Overpaid state witholding -- strategy?

I'm in a situation where the amount I paid California in

2006 estimated tax payments during 2006 is considerably more than my actual tax liability.

Is it possible to not claim the excess amount paid on Schedule A, such that the refund received in 2007 becomes not federally taxable? If not, are there any other strategies? (Not itemizing in 2006 seems one approach.)

Thanks,

Steve

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Reply to
Steve Pope
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Claiming only part of your payment on Schedule A won't help. The only thing that would make the refund nontaxable would be not itemizing on 2007. This doesn't make much sense to me off the top of my head, but you could always file 2006 with the standard deduction, wait until the 2007 dust settles, and then amend 2006 to itemize if it turns out that was the way to go.

-- Phil Marti Clarksburg, MD

Reply to
Phil Marti

"Steve Pope" wrote

In this case, you are free to not claim as as itemized deduction, all that was withheld/paid.

-- Paul A. Thomas, CPA Athens, Georgia

Reply to
Paul Thomas

Provided only that not claiming the deduction does not lower your federal taxes (think AMT, for an example) then you are not required to claim the deduction. dick w

Reply to
Dick Weaver

Steve, you may choose to use the sales tax deduction which will result in no income reporting of the refund of state taxes. You may also deduct only the taxes actually paid for state taxes, and choose to allow the state to keep the refund for the next year taxes as well.

Reply to
mytax

A state tax credit that rolls to your account for next year is still reported by the state on a 1099G and may be reportable on Form 1040 Line 10. __ Art Kamlet ArtKamlet @ AOL.com Columbus OH K2PZH

Reply to
Arthur Kamlet

Thanks to all who replied. Since I am below the AGI threshold that limits itemized deductions, the benefit of the deduction of the full amount of state estimated tax paid will be limited only by AMT. And the way I read pub 575, I will get this AMT back when in the following year I compute the amount of the state refund that is taxable. (True?)

The amount of state estimated tax I overpaid in 2006 is large, but the total is still only about 2/3 of my 2005 state tax liability, so I think I'm okay as far as claiming it goes. Steve

Reply to
Steve Pope

Yes, that's the gist of the problem here. I risk paying double Federal tax on the amount I overpaid.

My belief is that if I simply don't deduct the excess estimated tax payments, and then try to claim I don't owe tax on the refund (since it was never deducted), while this seems righteous I will lose (although if anyone has tried exactly that, I'm interested to hear what happened.). (And whether I use the refund to pay future state tax is immaterial.)

Steve

Reply to
Steve Pope

I looked at line 10 of the 2006 1040. It says to look on page 24. Page 24 says: "None of your refund is taxable if, in the year you paid the tax, you either (a) did not itemize deductions, or (b) elected to deduct state and local general sales taxes instead of state and local income taxes." it also says "If the refund was for a tax you paid in 2005 and you deducted state and local income taxes on line 5 of your 2005 Schedule A, use the worksheet below to see if any of your refund is taxable." This sounds simple enough, but are you suggesting you will deduct in 2005 not ALL of your state income tax payments?

Reply to
Gil Faver

The IRS instructions are pretty clear that the state tax refund is taxable only to the extent that you got a benefit the previous year by deducting the corresponding state tax withholdings or estimated payments. See the instructions for line 10 of 1040, which has a worksheet. It also refers you to Pub. 525 for more complex situations (i.e. if you didn't benefit from the deduction due to deduction phase-out or paying the AMT, among other reasons). There is a thread on the fairmark message board that has just gotten into a related topic, although the thread started on a different topic. It discusses whether you have the option to not deduct the full state tax paid in one year in anticipation of a refund the next year. The conclusion seems to be that you can.

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Steve

Reply to
Hiker

Thanks, that seems very useful. The part that one cannot amend to take a lower deduction (only higher) is very interesting; I hadn't heard of that before. My EA is planning to run several scenarios and then I can combine that information with all the seemingly subjective info on IRS positions and make a decision which way to go. Steve

Reply to
Steve Pope

Won't work due to my particular numbers.

That is one of the ideas on the table, and there's some support for it in the link in Hiker's post to this thread. Steve

Reply to
Steve Pope

Maybe I have done it wrong for 50 years, but this is what I do and I haven't heard a peep out of the IRS yet (it's a moot point with me now since I am retired and no longer itemize). When preparing my taxes I figure the fed and state (CA) taxes. The figure that I use on the federal form for itemizing state taxes is the actual calculated _tax_ paid for the tax year regardless of the amount withheld if the withholding was more. The next year I do not list the refund at all because I never deducted it during the previous year. I have always figured that there is a difference between the _tax owed_ (the actual amount that the state wants for the tax year), and the _amount withheld_ (a wild ass guess as to what the actual tax might be, but often wrong). I have always disregarded the withheld amount (for federal deduction of state taxes) and used the actual number instead. The IRS has always accepted this.

--

-Ernie-

Reply to
Ernie Klein

As a general rule, you cannot reduce your claimed deduction for state taxes paid for the current year's federal income tax return by the amount of any state tax refund you anticipate receiving in the next year. Code Sec. 164 allows a deduction for the taxable year in the amount of any state taxes paid or accrued within that taxable year. Since most individuals are cash-method taxpayers, the operative word is "paid." The general effect of this provision is that, if in Year 1 you remitted an amount to a state taxing authority in payment of your state tax liability, that amount is an amount of state taxes "paid" within Year 1 and the deduction therefore is only allowed for Year 1. Under the general rule of Section 61, assisted by the tax benefit rule (see, e.g., Arrowsmith v. Commissioner), a recovery or reimbursement in Year 2 for any amount of state taxes paid in Year 1 is included in gross income in Year 2, except to the extent that (a) the deduction allowed for that amount in Year 1 did not reduce the income tax due for Year

1, see Section 111, or (b) no deduction was allowed (emphasis on "allowed," not on "claimed") for Year 1, see the tax benefit rule. It needs to be emphasized that the focus under both Section 111 and the tax benefit rule is the degree to which a deduction was "allowed" for Year 1, not the degree to which such a deduction was actually claimed. Thus, if you actually paid $500 to State A as State A income tax in Year 1, you are allowed a deduction of $500 for Year 1 under Sec. 164. If you choose, instead, to claim a smaller amount, that is your choice, and you cannot rectify the effects of that choice in a later year (i.e., you must amend the return for Year 1 to claim the greater deduction - the amendment is permitted because the event on which the amendment is based, actual payment, occurred in Year 1). If in Year 2 you receive a refund from State A of overpaid State A income taxes for Year 1 in the amount of $100, you must include that $100 in income for Year 2 unless either (a) claiming the deduction for that amount on your Year 1 return did not reduce your Year 1 federal income tax, see Section 111, or (b) no deduction was allowed for that amount in Year 1. Thus, if you intentionally overpay your State A income tax in Year 1 by $200, and receive a refund of that amount from State A in Year 2, you must include that $200 in income for Year 2 regardless of whether or not you claimed a deduction for that amount in Year 1 unless either (a) claiming the deduction would not have reduced your tax due for Year 1 (Sec. 111) or (b) a deduction for that amount was not allowed for Year 1. As a result, unless you can prove that, under some theory, you would not have been allowed a deduction for that $200 in Year 1 under Sec. 164, or you can prove that your Year 1 tax liability would not have been reduced had you in fact claimed a deduction for Year 1 of that $200, then you must include that $200 in your gross income for Year 2. Thus, if in Year 1 you anticipate that you will be getting a refund in Year 2 of $x of state income tax you actually paid in Year 1, you will only be hurting yourself because you will have overstated your income for Year 1 without being able to rectify that situation by understating your income for Year 2 by not reporting the refund received in Year 2. The rationale for this is: you were allowed (again, emphasis on "allowed" not on "claimed") a deduction in Year 1 for the $x you paid in Year 1, and thus you cannot exclude that amount from your Year 2 income under Section 111 because that section only applies to deductions "allowed" that did not decrease your Year 1 tax liability, and without any other facts, your Year 1 tax liability would have been reduced had you in fact claimed the allowed deduction of $x in Year 1. By similar reasoning, under the tax benefit rule, since you were allowed a deduction for that $x in Year 1, you must include the refund received in Year 2 as income for Year 2. The reason why you cannot simply amend your Year 1 return to claim the lower deduction on account of the receipt of the refund in Year 2 is because of the general principle that each tax year must stand on its own, and each year's tax liability is determined based on the events occurring during that year. Since you actually paid $x in Year 1, and did not receive the refund of $x until Year 2, the only relevant event that can be taken into account in determining your tax liability for Year 1 is the fact of payment of $x; since the offsetting refund received did not occur until Year 2, it cannot be taken into account in determining your tax liability for Year 1. However, you can amend your Year 1 return to increase the deduction you claimed (to the extent of your actual payments made during Year 1) for the same reason - the payment took place in Year 1 and thus the only tax year in which it can be taken into account is Year 1. As a result, if you initially failed to take that payment into account on your initial return for Year 1, you may amend your Year 1 return to take that payment into account and claim the larger deduction for Year 1. As a corrollary, you cannot take the additional deduction on your Year 2 return because the relevant event, payment of $x, occurred in Year 1 and therefore cannot be taken into account in Year 2, or any other year other than Year 1. That, in a nutshell explains why you can amend your Year 1 return to claim a larger deduction, but cannot amend your Year 1 return to claim a smaller deduction (unless, of course, you really didn't pay in Year 1 the amount claimed as a deduction for Year 1, in which case you should amend your return to claim the smaller deduction). Finally, the topic of making a "bad-faith" payment in Year 1 was raised. Another general principle of tax-law is that a deduction claimed for a payment made is only allowed if the payment actually made comports with the substance of the rationale for which the deduction was allowed - i.e., substance over form. Sec. 164 only permits a deduction for state taxes, a tax being a compulsory levy, and not for voluntary payments. Thus, if under all possible circumstances your state tax liability for Year 1 would never exceed $500, and if you paid $1,500 to the relevant state taxing authority in Year 1 at a time when it was, or should have been, obvious to you that your tax liability was only $500, then you would not be permitted to claim a deduction for the excess $1,000 payment you made because that payment was in substance a purely voluntary payment and bore no relationship to the sort of compulsory levy that constitutes a "tax." It should be noted, this is a case-law doctrine, not a Code provision, so you won't find any section in the Code that explicitly imposes this limitation. As a result, when you receive a refund of $1,000 from the state in Year 2, that $1,000 would not be included in gross income for Year 2 because, under the tax benefit rule, that refund represents a recovery of an amount paid in Year 1 that provided no tax benefit in Year 1. It should be noted, however, that the state will provide you with a 1099, and the refund will be reported to the IRS, which will be expecting that amount to be included in income, so you had better attach a Disclosure Statement to your Year 2 return explaining why you did not include the amount in income; otherwise, you will most assuredly be assessed a deficiency for Year 2. It should also be noted that trying to prove that your overpayment of state tax in Year 1 was not in good faith and that therefore a deduction for the overpayment would not have been allowed for Year 1 under Sec. 164 is an extremely hard uphill battle. You will, generally, be bound by the consequences of your own actions, and will generally not be permitted to gainsay those actions at a later date - this is analogous to the doctrine that, absent a showing amounting to fraud, a taxpayer is generally not permitted to deny or disclaim the form in which he chose to cast his transactions (see, e.g., Moline Properties). As a result, the IRS will almost always prevail on the argument that (a) you were allowed a deduction in Year 1 for the amount of the overpayment and thus (b) you are required to include the amount of the refund as income in Year 2. The fact that you didn't actually claim the deduction in Year 1 will, generally, be irrelevant to the issue of whether the refund must be included in income for Year 2, and your only remedy will be to file an amended return for Year 1 to claim the additional deduction. This result is part of the more general principle that your tax returns should reflect your true income, and that income and deductible expenses be matched on an annual accounting period basis. In other words, allowing you to voluntarily overpay your state taxes in Year 1 and claim a deduction therefor, and to then report the refund thereof as additional income in Year 2 would be to permit you to massage your income solely for the purpose of tax minimization, and would flout the requirement that your returns clearly reflect your economic income. The bottom line is: you really cannot "manage" your income by netting an anticipated Year 2 refund of state tax against the amount of state tax actually paid in Year 1 in order to claim a smaller deduction for Year 1. Additionally, while you can probably engage in some small-scale income shifting by overpaying your state taxes in Year 1, you are unlikely to get much benefit out of doing so if your intentional overpayment so grossly exceeds your actual state tax liability that your Year 1 deduction will be denied. While an exorbitant claim would probably get through the initial automated review, the exagerated claim would most likely trip the DIFF score red-flag, and would result in an audit for Years 1 and 2.
Reply to
Shyster1040

As I discuss in (perhaps unnecessary detail) in another post on this thread, voluntarily choosing to claim a deduction for less than all of the state income tax you actually paid in Year 1 will not, of itself, permit you to exclude from income for Year 2 the state income tax refund you receive in Year 2. The rationale turns on the fact that both Section 111 (which permits the excusion of recoveries of amounts paid that were allowable as a deduction but did not actually reduce your tax liability for the year in which allowed) and the tax benefit rule turn on whether or not a deduction was "allowed" in the prior year for an amount paid in that prior year, and not on whether the deduction was actually "claimed" for that prior year. Thus, even if you don't claim the deduction for 2006, you will still be required to include the refund in income for

2007 if the deduction was allowed for 2006 under Sec. 164. You will therefore merely overstate your income for 2006 without being able to understate your income for 2007.
Reply to
Shyster1040

If true then that's the ultimate tax straddle. Are there no limits?

That would be the point - a deduction in year 1 and shifting that income to year 2. If I have a particularly good year that puts me into a higher tax bracket, overpaying state tax this year can be a way to keep the extra income in a lower bracket by shifting it to next year when I don't expect to make as much. Stu

Reply to
Stuart A. Bronstein

My late husband did the same thing for about 15 years, from the early 1960's to the mid 1970's when I went back to school and studied taxes and figured out that he was wrong! And the IRS never questioned us either. But that doesn't mean it was right. As a cash method taxpayer you deduct the tax you paid during the year -- not the actual tax liability shown on your return for that year. That would be the accrued tax, not the tax paid. Katie in San Diego

Reply to
Katie

Did you mean "Provided only that not claiming the deduction LOWERS your federal taxes (think AMT, for an example) then you are not required to claim the deduction"? There used to be a situation where not claiming a deduction reduced the AMT because of a drafting error related to the way capital gains were taxed under the AMT but Congress fixed that a couple of years ago. Cheers, WDK

Reply to
KEBSCHULLW

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