Date: February 2nd 2006

This came in a few days ago from CFS, the makers of the wonderful TaxTools and other utility software. I have not yet seen this information broadcast by any other source, and it was news to me, so here it is (hopefully) for your benefit and the benefit of your clients:

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.



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