Overpay state tax on purpose to get a higher federal refund

My co-worker (no, not me!) is convinced this will work. He is single, makes about $70-$80K, and lives in California and will itemize deductions in 2006 but not 2007. Oh, and he's
annoying and keeps talking about this brilliant plan so I don't want this to work out for him: 1. This month (Dec 2006), send in a $5,000 extra for state taxes using California's 540-ES estimated tax form. 2. File CA state 2006 taxes as soon as possible in 2007 to get the $5,000 overpayment back by, say, March. 3. File federal 2006 taxes in April 2007, itemizing deductions, including that $5,000 overpayment. 4. In 2008, when it comes to file 2007 taxes, the $5,000 CA state tax refund he'll get back in March 2007 is apparently not taxable, at least according to the "State and Local Income Tax Refund Worksheet-Line 10" on page 24 on the 2006 1040 instructions. Net result: He has loaned the state of California $5,000 interest-free for about 3 months, losing a little in interest (5% x 3/12 x $5000 = $62.50), but gaining $1,400 (28% x $5,000) in reduced federal taxes. How can an overpayment not be taxable the next year, especially if it is used just to result in reducing federal taxes the previous year?? This doesn't smell right but I can't poke a hole in it. << ======================================================= >> << The foregoing was not intended or written to be used, >> << nor can it used, for the purpose of avoiding penalties >> << that may be imposed upon the taxpayer. >> << >> << The Charter and the Guidelines for submitting posts >> << to this newsgroup as well as our anti-spamming policy >> << are at www.asktax.org. >> << Copyright (2006) - All rights reserved. >> << ======================================================= >>
Add pictures here
<% if( /^image/.test(type) ){ %>
<% } %>
<%-name%>
Add image file
Upload

He has misinterpreted the intent & purpose of the instructions. He will get a bill some time before 4/15/2011 interest & penalty on top of the income taxes due on the under reported SITR (State Income Tax Refund) << ======================================================= >> << The foregoing was not intended or written to be used, >> << nor can it used, for the purpose of avoiding penalties >> << that may be imposed upon the taxpayer. >> << >> << The Charter and the Guidelines for submitting posts >> << to this newsgroup as well as our anti-spamming policy >> << are at www.asktax.org. >> << Copyright (2006) - All rights reserved. >> << ======================================================= >>
Add pictures here
<% if( /^image/.test(type) ){ %>
<% } %>
<%-name%>
Add image file
Upload

How does that worksheet lead him, or you, to conclude that the refund is not taxable? The refund would be taxable. He is probably doing something wrong on the worksheet. In 2008, when he files for 2007, the worksheet will refer to his 2006 tax return, not his 2007 tax return, just as it now refers to 2005 when you are filing for 2006. The worksheet is based on the year you took the deduction, not the year you got the refund. Is that the misunderstanding? Bob Sandler
<< ======================================================= >> << The foregoing was not intended or written to be used, >> << nor can it used, for the purpose of avoiding penalties >> << that may be imposed upon the taxpayer. >> << >> << The Charter and the Guidelines for submitting posts >> << to this newsgroup as well as our anti-spamming policy >> << are at www.asktax.org. >> << Copyright (2006) - All rights reserved. >> << ======================================================= >>
Add pictures here
<% if( /^image/.test(type) ){ %>
<% } %>
<%-name%>
Add image file
Upload

I'm not a tax pro, but I think the wheels come off the wagon at this step. Your friend should check his math.
-- Vic Roberts Replace xxx with vdr in e-mail address.
<< ======================================================= >> << The foregoing was not intended or written to be used, >> << nor can it used, for the purpose of avoiding penalties >> << that may be imposed upon the taxpayer. >> << >> << The Charter and the Guidelines for submitting posts >> << to this newsgroup as well as our anti-spamming policy >> << are at www.asktax.org. >> << Copyright (2006) - All rights reserved. >> << ======================================================= >>
Add pictures here
<% if( /^image/.test(type) ){ %>
<% } %>
<%-name%>
Add image file
Upload
<snip cow-orker's cunning plan>

He's making a mistake on the worksheet.
-- D.F. Manno | snipped-for-privacy@mail.com Now this is not the end. It is not even the beginning of the end. But it is, perhaps, the end of the beginning. Winston Churchill << ======================================================= >> << The foregoing was not intended or written to be used, >> << nor can it used, for the purpose of avoiding penalties >> << that may be imposed upon the taxpayer. >> << >> << The Charter and the Guidelines for submitting posts >> << to this newsgroup as well as our anti-spamming policy >> << are at www.asktax.org. >> << Copyright (2006) - All rights reserved. >> << ======================================================= >>
Add pictures here
<% if( /^image/.test(type) ){ %>
<% } %>
<%-name%>
Add image file
Upload

I think he needs to re-read the instructions.
The instructions are applying the tax benefit rule, and since he received the benefit from itemizing his 2006 deductions, the refund of his 2006 state tax will be taxable. __ Art Kamlet ArtKamlet @ AOL.com Columbus OH K2PZH
<< ======================================================= >> << The foregoing was not intended or written to be used, >> << nor can it used, for the purpose of avoiding penalties >> << that may be imposed upon the taxpayer. >> << >> << The Charter and the Guidelines for submitting posts >> << to this newsgroup as well as our anti-spamming policy >> << are at www.asktax.org. >> << Copyright (2006) - All rights reserved. >> << ======================================================= >>
Add pictures here
<% if( /^image/.test(type) ){ %>
<% } %>
<%-name%>
Add image file
Upload

He'll lose the audit when they challenge the overpayment.
Seth
<< ======================================================= >> << The foregoing was not intended or written to be used, >> << nor can it used, for the purpose of avoiding penalties >> << that may be imposed upon the taxpayer. >> << >> << The Charter and the Guidelines for submitting posts >> << to this newsgroup as well as our anti-spamming policy >> << are at www.asktax.org. >> << Copyright (2006) - All rights reserved. >> << ======================================================= >>
Add pictures here
<% if( /^image/.test(type) ){ %>
<% } %>
<%-name%>
Add image file
Upload
FredK wrote:

This where his "plan" falls apart. The refund, to the extent that he got a tax benefit from it the previous year IS taxable in the year of the refund. Tell him to read the instructions again. << ======================================================= >> << The foregoing was not intended or written to be used, >> << nor can it used, for the purpose of avoiding penalties >> << that may be imposed upon the taxpayer. >> << >> << The Charter and the Guidelines for submitting posts >> << to this newsgroup as well as our anti-spamming policy >> << are at www.asktax.org. >> << Copyright (2006) - All rights reserved. >> << ======================================================= >>
Add pictures here
<% if( /^image/.test(type) ){ %>
<% } %>
<%-name%>
Add image file
Upload
FredK wrote:

Oh, it's taxable alright. The 1040 instructions are not being understood correctly. Since he itemized in 2006 (the year he paid the state tax) and got a tax benefit, the refund will be taxable in 2007 (whether or not he itemizes in 2007 is irrelevant). There are some detailed rules regarding the difference between what he could have deducted and what he actually did deduct, but in the end, rest assured this loophole has been thoroughly closed. There can be some net benefit if he knows that his marginal tax rate will drop next year, since the deduction this year could offset, say, 25% tax-rate income while the refund might be taxable the following year at only 15%. But I've also heard that CA tax authority sniffs this out and might question the unjustified overpayment. Ironically, until recent changes, when selling non-residential real estate, the CA taxing authority forced this situation themselves, by requiring withholding on the sale that typically would far exceed the actual tax due. -Mark Bole
<< ======================================================= >> << The foregoing was not intended or written to be used, >> << nor can it used, for the purpose of avoiding penalties >> << that may be imposed upon the taxpayer. >> << >> << The Charter and the Guidelines for submitting posts >> << to this newsgroup as well as our anti-spamming policy >> << are at www.asktax.org. >> << Copyright (2006) - All rights reserved. >> << ======================================================= >>
Add pictures here
<% if( /^image/.test(type) ){ %>
<% } %>
<%-name%>
Add image file
Upload

He's completing the worksheet incorrectly. To the extent the excess $5000 payment reduces his 2006 taxes, the refund becomes taxable in 2007. State income tax refunds are not taxable when you did NOT itemize the previous year. Ira Smilovitz
<< ======================================================= >> << The foregoing was not intended or written to be used, >> << nor can it used, for the purpose of avoiding penalties >> << that may be imposed upon the taxpayer. >> << >> << The Charter and the Guidelines for submitting posts >> << to this newsgroup as well as our anti-spamming policy >> << are at www.asktax.org. >> << Copyright (2006) - All rights reserved. >> << ======================================================= >>
Add pictures here
<% if( /^image/.test(type) ){ %>
<% } %>
<%-name%>
Add image file
Upload

No, this won't work. He will get a 2007 1099G from California documenting his refund, which will have to be added back to his income on his Federal tax return because he itemized in 2006. So he will pay federal tax for it on his 2007 return. But CA doesn't tax refunds, so it will be subtracted from his CA return. But CA also doesn't allow state tax paid as an itemized deduction, so when he filed his 2006 return, he had to subtract the $5,000 from his itemized deductions in the first place. So all he has done is delay paying tax on the $5,000 from the 2006 return to the 2007 return. Dennis
<< ======================================================= >> << The foregoing was not intended or written to be used, >> << nor can it used, for the purpose of avoiding penalties >> << that may be imposed upon the taxpayer. >> << >> << The Charter and the Guidelines for submitting posts >> << to this newsgroup as well as our anti-spamming policy >> << are at www.asktax.org. >> << Copyright (2006) - All rights reserved. >> << ======================================================= >>
Add pictures here
<% if( /^image/.test(type) ){ %>
<% } %>
<%-name%>
Add image file
Upload
FredK wrote:

Look at the TIP in the instructions:
"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." He DID itemize deductions in the year he paid the tax, so it is taxable. I guess that it's possible, if you know that your income the next year will be much lower, to overpay your state tax to increase the deduction, then pay tax on the refund the next year at a lower rate. I'd be surprised if the IRS doesn't have some sort of limitation on this sort of income shifting. << ======================================================= >> << The foregoing was not intended or written to be used, >> << nor can it used, for the purpose of avoiding penalties >> << that may be imposed upon the taxpayer. >> << >> << The Charter and the Guidelines for submitting posts >> << to this newsgroup as well as our anti-spamming policy >> << are at www.asktax.org. >> << Copyright (2006) - All rights reserved. >> << ======================================================= >>
Add pictures here
<% if( /^image/.test(type) ){ %>
<% } %>
<%-name%>
Add image file
Upload
FredK wrote:

Well, I think you can poke some holes in it if you put some numbers into the state & local income tax refund worksheet. The refund will be taxable income in 2007 to the extent his total 2006 itemized deductions (including the extra $5,000 in state income tax), as limited by his 2006 AGI, exceed the 2006 standard deduction. (So plug in $5,150, etc. in place of $5,000, etc. on Line 3 of the worksheet.) In other words, the refund will be taxable income in 2007 to the extent he gets a tax benefit from the deduction in 2006. It's still a deferral, of course.
The deduction may be disallowed by the IRS to the extent that it does not reflect a reasonable estimate of the state tax due on his 2006 return. See, e.g., PLR 8222009, 2/26/1982. Katie in San Diego
<< ======================================================= >> << The foregoing was not intended or written to be used, >> << nor can it used, for the purpose of avoiding penalties >> << that may be imposed upon the taxpayer. >> << >> << The Charter and the Guidelines for submitting posts >> << to this newsgroup as well as our anti-spamming policy >> << are at www.asktax.org. >> << Copyright (2006) - All rights reserved. >> << ======================================================= >>
Add pictures here
<% if( /^image/.test(type) ){ %>
<% } %>
<%-name%>
Add image file
Upload

I wouldn't be so sure about that. It looks an awful lot like a 1092 straddle to me.
Stu
<< ======================================================= >> << The foregoing was not intended or written to be used, >> << nor can it used, for the purpose of avoiding penalties >> << that may be imposed upon the taxpayer. >> << >> << The Charter and the Guidelines for submitting posts >> << to this newsgroup as well as our anti-spamming policy >> << are at www.asktax.org. >> << Copyright (2006) - All rights reserved. >> << ======================================================= >>
Add pictures here
<% if( /^image/.test(type) ){ %>
<% } %>
<%-name%>
Add image file
Upload
Your friend has it figured incorrectly. To use the examples of the 2005 tax year Form 1040, to the extent that his itemized deductions exceeded $5,000 (assuming he's single, and not head of household), the portion of his state income tax refund that is taxable in 2006 for federal income tax purposes is the lesser of (a) his actual tax refund, or (b) the excess of his itemized deductions over $5,000. Since he'd have made state income tax payments in excess of $5,000, and since he itemized, his allowable itemized deductions from line 28 of Schedule A (2005 Form 1040) would have been at least $5,000. Thus, he would have had to answer "YES" to the question on line 6 of the worksheet. For example, assume that he paid california taxes of $6,000, plus the additional $5,000 at year-end. Also assume that he had other allowable itemized deductions of $2,050, for total allowable miscellaneous deductions of $13,050 for 2005. In 2006 he would receive a check from California for $5,000 along with a Form 1099-G (a copy of which goes to the IRS). Going through the worksheet, and assuming that he is single, not blind or over 65, he would have the following entries: Line 1: $5,000 Line 2: $13,050 Line 3: $5,000 Line 4: "NO," -0- Line 5: $5,000 + $0 = $5,000 Line 6: "YES," $8,050 ($5,000 is less than $13,050 and line 2 minus line 5 = $13,050 - $5,000 = $8,050) Line 7: $5,000 (smaller of line 1 or line 6 - $5,000 is smaller than $8,050)
Thus, the TAXABLE PART of your friend's refund would be $5,000. In other words, the entire amount of the excess that he paid over to California in December. << ======================================================= >> << The foregoing was not intended or written to be used, >> << nor can it used, for the purpose of avoiding penalties >> << that may be imposed upon the taxpayer. >> << >> << The Charter and the Guidelines for submitting posts >> << to this newsgroup as well as our anti-spamming policy >> << are at www.asktax.org. >> << Copyright (2006) - All rights reserved. >> << ======================================================= >>
Add pictures here
<% if( /^image/.test(type) ){ %>
<% } %>
<%-name%>
Add image file
Upload

Hard to believe the $5,000 isn't taxable for 1040 purposes. If he itemized for 2006, that's what's used on the worksheet, not 2007. Your co worker could spend his time selling the idea if it would work. Jeff Berk Jenkintown, PA
<< ======================================================= >> << The foregoing was not intended or written to be used, >> << nor can it used, for the purpose of avoiding penalties >> << that may be imposed upon the taxpayer. >> << >> << The Charter and the Guidelines for submitting posts >> << to this newsgroup as well as our anti-spamming policy >> << are at www.asktax.org. >> << Copyright (2006) - All rights reserved. >> << ======================================================= >>
Add pictures here
<% if( /^image/.test(type) ){ %>
<% } %>
<%-name%>
Add image file
Upload
Stuart A. Bronstein wrote:

Seems like a stretch to me to call it "offsetting positions." However, that is another way the IRS might attack it. I think someone else pointed out that, ironically, California law actually REQUIRES some individual taxpayers to grossly overpay their state taxes. Purchasers of California real property are required to withhold 3-1/3 percent of the sale price and pay it over to the state. This is often a great deal more than the actual tax liability of the seller relating to the sale. The seller gets the refund the following year when the return is filed. Beginning in 2007, individual sellers can elect to have the buyer withhold 9.3 percent of the gain (the highest individual income tax rate) rather than 3-1/3 percent of the gross. Katie in San Diego
<< ======================================================= >> << The foregoing was not intended or written to be used, >> << nor can it used, for the purpose of avoiding penalties >> << that may be imposed upon the taxpayer. >> << >> << The Charter and the Guidelines for submitting posts >> << to this newsgroup as well as our anti-spamming policy >> << are at www.asktax.org. >> << Copyright (2006) - All rights reserved. >> << ======================================================= >>
Add pictures here
<% if( /^image/.test(type) ){ %>
<% } %>
<%-name%>
Add image file
Upload
Stuart A. Bronstein wrote:

Seems like a stretch to me to call it "offsetting positions." However, that is another way the IRS might attack it. I think someone else pointed out that, ironically, California law actually REQUIRES some individual taxpayers to grossly overpay their state taxes. Purchasers of California real property are required to withhold 3-1/3 percent of the sale price and pay it over to the state. This is often a great deal more than the actual tax liability of the seller relating to the sale. The seller gets the refund the following year when the return is filed. Beginning in 2007, individual sellers can elect to have the buyer withhold 9.3 percent of the gain (the highest individual income tax rate) rather than 3-1/3 percent of the gross. Katie in San Diego
<< ======================================================= >> << The foregoing was not intended or written to be used, >> << nor can it used, for the purpose of avoiding penalties >> << that may be imposed upon the taxpayer. >> << >> << The Charter and the Guidelines for submitting posts >> << to this newsgroup as well as our anti-spamming policy >> << are at www.asktax.org. >> << Copyright (2006) - All rights reserved. >> << ======================================================= >>
Add pictures here
<% if( /^image/.test(type) ){ %>
<% } %>
<%-name%>
Add image file
Upload

BeanSmart.com is a site by and for consumers of financial services and advice. We are not affiliated with any of the banks, financial services or software manufacturers discussed here. All logos and trade names are the property of their respective owners.

Tax and financial advice you come across on this site is freely given by your peers and professionals on their own time and out of the kindness of their hearts. We can guarantee neither accuracy of such advice nor its applicability for your situation. Simply put, you are fully responsible for the results of using information from this site in real life situations.