The tax benefit rule was originally established by case law but later codified as Section 111. It provides a taxpayer is not permitted to retain the tax benefit of a deduction when later events demonstrate she is not entitled to it. The rule prevents taxpayers from receiving the benefit of a deduction in one year, but upon an unexpected change of circumstances in a later year, receiving a recovery of items that were deducted as a loss in the prior year (and without treating that recovery as income).

An example of the rule is where a taxpayer takes a deduction for a bad debt in year one under Section 166(a). Without the tax benefit rule, the repayment of the bad debt in year two (which would be a nontaxable return of capital) is not a taxable event. Thus, the taxpayer would have had the benefit of the deduction while also receiving the benefit of the recovery of nontaxable cash. To prevent that double benefit, the tax benefit rule requires the taxpayer to recognize income from the receipt of the unexpected payment in year two to offset the tax benefit of the deduction in year one.

Section 111(a) states the rule in the reverse: “Gross income does not include income attributable to the recovery during the taxable year of any amount deducted in any prior taxable year to the extent such amount did not reduce the amount of tax imposed by this chapter.” Thus, Section 111(a) can be used by a taxpayer to prevent items from being treated as income in a recovery year where the taxpayer never benefitted from the deduction in a prior year.

One example is Private Letter Ruling 200064014, in which a taxpayer elected to take the standard deduction and therefore did not claim a deduction related to real property taxes the taxpayer paid. In the following year, the taxpayer received a rebate of the taxes paid in the prior year. The issue was whether such rebate (a) was taxable because the taxpayer could have used the payment of the state taxes as a deduction had she itemized or (b) was it a tax-free rebate because she chose the standard deduction. The IRS concluded where the taxpayer elects to itemize deductions and therefore receives the benefit of the property tax deduction, the receipt of the tax rebate in the following year is a taxable event under the tax benefit rule. However, pursuant to Section 111(a), where the taxpayer elected to take the standard deduction, the receipt of the rebate is not taxable because the taxpayer did not receive a benefit in the prior year.

John G. Hodnette is an attorney with Fox Rothschild in Charlotte.

December 14, 2023/by TAX