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Taxable Refunds and the AMT

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This entry was posted on 4/24/2007 8:56 PM and is filed under uncategorized.

A client of mine recently received a CP2000 notice from the IRS, proposing that they include their state income tax refund received during 2005 in their taxable income. Based on my advice, he replied that it was not taxable. I am confident the IRS will go along with this.

My client's 2004 Federal 1040 had about $1200 of Alternative Minimum Tax (AMT) on it. He had to pay that much AMT on top of his regular tax for 2004. His 2004 state return resulted in an $800 refund. He did itemize his deductions in 2004 and claimed $9000 of state income taxes as a deduction. It would seem he would have to claim a refund as taxable, but that is not the case.

Since he could have claimed only $8200 of state income taxes and still got the same bottom line number on his 2004 1040, the refund is not taxable. He could have claimed only $8200 of state taxes and got the same answer because of the AMT. Often the AMT results in this: No matter how much in state taxes you add in to your itemized deductions, your total tax doesn't change, because as you lower your regular tax by $100, your AMT rises by $100. Since my client was in this flat zone, another $800 of state income taxes (the amount of his refund,) did him no good in 2004, so it is not taxable as a refund in 2005.

There is a term some accountants use. It is "buried". He had so much in state income taxes deducted, that more of the same, would have done him no good. Think of it as meaning, you have reached zero, and can go no lower. At the point where you have so much in deductions, that additional deductions do you no good, you have buried something, in this case, his state income tax deduction. Other clients of mine, bury their taxable income. They have so much in deductions, they have negative taxable income. This matters when they get a state income tax refund, and we have to decide if it is taxable?

So my client with the AMT in the prior year, doesn't have to report his state income tax refund as taxable, but there are cases where one can have AMT in the prior year, and have at least a partially taxable state income tax refund. I have not covered all situations here. What helps in following along with this situation, is a cardinal rule of tax preparation: The tax benefit rule. If you derived a benefit from a prior deduction, a refund is at least partially taxable. If you did not derive a benefit, a refund is not taxable. What you may find helpful here is IRS Publication 525, pages 25-26 of the 2006 edition. What is missing from publication 525 is a worksheet for this specific situation.


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    • 5/9/2008 9:53 AM WD Kebschull wrote:
      I agree with the what was posted regarding the taxation of state income tax refunds. However, there are situations regarding state income tax refunds and the AMT that were not covered.

      If there is a limited long-term capital gains rate based tax benefit in a year that the AMT is paid as a result of a state income tax overpayment causing more of the capital gains to be taxed at the lower rate (5 percent in 2007) and fewer of the LTCG's to be taxed at the higher rate (15 percent in 2007) there is a tax benefit of 10 percent of the tax overpayment that produced this benefit. Thus that portion of the refund would be "taxable".

      However, I submit that, based on the language in section 111(a) of the Internal Revenue Code, the refund can only be used to increase the portion of capital gains taxed at 15 percent rather than 5 percent.

      Based on IRS instructions (see publication 525) the taxable refund will be included in gross income where it can be taxed at the regular tax rate after the income used to overpay the state income tax in the year that the AMT paid was taxed at the AMT rate.

      Interestingly, tax refunds that produced a tax benefit in a year the regular tax was paid are excluded from alternative minimum taxable income as a result of the instruction on Line 7 of Form 6251. Clearly, IRS instructions are in conflict with section 56(b)(1)(D) of the Internal Revenue Code.

      Here is the link to comments that I summited to a House Ways and Means subcommittee last year.
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