent of deductible sales taxes, which in most cases are not even disclosed on the 1040, matching a 1099-G to the "difference" will not be possible. Until there is something more sophisticated, IRS will have to choose between (1)abandoning their matching of the 1099-G and (2)hassling taxpayers to collect on refunds that were not fully taxable.