Estimated State payment too big --> money back; + 2018 Tax Reform

Question

In Apr 2018, for 2017 taxes, I filed for extension and made a payment for estimated tax for the State & local taxes of NY of 20K. I was completely wrong, and ended up getting a State refund of 30K when finally filing in Oct 2018. (EDIT: emphasize on: the 20K paid in 2018 were not counted towards the itemized deduction. I got not deduction for those 20K paid).

Now, for 2018, with Trump TCJA, State and Local Taxes deductions are capped at 10K, so I'm not itemizing.

My accountant claims those 30K are taxable refunds (form 1040 / sched 1 / 10 ). I believe the fair amount I should be taxed on is "the refund", 10K, not the refund + my over estimation. I never claimed any deduction on the 20K, so the income that did not get taxed on is 30K - 20K = 10K. And I would hope that is what I should count as income in 2018.

Without the tax overhaul (Trump's TCJA), the estimated payment of 20K / Apr 2018 would have been itemized which would offset some of the 30K refund, as in Question about federal taxation of state refund (US)

Is my accountant right? What can I do in such a situation? Is there a way to try to negotiate with the IRS? Many thanks for your help.

Answer 1

You need to allocate the $30,000 recovery between payments made in 2017 and payments in 2018. For example, if you paid (and deducted as an itemized deduction) $30,000 in 2017, then the $30,000 recovery would be allocated as 60% for 2017 payments and 40% for 2018 payments. The 60% does need to be included as income on schedule 1. The 40% would affect your itemized deduction for 2018, but since you’re not itemizing, it has no effect.

You are supposed to include a statement with your return describing how the allocation was done. See “Recoveries” in publication 525.

Answer 2

Was the $20K state tax payment made in 2017, or made in 2018 for your 2017 taxes?

If the $20K payment was made in 2017, it could have been deducted on your 2017 federal return, along with any other state tax payments. The TCJA was not in effect for 2017 and the $10K cap did not apply.

It seems that you received the $30K refund in 2018. Regardless of the TCJA, such a refund is taxable only to the extent that the corresponding overpayment was deducted (and saved you money over the standard deduction) in a previous federal tax year.

If both the $20K payment and the $30K refund occurred in 2018, then the only part of the $30K that is taxable is the amount of whatever other payments of state tax for the same year (if any) were profitably deducted on your 2017 (or earlier) federal return. Then, you can federally deduct your state tax paid in 2018 up to $10K.

The principle is that you end up benefiting from federal deductions of state taxes as if you paid exactly the right amount every time (no overpayment). Refunds are taxed in a way that effectively adjusts the federal deduction previously taken to that which would have been taken on the exact state tax owed. And the "would have been" takes into account caps, fallback to the standard deduction, etc.

It was certainly undesirable to make a state tax payment in 2018 for year 2017, versus making the payment in 2017 when it was fully deductible.

EDIT: The potentially unclear aspect is how the 2017 state tax refund received in 2018 is treated when state tax payments for 2017 were made in both 2017 and 2018 (and deducted for 2017). I found a source commenting on this explicitly. See the section "Taxpayer makes payments of year 1 taxes in year 2", and the key statement:

The IRS’ position, however, is that the overpayment was generated by the total payments and cannot be allocated directly to any payment. Accordingly, the overpayment ... would be proportionately allocated to each year’s payment.

Thus, some but not all of the $30K refund is taxable. The part allocated to 2018 is not taxable but reduces your net state tax payments in 2018.

Answer 3

Here's how it works. If you take a tax deduction for state income tax in a given year, and you get a refund on that tax, then you must declare the refund as income in the year you get the refund.

But if you didn't take all the deduction you're entitled to, you don't need to declare all the refund you get.

Example:

• 2014 - I take a schedule A tax deduction for my FULL state income tax withheld/prepaid in - 2014.
• 2015 - I do not take a tax deduction for my state taxes withheld in 2015
• 2016 - I take a Schedule A tax deduction for $10,000 less than my state income tax withheld. (withholding was $27,410, I took a deduction for $17,410).

For whatever reasons, I get all the state tax refunds in calendar year 2017.

• The 2014 refund of $14,100 is declared as income on my 2017 Federal taxes, because I deducted all the withholding in 2014.
• The 2015 refund of $9,313 is not declared as income, because I didn't itemize on my Federal 2015.
• On the 2016 refund of $12,411, I only declare $2,411 as income on my Federal 2017 taxes, because I didn't deduct the other $10,000.

You see the common thread? Whatever you did not benefit from a deduction on, you also do not need to declare as income. The 2015 refund was totally excluded, as was $10,000 of the 2016 refund.

So hypothetically let's say you had $55,000 of withholding and also made a $5000 prepayment for your 2017 state tax, and on your 2017 Federal Schedule A you took $55,000 in deductions because you forgot the $5000 payment. Then in calendar year 2018 you get your 2017 refund of $30,000. You declare as income that less the $5000 you forgot to deduct, or $25,000. And you do it on your 2018 taxes because that's when you received the money. (Weird but applicable).

In 2018, if your state tax was $22,000 withheld and $9,000 actual, and you did itemize and take the allowed $10,000 of deduction (disallowing $12,000), and you got a $13,000 refund in 2019, again you would only need to pay tax on the $1000 since you didn't take a deduction on the other $12,000.

How do I know this? I took the IRS to tax court on this exact issue, and IRS attorneys totally agreed with me and said the auditor was wrong. It was settled so easily it did not become published law, so I can't cite it.

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A "cleaner" way to do the whole above thing of avoid having to declare state tax refunds as Federal income, is to not take the state tax deduction at the time you file your Federal. Then, after your state taxes settle, amend your Federal to deduct the actual amount of state tax. This is what the IRS actually wants (in the sense that IRS likes simple because simple is more easily audited), and it spares the runaround of deducting withholding and declaring refund.

This strategy is especially helpful if you have high state over-withholding triggering AMT (high state refunds are an AMT magnet because the state withholding appears out-of-proportion to taxable income). That is the situation my court case applied to, and the IRS attorneys said "that's the way to do it", otherwise the state tax refund would unwind the AMT in calculations worthy of Stephen Hawking.

• In 2018 I amend my 2015 Federal taxes to claim the 2015 state tax I didn't take before. I have two valid choices (more than two, but whatevs):

  • Amend my 2015 to take the withholding, then amend my 2017 to declare the refund. This will result in taxes and penalties due on my 2017.
  • Amend my 2015 to take the actual, final amount of my state tax; and do not change my 2017 tax. (Literally I am claiming $9,313 less than I am entitled to, and in 2017 declaring $9,313 less of my refund, or $0.)

• How does this affect my 2015 state taxes? Run the numbers but states usually disregard both your deduction of state tax withheld and your declartion of state tax refunds. (either by a parallel 1040-like form that doesn't have those line items, or they "Adjust" your 1040 numbers to remove them). So this becomes a "wash" as far as your state income. Check your state rules on if you need to amend 2015, but with my second actual-tax method, you definitely wouldn't need to amend state 2017.