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Tax Benefit Rule

Basically, the tax benefit rule states that if a deduction from a taxpayer’s gross income in one year is recovered in a subsequent year, the recovery of that amount is included in the taxpayer’s income in that subsequent year. The tax benefit rule was developed by the courts and is partially codified in section 111 of the Internal Revenue Code (IRC). Under the rule, an amount will be included in income of the current year if the following criteria are met: (1) the amount was deducted in a previous year; (2) the deduction gave the taxpayer a tax benefit; (3) there is an event in the current year that is fundamentally inconsistent with the basis for the original deduction; and (4) a provision of the Internal Revenue Code does not prevent nonrecognition and inclusion of the amount in gross income.

The US Supreme Court established the “fundamentally inconsistent” standard in Hillsboro National Bank v. Commissioner. The Court said that the tax benefit rule is applied when a subsequent event that is “fundamentally inconsistent with the premise on which (an earlier) deduction was based” occurs. The Court explained that fundamentally inconsistent means “if that event had occurred within the same taxable year, it would have foreclosed the deduction.” Hillsboro Nat. Bank v. Comm’r, 460 U.S. 370, 383-4 (1983).

Section 111 of the IRC states that income attributable to the recovery of any amount deducted in a prior tax year is not included in the gross income of the current tax year except to the extent that it lowered income tax liability.

The tax benefit rule can be applied so that various types of amounts that were deducted in one year are recoverable and included in gross income in a subsequent year. For example:

  • Medical expenses deducted in one year that resulted in a reduced tax that were reimbursed in a subsequent year (through insurance or otherwise) are included in gross income in that subsequent year.
  • Fees paid to an attorney or accountant in one year, but later recovered after litigation are included in gross income.
  • A payment from an insurance company under a policy for a loss that was previously deducted is included in gross income.
  • A gift to a charity, for which the taxpayer claimed a charitable deduction, which is returned to the taxpayer in a subsequent year is subject to the tax benefit rule.
  • If an amount paid as state income taxes was previously deducted, but then the amount was refunded, the amount is included in gross income.

If any of the above situations apply, the taxpayer will have to include the recovered amount in his or her gross income.

Preparing for a Meeting with Your Tax Attorney

To read and print out a copy of the checklist, please follow the link below.

Preparing for a Meeting with your Tax Attorney

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