In a news release and revenue ruling issued on 29 March, 2019, the IRS provided detailed guidance on how to determine whether refunds of state income taxes for 2018 and subsequent years are taxable. See IR-2019-59, https://www.irs.gov/newsroom/with-new-salt-limit-irs-explains-tax-treatment-of-state-and-local-tax-refunds, and Rev. Rul. 2019-11, https://www.irs.gov/pub/irs-drop/rr-19-11.pdf.
The guidance is necessary because the 2017 Tax Cuts and Jobs Act (TCJA) imposed a new $10,000 limit on the amount of state and local taxes that may be deducted.
Under federal tax law, a recovery of an amount that was deducted on a prior income tax return is subject to the “tax benefit rule,” which holds that the recovery is subject to tax to the extent that it resulted in a tax benefit in the prior year. Section 111(a) of the Internal Revenue Code says that any portion of a recovery that did not actually reduce the amount of tax in the prior year is not taxable.
The new ruling holds that in some situations in which the taxpayer receives a state income tax refund, all or part of it is not taxable because the new deduction limit operated to limit the tax benefit received from payment of the taxes refunded. Generally, it says that the taxpayer must first determine the amount of itemized deductions (or the standard deduction) the taxpayer would have taken on the prior year return had the taxpayer paid only the correct amount of state income tax (that is, the total tax payments less the refund). The taxpayer then recalculates the allowable deductions assuming he or she paid only the correct amount of tax. The ruling provides four helpful examples of the calculations required, in three of which all or part of the refund is not taxable.
The ruling was welcomed in the tax community as a correct and easily applied resolution of a difficult problem.
Many transferees will have overpaid state income taxes due to the TCJA, and will also be affected by the $10,000 deduction limitation. The new guidance will allow them to determine whether a subsequent refund is taxable, and if it is not, possibly reduce necessary gross-ups.