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When are state income tax refunds includible in federal taxable income?


Z, Inc., a calendar-year accrual-basis taxpayer, sustained a $3 million net operating loss (NOL) in 1992. Z can carry back the loss to 1989 and recover approximately $1 million of Federal income tax and $250,000 of state income tax.

Z filed Federal and state refund claims on Mar. 16, 1993. It receives approval of its state tax refund on Sept. 15, 1993. Due to delays in the state's check processing system, Z does not receive its refund check until Jan. 3, 1994.

When must Z include the state tax refund in its Federal taxable income?

Possible solutions

1. Z reports the $250,000 state income tax refund in its 1992 Federal gross income, reducing its NOL carryback to $2.75 million.

2. Z includes the state income tax refund in its 1993 Federal gross income, when the refund is approved by the state.

3. Z includes the refund in its 1994 Federal gross income, when the refund check is received.

Tax Court decisions

In Yapp Corp, TC Memo 1992-348, the Tax Court decided that response No.2 was correct for Illinois corporate income tax refunds. The IRS had argued for response No. 1. The court held for the taxpayer, following its earlier decisions in Doyle, Dane, Bernbach, Inc., 79 TC 101 (1982), nonacq. 1988-1 CB 1.

The Doyle, Dane case involved New York State taxes. The court decided that the refund need not be included in Federal gross income until the year in which the right to the refund is ultimately determined. The court relied state law giving the New York State Tax Commission the right to examine any refund claim before deciding whether to allow the claim.

The IRS argued that its position, enunciated in Rev. Rul. 65-190 and reaffirmed in Rev. Rul. 69-372, should prevail. The court disagreed, noting that assumptions as to the validity of the transactions and the correctness of the claimed amount "begs the very question which must be addressed in applying the 'all events' test and is at the heart of the issue herein. Consequently, Rev. Rul. 65-190 . . . rests on a foundation which is shaky at best."

In both cases, the Tax Court decided that a taxpayer was not required under the all-events test to include a state income tax refund in Federal gross income "until the year the right to those refunds is ultimately determined." In each case, state law required approval before the claim could be allowed.

Planning opportunity

Taxpayers may choose to follow the Tax Court decisions and exclude state income tax refunds from Federal gross income for the loss year if the state must approve the claim. Of course, the state approval procedure must be substantive. For example, in both Tax Court cases, the amounts claimed and refunded were not the same after the state reviews were conducted.

Following the court's decisions defers the recognition of Federal gross income and the resulting Federal tax. Z would receive approximately $85,000 more from its Federal income tax refund by carrying the full NOL back to 1989.

If Z continues to have NOLs after 1992, its cash position would be improved because the state income tax refund will offset future Federal NOLs rather than reduce the 1992 Federal NOL carryback to 1989.

Conflict between the Service

and the Tax Court

The IRS does not agree with the Tax Court's reasoning, as evidenced by its nonacquiescence in Doyle, Dane. Taxpayers willing to litigate this issue in the Tax Court have favorable precedent.

Substantial authority

The two court decisions provide substantial authority for taxpayers following the court's position. Therefore, disclosure on Form 8275, Disclosure Statement, is not necessary. (See Regs. Sec. 1.6662-4(d)(3).

Amended returns for refunds not

related to NOL carrybacks

Taxpayers often file Federal and state refund claims to correct previously filed returns. Ordinarily, tax refunds receivable may be recorded on the books when the claim is filed, but the Yapp decision may allow deferring the inclusion of state income tax refunds in Federal gross income until the state claims are approved.
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Article Details
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Author:Clifton, S. Diane
Publication:The Tax Adviser
Date:May 1, 1993
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