IRS's Multi-Billion Flimflam: "Double or Nothing" Taxation of Tax Refunds

The following letter is a redacted version of the letter that IRS sent
to me.The letter has two major flaws that completely destroy IRS's
arguments for "DOUBLE OR NOTHING" taxation of tax refunds. When the
regular tax is paid in both years all kinds of itemized deduction
recoveries that provided a tax benefit in the prior year may be double
taxed.

The IRS respondent never gets around to explaing precisely how under
section 111(a) of the IRC the gross income attributable to a recovery
can exceed the amount of the recovery. Because IRS instructions
include itemized deduction recoveries in the calculation of taxable
Social Security benefits, the gross income attributable to an itemized
deduction recovery can be up to 1.85 times the amount of the recovery.
Taxable can be more than twice the amount of the recovery when, based
on IRS instructions, the gross income attributable to the recovery
reduces medical or casualty and theft loss deductions and miscellaneous
deductios.


The respondednt atempts to justify the exclusion from AMTI of tax
refunds that provided a tax benefit in the prior year when the regular
tax was paid. He overlooked the fact that the justification for
section 56(b)(1)(D) is to exclude from AMTI a refund of a tax
overpayment in a prior year when the AMT was paid and there was a
limited tax benefit resulting from a tax overpayment and the two-tier
capital gains rate structure. See Page 2 of Form 6251, Schedule A,
Form 1040, and Schedule D. Based on IRS instructions since 1988,
neither the income used for a tax overpayment(to the extent that it
provided a tax benefit)in a year the regular tax was paid nor the
refund of the overpayment received in a year that the AMT is paid have
been taxed.

If there is a limited long-term capital gains rate based benefit from a
tax overpayment in a year the AMT is paid and the refund is received in
a year the regular tax is paid, the income used for the overpayment
will be tax at the AMT rate and the refund will be taxed at the regular
tax rate.

Based on IRS instructions, the sequence in which the regular tax and
the AMT is paid determines whether the overpayment income / refund is
taxed
"DOUBLE OR NOTHING".

LOOKS LIKE AT TWO MULTI-BILLION TAX FRAUDS TO ME!!! ONE (OF THE TWO)
ON TAXPAYERS AND ONE ON THE UNITED STATES TREASURY

CHEERS,


WDK


Tax Notes Today ,MARCH 18, 1999 THURSDAY,

DEPARTMENT: Official Announcements, Notices, and News Releases; IRS Tax
Correspondence

CITE: 1999 TNT 52-53

HEADLINE: 1999 TNT 52-53 TAXPAYER IRATE ABOUT IRS'S POSITION ON AMT AND
TAX BENEFIT RULE. (Section 111 -- Tax Benefit Recovery Items;)

(Release Date: DECEMBER 08, 1998) (Doc 1999-10275 (28 original pages))

CODE: Section 111 -- Tax Benefit Recovery Items;
Section 56 -- Minimum Tax Adjustments

ABSTRACT: In a December 8, 1998 letter, an individual whose name has
been withheld has complained about the IRS's "twisted interpretations"
of deduction recoveries under sections 111(a) and 56(b)(1)(D).
* * * * *
Refer Reply to: * * *

Date: * * *

Dear * * *

[39] This is in reply to your letter of * * * to * * * We are
responding on his behalf.
[40] In a number of letters to the Internal Revenue Service (Service)
and Congress you have stated your belief that the Service has not
followed the law as it relates to the inclusion of tax refunds in gross
income and is improperly excluding such refund from alternative minimum
taxable income (AMTI). In our responses to those letters, we have set
forth why we believe the Service is correctly interpreting the law as
it relates to those items of concern. This letter responds in more
detail to the points you have raised in your letters.

SECTION 111(a)

[41] You assert that section 111(a) /1/ requires that a refund of state
income taxes that provided a tax benefit for the taxable year deducted,
be taken into account in a manner that will result in an increase in
taxable income in the year of recovery only to the extent of the amount
of the refund. You believe it is improper for the Service to include
the entire refund in gross income thereby increasing adjusted gross
income (AGI) and possibly increasing the amount of social security
benefits required to be included in gross income, and possibly reducing
the allowable amount ofmedical expense deductions and miscellaneous
itemized eductions. You point out that under the Service's position a
taxpayer's taxable income may be increased in the year of recovery by
more than taxable income was reduced in the year the excess state
income taxes were deducted.

[42] We agree that such a result may occur under the Service's
interpretation of the law. We do not agree, however, that section
111(a) requires a different result.

[43] Section 111(a) provides that "[g]ross 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 . . . [Chapter 1 of the Code]".
/2/

[44] Section 111(a) is a codification of part of the judicially created

tax benefit rule. There are two components to the rule: an inclusionary
component and an exclusionary component. Under the inclusionary
component an amount deducted for taxable year may be included in gross
income under section 61 /3/ in a subsequent taxble year as a result of
an event occurring in the subsequent year that is fundamentally
inconsistent with the prior deduction. However, such inclusion may be
limited under the exclusionary component of the rule, codified in
section 111(a).

[45] Section 111(a) only excludes an item from gross income to the
extent deduction of that item did not reduce tax liability for the
taxable year deducted. If such item did provide a tax benefit when
deducted, there is no statutory justification to exclude any portion of
it from gross income for the taxable year of recovery, with all the
attendant consequences flowing therefrom. Because of the steps mandated
in computing taxable income by the Internal Revenue Code an item that
is included in gross income necessarily affects the amount of AGI which
in turn can affect other items of income or deduction.

[46] Section 111(a) does not provide that taxable income shall include
the recovery of any amount previously deducted only to the extent such
amount previously reduced tax liability and taxable income. Nor does it
provide that gross income shall include the recovery of any amount
previously deducted only to the extent necessary to increase taxable
income in the year of recovery equal to the reduction in taxable income
caused by the prior deduction.

[47] The entire focus for the triggering of section 111(a)'s exclusion
mechanism concerns whether the taxpayer got a reduction in tax
liability for the taxable year of the deduction. In making that
determination the Service has, at least under a prior version of
section 111, taken into account the effect of a deduction on other
items for the taxable year of deduction. See Rev. Rul. 77-79, 1977-1
C.B. 34 (where a $1,500 severance tax deduction reduced the taxpayer's
otherwise allowable percentage depletion deduction by $500, only $1,000
was includible in gross income for the taxable year when the entire
$1,500 severance tax was refunded). However, once a determination has
been made that a certain amount of a deduction reduced both the tax
base and tax liability, section 111(a) has never provided a mechanism
for considering what effect inclusion of that amount in gross income
might have on other items in the taxable year of recovery.

[48] Once it has been determined that an amount previously deducted but
recovered in a later taxable year resulted in a tax benefit in the year
of the deduction, the recovered amount enters into gross income for all
purposes for the taxable year of recovery. There is no statutory
mechanism to ensure that the tax liability attributable to the recovery
equals the tax benefit previously received.

[49] For example, in Alice Phelan Sullivan Corp. v. United States, 381
F.2d 399 (Ct. Cl. 1967) the taxpayer contended that the amount of tax
imposed for the taxable year of recovery should be no greater than the
tax saved for the taxable year of the deduction. The court disagreed:
Since taxpayer in this case did obtain full tax benefit
from its earlier deductions, those deductions were properly
classified as income upon recoupment and must be taxed as such.
This can mean nothing less than the application of that tax rate
which is in effect during the year in which the recovered item
is recognized as a factor of income.
Id. at 403.

[50] Although we continue to disagree with your interpretation of
section 111(a) we understand why you consider its application to
produce arguably unfair results in certain circumstances. It has long
been recognized that the tax benefit rule is a very precise error
correction device; it does not put the taxpayer in exactly the same
position that the taxpayer would have occupied if the taxpayer had
never deducted the refunded amount. As one commentator has noted:

The tax benefit rule is an example of inexact correction.
When applicable, the Rule creates current income equal to the
amount of a beneficial prior deduction. While that may appear to
be exact, it is not, for it omits several important collateral
considerations such as the time value of money, the effect of
penalties, the prior statute of limitations, changing tax rates,
changing tax brackets, changing tax character, filing status,
and the effect of the prior deduction and current inclusion on
other items. In many cases, such collateral considerations can
have a greater impact than does the raw inclusion. . . .
[A] deduction from gross income may have many other
collateral consequences, affecting areas such as medical expense
deductions, at risk rules, hobby losses, and passive activity
deductions. Subsequent recovery inclusions will likewise affect
such areas in the recovery year. . . .
Thus, the tax benefit rule results in an inexact
correction. Ideally, a taxpayer would correct a recovered
deduction by repaying the actual tax saved, with interest. The
Rule does not even attempt to approximate that ideal.
Steven J. Willis, The Tax Benefit Rule: A Different View and a Unified
Theory of Error Correction, 42 Fla. L. Rev. 593-94 (1990).

[51] Although the example you pose illustrates an unfavorable result
for taxpayers, it must also be recognized that the tax benefit rule may
work in a taxpayer's favor. For example, as a result of including a
state income tax refund in gross income a taxpayer may be able to
deduct charitable contributions, the deduction of which is generally
limited to a percentage of AGI, the carryover of which would otherwise
expire without benefitting the taxpayer.

[52] We would also like to point out that the unfavorable results you
illustrate, at least in the context of possible overpayments of state
income taxes, may either be greatly mitigated or entirely avoided
through careful tax planning. First, a taxpayer who anticipates an
adverse effect from a refund of state income taxes may, to the extent
allowed by state law, adjust estimated tax payments and wage
withholding to minimize the possibility of receiving such a refund.

[53] Second, it is true that once a taxpayer has claimed a proper
deduction the taxpayer may not in a subsequent taxable year avoid
having to include a refund of the deducted item in gross income by
amending the taxpayer's tax return for the taxable year of the
deduction. See Klinghamer v. Brodrick, 242 F.2d 563 (10th Cir. 1957);
Hillsboro National Bank v. Commissioner, 460 U.S. 370, 378 fn. 10
(1983). However, where on the original return a taxpayer does not claim
an allowable deduction for state income taxes that could have produced
a tax benefit, section 111(a) excludes a refund of the undeducted taxes
from gross income. McCabe v. Commissioner, T.C. Memo 1983-325; Rev.
Rul. 79-315, 1979-2 C.B. 27. Thus, a taxpayer who anticipates an
adverse effect from a refund of state income taxes may simply deduct
the correct amount of state income taxes on the taxpayer's original
return. If it turns out that the refund would not produce an adverse
result by being included in gross income, the taxpayer may amend the
original return to claim the entire deduction allowable.

[54] In other contexts Congress has provided more precise ways to deal
with events occurring in later years that are inconsistent with the
treatment of an item in a prior taxable year. /4/ Because of Congress'
recent tendency to increase the number of items of income or deduction
that are affected by AGI, results like those you have illustrated may
occur with increasing frequency. Thus, you may wish to write your
Congressional representatives to advocate a change in the law. However,
unless and until Congress enacts a statute providing for a more precise
error correction mechanism in the context of deduction recoveries, the
Service will be required to include tax refunds that resulted in a
prior tax benefit in gross income, with all the collateral consequences
flowing therefrom.

1986 AMENDMENT OF SECTION 111

[55] You assert that the Supreme Court's decision in Hillsboro supports
your interpretation of section 111(a) and that Congress amended section
111(a) in the Tax Reform Act of 1986 (1986 Act) in part in response to
that case. In his letter to you * * * has already indicated why we do
not believe Hillsboro supports your interpretation of section 111(a).
Here we explain why Congress amended section 111(a) in the 1986 Act.

[56] Prior to being amended in the Deficit Reduction Act of 1984 (1984
Act), section 111(a) excluded the recovery of certain amounts from
gross income to the extent of the amount of the "recovery exclusion"
relating to that item. Because of the way the service and Treasury
Department computed the amount of the "recovery exclusion" there were
certain circumstances where a taxpayer was able to exclude from gross
income recoveries of items that when deducted as itemized deductions
had previously provided a tax benefit. In the 1984 Act Congress amended
section 111 to prevent this result.

[57] As amended by the 1984 Act section 111(a) provided:

(a) Deductions -- 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 income subject to tax.

[58] Although this amendment fixed one problem it created another.
Because it was possible for a deduction to reduce taxable income, but
not AMTI, under the amended statute a taxpayer subject to the
alternative minimum tax (AMT) could be required to include the recovery
of an item in gross income even though it did not reduce the taxpayer's
tax liability. As the following legislative history makes clear,
Congress amended section 111 /5/ in the 1986 Act to remove this flaw:
The bill provides that an amount is excludible from income
only to the extent that it does not reduce a taxpayer's income
tax under chapter 1 of the Code. Thus, where a deduction reduces
taxable income but does not reduce tax (because, for example,
the taxpayer is subject to the alternative minimum tax),
recovery of the amount giving rise to the deduction may be
excludible from income under section 111.
H.R. Rep. No. 426, 99th Cong., 1st Sess. 937 (1985); S. Rep. No. 313,
99th Cong., 2d Sess. 957 (1986). There is no indication that in the
1986 Act Congress intended to alter the long-standing rule that
recovered amounts that did result in a tax benefit in a prior taxable
year must be included in gross income in the taxable year of recovery.

ALTERNATIVE MINIMUM TAX

[59] As stated in prior correspondence we disagree with your assertion
that recoveries of taxes described in paragraphs (1), (2), or (3) of
section 164(a) should only be excluded from gross income in computing
AMTI to the extent deduction of the taxes did not reduce the taxpayer's
income tax liability. Under your Interpretation section 56(b)(1)(D)
would be unnecessary; it would only apply to exclude items from gross
income when such items are already excluded from gross income under
section 111.

[60] Section 56(b)(1)(D) provides that no recovery of any tax to which
section 56(b)(1)(A)(ii) applied shall be included in gross income for
purposes of computing AMTI. By its terms section 56(b)(1)(A)(ii) denies
any deduction in computing AMTI for taxes described in section
164(a)(1)-(3). It does not limit its application to taxable years in
which the taxpayer is liable for AMT. Because these taxes are never
deductible in computing AMTI, recoveries of such taxes are always
excluded from gross income, under section 56(b)(1)(D), for purposes of
computing AMTI.

[61] Section 55(b)(2) defines AMTI as the taxpayer's taxable income for
the taxable year determined with the adjustments provided in section 56
and section 58, and increased by the items of tax preference described
in section 57. Thus, even if a taxpayer does not have to pay AMT for a
taxable year, and may not be required to file Form 6251 for that year,
it does not mean that the taxpayer does not have AMTI. /6/ Furthermore,
it is important to determine the amount of a taxpayer's AMTI even if
the taxpayer is not liable for AMT.

[62] For example, section 56(a)(4) provides that the AMT net operating
loss deduction must be used to determine AMTI rather than the regular
tax net operating loss deduction. Section 56(d)(1)(B)(ii) provides that
AMTI is used instead of taxable income to determine how much of an AMT
net operating loss deduction is absorbed in a taxable year. Thus, even
if a taxpayer is not subject to AMT for a taxable year to which net
operating losses are carried, it is still necessary to determine the
AMTI for that year to determine how much of the AMT net operating loss
deduction is absorbed. In computing this AMTI, the taxes described in
section 164(a)(1),(2), and (3) are not allowable deductions.

[63] We also disagree with your assertion that the Service's
interpretation of section 56(b)(1)(D) creates an unjustified windfall
for affluent taxpayers.

[64] The purpose of the AMT is to ensure that no taxpayer with
substantial economic income avoids significant tax liability by using
certain exclusions, deductions, or credits. See H.R. Rep. No. 426, 99th
Cong., 1st Sess. 305-06 (1985); S. Rep. No. 313, 99th Cong., 2d Sess.
518 (1986). Section 55 generally imposes AMT on a taxpayer to the
extent the tentative tax on taxable AMTI (tentative minimum tax)
exceeds the taxpayer's regular tax liability. However, essentially what
happens is that the taxpayer computes tax liability on regular taxable
income and tax liability on AMTI and pays the higher amount.

[65] AMTI is a separate measure of taxable income. It has its own rate
structure and exemptions. Some items of income and deduction are common
to both the computation of AMTI and taxable income. For example, wages
are includible both in AMTI and taxable income. However, the two
measures of income also have differences. [66] These differences may be
classified as permanent or temporary. Permanent differences are items
of income or deduction that are taken into account under one tax system
but never taken into account under the other tax system. For example,
percentage depletion (other than certain oil and gas depletion) in
excess of the adjusted basis of property is allowable in computing
taxable income but not allowable in computing AMTI. Temporary
differences relate solely to the time when items of income or deduction
are taken into account under the two tax systems.

[67] Because the regular tax imposed on a given level of taxable income
exceeds that imposed on the same level of AMTI, to be subject to the
AMT the taxpayer's AMTI must exceed the taxpayer's taxable income. For
example, assume an unmarried taxpayer filing as single has the
following income, deductions, and tax liability for 1994:

Regular Tax AMT
Gross Income $100,000 $100,000
State Income Tax
Deduction (10,000)
Personal Exemption (2,450)
AMT Exemption (33,750)
________ ________
Income Subject to Tax $87,550 $66,250
Tax on Above Amounts $22,538 $17,225

[68] Because regular tax is higher than tentative minimum tax, the
taxpayer is liable for $22,538 of regular tax for 1994. The taxpayer
received a full tax benefit from the state income deduction because it
reduced the amount of tax the taxpayer owed.

[69] Now assume the taxpayer has the following income, deductions, and
tax liability for 1995:

Regular Tax AMT
Tax-Exempt Interest on
Private Activity Bonds
$100,000
Other Gross Income $100,000 100,000
(Not Including State
Income Tax Refund)
State Income Tax
Refund (From Taxes
Deducted in 1994) 1,000
Standard Deduction (3,900)
Personal Exemption (2,500)
AMT Exemption (11,875)
_________
Income Subject to Tax $ 94,600 $ 188,125
Tax on Above Amounts $24,602 $ 49,175

[70] Under the Service s view, illustrated above, the taxpayer would be
subject to a regular tax liability of $24,602 and an AMT liability of
$24,573 ($49,175-$24,602). Under your interpretation of section
56(b)(1)(D) the $1,000 state income tax refund would also be included
in AMTI resulting in an additional tax liability of $350. Apparently
you feel that because the taxpayer would be subject to the same total
tax liability, i.e. $49,175, whether the state income tax refund were
included in regular taxable income or not, the taxpayer receives an
unwarranted benefit unless the state income tax refund is also included
in AMTI.

[71] Any perceived unwarranted benefit, however, is illusory. It must
be remembered that the AMT tax base differs from the regular tax base.
For an individual taxpayer state income taxes are never deductible in
computing AMTI. Thus, as far as the AMT is concerned, such expenses
should be treated the same as any other nondeductible expense.

[72] When a taxpayer receives a refund of a payment that is
non-deductible under the regular tax system that payment is not treated
as gross income. For example, personal expenses are not allowable
deductions in computing taxable income. A shopper purchasing food for
personal consumption who receives change from a cashier after making a
food purchase is not required to include the change in gross income.
When the excess payment is handed to the cashier a debt is created from
the grocery store to the shopper. The shopper has a basis in the debt
equal to the excess payment. Therefore, when the shopper receives the
change there is a nontaxable return of capital.

[73] Likewise, from a theoretical standpoint an individual taxpayer who
receives a refund of state income taxes should not be required to
include the refund in gross income for purposes of computing AMTI.
Section 56(b)(1)(D) provides this result. The fact that a taxpayer was
not liable for AMT for the taxable year when the state income taxes
were deducted, and therefore received a tax benefit from the deduction
through a reduction in regular tax liability should not change the
result. A taxpayer is only required to compute tax liability on regular
taxable income and tax liability on AMTI and pay the higher amount. The
integrity of the espective tax bases should be maintained in
determining which tax applies and to what extent.

[74] It is true that a taxpayer who anticipates paying the regular tax
in one taxable year and the AMT in the succeeding taxable year, may, in
some circumstances, achieve tax savings by overpaying state income
taxes in the first taxable year. However, there are many situations in
which taxpayers have opportunities to lessen their tax liability by
shifting income and deductions from one taxable year to another taxable
year, e.g., deferring income until retirement when taxpayers may be
subject to lower marginal tax rates. Many taxpayers subject to the AMT
tend to be subject to it on a recurrent basis so that overpaying state
income taxes may be of limited benefit. To the extent a taxpayer
grossly overpays state income taxes the Service might challenge the
propriety of the deduction. In any event, the fact that there may be
some planning opportunities available by overpaying state income taxes
does not justify ignoring the clear language of section 56(b)(1)(D).

[75] As you pointed out in your letter, according to Form 6251 for
every year other than 1993 a state income tax refund included in gross
income for regular tax purposes might indirectly affect the amount of
AMTI by affecting the amount of a deduction allowed in computing AMTI.
There is an explanation for this apparent inconsistency.

[76] As previously noted the AMT is a tax system separate from but
related to the regular tax system. When the 1986 Act version of the AMT
was enacted there was some uncertainty as to just how separate the two
tax systems were. Under a truly separate but parallel to the regular
tax AMT tax system, AMTI would be computed as if the regular tax did
not exist. In other words there should be an AMT gross income, AMT AGI,
etc., and all deductions and income items based on percentages of
certain measures of income such as AGI, would be based on those
percentages as determined for AMT purposes rather than regular tax
purposes.

[77] In interpreting how the 1986 Act version of the AMT should apply
to particular situations, the Office of Chief Counsel of the Internal
Revenue Service in published rulings took the view that the AMT should
be treated as a separate but parallel tax system. However, this view
was not fully reflected on the appropriate tax forms until 1993.

[78] Upon issuance of the proposed 1993 Form 6251 many tax
practitioners objected to computing AMTI on a fully separate but
parallel basis. They objected to computing deduction limitations based
on AMT AGI rather than regular tax AGI because of the added complexity.
The Treasury Department carefully considered these comments.

[79] Based in part on the Staff of the Joint Committee on Taxation's
report on the 1986 Act, the Treasury Department concluded that it had
the authority to issue regulations deviating from the separate but
parallel concept in appropriate circumstances to eliminate complexity
and the administrative burden on taxpayers. See Staff of the Joint
Committee on Taxation, 99th Cong., General Explanation of the Tax
Reform Act of 1986 438 n.9 (Comm. Print 1987).

[80] In late 1994 the Treasury Department issued section 1.55-1 of the
Income Tax Regulations. These regulations generally provide for the
computation of AMTI on a separate but parallel basis. However, in
response to the concerns of tax practitioners, paragraph (b) of the
regulations provide that regular tax AGI or regular tax modified AGI is
to be used in determining limitations on deductions, exclusions, and
items of income in computing AMTI. The regulations are effective for
taxable years beginningafter December 31, 1993.

[81] Regarding 1993 and prior years the Service issued Notice 94-28,
1994-14 I.R.B. 13 in April 1994. For purposes of computing 1993 AMTI
this notice allows taxpayers to make a binding election to either
compute items of income, deduction, or exclusion reference to regular
tax AGI or AMT AGI. Because Form 6251 for taxable years prior to 1993
was unclear on the requirement to compute AMT AGI separately, the
notice announced that the Service would not challenge computations of
AMTI based on regular tax AGI for taxable years beginning before
January 1, 1993, for returns filed before March 17, 1994. For open year
prior to 1993 this gave taxpayers the best of both worlds. If it would
be to their advantage to make computations based on AMT AGI, taxpayers
could amend their returns to do so. However, if a taxpayer had used
regular tax AGI and this produced a better result than using AMT AGI,
the taxpayer was not required to amend the return.

[82] Some taxpayers have objected to the regulations. Affluent
taxpayers who give large amounts to charity general do not like the new
regulations because their charitable contribution deductions may be
limited because of AGI and their AMT AGI often exceeds their regular
tax AGI. Thus, the validity of the regulations may be challenged at
some point in the future. However, these regulations do not undercut
the Service's interpretation of section 56(b)(1)(D). Any effect on an
item of AMT deduction or income resulting from including a state income
tax refund in regular tax AGI arises solely from basing limitations
regular tax AGI rather than AMT AGI.

CONCLUSION

[83] We recognize that you have put a lot of time and effort into
formulating your position that the Service is improperly interpreting
sections 111(a) and 56(b)(1)(D). However, as noted in prior
correspondence, we do not concur with your views. We do, however,
appreciate your interest in this matter and hope our response is
helpful to you.

Sincerely,


Enclosure:
Steven J. Willis, The Tax Benefit Rule: A Different View and a
Unified Theory of Error Correction, 42 Fla. L. Rev. 575 (1990).
* * * * *
/1/ Unless specifically provided otherwise, all references to sections
refer to sections of the Internal Revenue Code as in effect for the
taxable years under discussion.

/2/ However, section 111(c) treats a deduction that increases a
carryover (such as a net operating loss carryover) that has not expired
before the beginning of the taxable year in which the recovery or
adjustment takes place as reducing the tax imposed by chapter 1 of the
Code. Section 111(a) and (c) apply to Federal income taxes because they
are imposed under chapter 1 of the Code. To simplify matters, in the
remainder of this letter it will be assumed that the deduction at issue
does not increase a carryover.

/3/ In your letter you assert that deduction recoveries are not
includible in gross income under section 61 but rather are includible
in gross income on a limited and conditional basis under section
111(a). Although deduction recoveries are not contained in the
illustrative list of items includible in gross income under section
61(a)(1) through (15), that list does not enumerate all items
includible in gross income. The first words of section 61(a) provides
that "[e]xcept as otherwise provided in this subtitle, gross income
means all income from whatever source derived, including (BUT NOT
LIMITED TO) (emphasis supplied) . .. [the items contained in the list].
Thus, to the extent deduction recoveries are includible in gross
income, they are includible under section 61 unless overridden by
section 111. However, we agree with you that the relevant test is
whether an item should be included in gross income in light of section
111.

/4/ For example see section 1341 and sections 1311 through 1314.

/5/ The effective date of the 1986 amendment was the same as if
included in the 1984 Act. Thus, the 1986 amendment retroactively
corrected the oversight made in the 1984 Act.

/6/ For example, for 1994 a single taxpayer with wages of $25,000 and
no deductions except the standard deduction and personal exemption
deduction will have taxable income of $18,750. Because the personal
exemption and standard deduction are not allowed in computing AMTI, the
taxpayer will have AMTI of $25,000. The tentative tax on this AMTI will
be zero because of the $33,750 AMT exemption amount. Even though the
taxpayer will be liable only for the regular tax attributable to the
$18,750 of taxable income the taxpayer will still have $25,000 of AMTI.

.

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