Refundable state tax credits must be reported as income if they exceed taxes actually paid, even if a company foregoes a refund and carries them forward.

David and Tami Maines qualified for Empire Zone tax credits in New York for opening a new business or expanding an existing one. There are three kinds of Empire Zone credits: an investment tax credit, a wage credit and a property tax credit. The investment and wage credits can be used against income taxes and, once income taxes are reduced to zero, any remaining credits can be carried forward or partly refunded in cash. The property tax credit is limited to the amount of property taxes actually paid in the past.

The Maineses received large “refunds” from the state from 2005 through 2007.

The US Tax Court said the excess investment and wage credits had to be reported as income whether or not they were actually refunded. The fact that the taxpayer had the option to take them in cash meant the refunds were “constructively received.”

However, since the property tax credit can be used only to get a refund of property taxes that were actually paid earlier, it merely reduces real taxes. If the taxpayer benefited from deducting the taxes earlier, then it must report the refund as income. If not, then the refund is not income. This is called the “tax benefit rule.” If an earlier tax benefit, like a deduction, was claimed and the basis for it is now disappearing (since the taxes paid are being given back), then income must be reported to reverse the earlier benefit.

The case is David J. Maines v. Commissioner. The Tax Court released its decision on March 11. The court reached a similar conclusion in another case six days later called Yigal Elbaz v. Commissioner.

by Keith Martin in Washington