Income Tax Course Covers the Often Misunderstood Deduction of State and Local Taxes
A federally licensed tax professional is certain to encounter taxpayer confusion about the federal income tax deduction for state and local taxes. These taxes are federally deductible in the year they are paid to a state or local government. The tax period covered by the payment is irrelevant; all that matters for the federal deduction is when payment is made.
Most states have a personal income tax. Seven states have no individual income tax and two states tax only limited types of personal income. Tax practitioners normally prepare state tax returns in addition to federal returns. Some states have special licenses for tax return preparers. For example, a California tax preparer license is required to prepare tax returns in that state.
The due dates for payment of taxes usually extend into the subsequent calendar year. Likewise, the refund of state income tax overpayments occurs in the year following the tax year. The training in an income tax course conveys the implications of this that are not obvious to the general public. That is, the timing for state and local payments determines the year of federal tax deduction — regardless of the year credited by the state or local government.
For example, a fourth quarter state estimated tax payment by December 31 earns a federal tax deduction for that year. This is true even if some of that payment is later refunded in the next year. But paying the fourth quarter state estimated tax payment in early January nullifies a deduction for the year covered by the payment. That is because the year it is paid is all that matters for the federal tax deduction.
One factor taught in ethics courses is that a taxpayer is prohibited from inflating a fourth quarter state estimated tax payment to an unreasonable level just to obtain a federal deduction. So tax professionals should take precautions about deducting state payments that are refunded in the first few months of the subsequent year.
In addition, almost all municipal entities tax the value of real property as well as personal property used for business activity. In many areas, bills mailed in the fall are not due until the following January. Payment before year-end entitles the taxpayer to a deduction for that year. But payment in January means claiming a the deduction on next year’s tax return.
Paying in the next year is sometimes the right strategy for taxpayers who are subject to the Alternative Minimum Tax and thus receive no tax advantage from paying extra local taxes. Advice on this matter is a valuable reason for a taxpayer to seek the services of someone with IRS tax preparer training.
Taxpayers who itemize deductions have the option of claiming either state and local income tax or sales tax for the year. Tax preparer software will calculate the largest deduction. In addition, taxpayers subject to the AMT may benefit from claiming the sales tax deduction even if it is lower than deducting state income tax.
Any taxpayer who takes a federal deduction for state income tax must later declare any state refund as federal income. But this does not happen to taxpayers who claim the state sales tax deduction instead of the state income tax deduction.
A deduction of state income tax includes both withholding and estimated tax payments paid in the federal tax year. It also includes any balance paid for a prior year. Deduction of sales tax is either the actual amount proven from receipts or an amount determined from a table based upon income. Tax professionals will remember to include the local component of sales tax in addition to the percentage charged by the state.
IRS Circular 230 Disclosure
Pursuant to the requirements of the Internal Revenue Service Circular 230, we inform you that, to the extent any advice relating to a Federal tax issue is contained in this communication, including in any attachments, it was not written or intended to be used, and cannot be used, for the purpose of (a) avoiding any tax related penalties that may be imposed on you or any other person under the Internal Revenue Code, or (b) promoting, marketing or recommending to another person any transaction or matter addressed in this communication.
Originally published here.
Sawyer Adams