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Tax Benefit Rule

You owe a doctor $1,000 for a medical procedure, and your insurance company refuses to pay. You pay the doctor yourself and include the expense as an itemized medical deduction in the year of the payment. But an amazing thing happens. Two years later, you get a check from the insurance company for $1,000 with a letter stating that your claim had been improperly denied. The good news is that you got your money back, but the bad news comes in the form of the tax benefit rule.

The purpose of the tax benefit rule is to create a balance between what appeared to be a proper deduction at the time it was taken and the fact that the assumptions on which the deduction was based were erroneous. If a taxpayer deducted an amount from his gross income in one year resulting in a tax benefit to him or her, and an event occurred in a later year that was fundamentally inconsistent with the premise on which the deduction was based, then the taxpayer must include an amount in gross income of the current year to the extent that the amount was deducted in the prior year.

The tax benefit rule has five elements. An amount must be included in gross income in the current year if, and to the extent that: (1) the amount was deducted in a prior year; (2) the deduction resulted in a tax benefit; (3) there is some type of recovery of the amount previously deducted; (4) an event occurs in the current year that is basically inconsistent with the premises on which the deduction was originally based; and (5) the inclusion in gross income is not prohibited by a specific provision of the Internal Revenue Code. If the erroneous item is an inclusion of income rather than a deduction or credit, the same five elements apply.

The tax benefit rule applies to both personal and business deductions. It also applies to tax credits, where tax in the recovery year is increased by the amount of the credit attributable to the recovered amount.

A taxpayer may not file an amended return reducing the benefit in the original year in order to avoid the inclusion of recovery of an item as income in the later year. In addition, a taxpayer may not avoid the inclusion of recovery by claiming that the statute of limitations has expired for the benefit year. It is the taxpayer, not the Internal Revenue Service, that has the burden of proving that a deduction in an earlier year did not generate a tax benefit.

The tax benefit rule applies to the recovery of many types of deductions including but not limited to charitable donations, employment-related payments, casualty losses, state and local tax refunds, expenses on mortgaged property, and bad debt recoveries. However, certain items do not trigger the tax benefit rule, including depreciation and depletion and unreported income. In addition, the tax benefit rule does not apply if a taxpayer claimed a standard deduction instead of itemizing a deduction later found to be erroneous because the taxpayer received no benefit in the original year.

Copyright 2012 LexisNexis, a division of Reed Elsevier Inc.

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