Re: IRS'S FEEBLE ATTEMPT TO DEFEND "DOUBLE OR NOTHING TAXATION OF RECOVERIES

ONLY EDITED SUBJECT LINE

On Jun 17, 2:22�pm, KEBSCHU...@xxxxxxx wrote:
When the following letters were published in Tax Analysts Tax Notes
Today, IRS instrutions for the tax treatment of state income tax
refunds provided for "DOUBLE OR NOTHING TAXATION" of the refunds.

What was not addressed by the IRS respondents is that a state income
tax overpayment in a year that the AMT is paid can produce a limited
long-term capital gains rate based tax benefit because of the two-tier
capital gains rate that was intorduced in 1997. If the taxpayer
received a limited long-term capital gains rate based tax benefit from
a state income tax overpayment in the year the AMT was paid and then
paid the regular tax in the refund year, the income used for the
overpayment would be taxed at the AMT rate and the refund would be
taxed at the regular tax rate. �This little fact destroys the argument
advanced by the IRS attorney in paragraphs 59 through 73.. �Section
56(b)(1)(D) precludes �a state income tax refund from being included
in AMTI after the income used for the tax overpayment �was included in
AMTI in a year the AMT was paid.

The exclusion from AMTI of refunds tof tax overpayments hat provided a
tax benefit in a year when the regular tax was paid has cost the
United States billions of dollars. �In recent years the loss has been
about a billion dollars per year.

Tax Notes Today ,MARCH 18, 1999 THURSDAY, DEPARTMENT: Official
Announcements, Notices, and News Releases; IRS Tax Correspondence

CITE: 1999 TNT 52-53

� � � � � � � � � � � � � � �* * * * *

� � � � � � � � � � � �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 refunds 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
of
medical expense deductions and miscellaneous itemized deductions. 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 taxable 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 imprecise 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
respective
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
beginning
after 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 by 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 years 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 generally 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 on 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).

� � � � � � � � � � � � � � �* * * * *

� � � � � � � � � � DEPARTMENT OF THE TREASURY

� � � � � � � � � � � � �February 3, 1999

� � Dear * * *

� �[84] Your letter of July 1, 1998, to * * * was recently forwarded
to my
office from the Office of Chief Counsel so that I could respond to
you. I am
sorry you did not receive a reply to your letter sooner. In your
letter you
stated your concerns about IRS' interpretation of sections 111(a) and
56(b)(1)(d) of the Internal Revenue Code.

� �[85] The Office of Chief Counsel and District Counsel, Delaware-
Maryland, have previously provided you with the Internal Revenue
Service's
position on the treatment of tax refunds under sections 111 and 56.
The
questions you raise in your July letter would involve a legislative
change
to Internal Revenue Code section 111(a). Therefore, we cannot respond
to the
questions because they involve matters under the jurisdiction of the
Office
of the Assistant Secretary (Tax Policy). We will, however, forward a
copy of
your letter to that office so they will have the benefit of your views
when
considering legislative proposals.

� �[86] Thank you for taking the time to write us with your concerns.

� � � � � � � � � � � � � � � � � Sincerely,

� � � � � � � � � � � � � � � � � John M. Dalrymple

� � � � � � � � � � � � � � �* * * * *

� � FOOTNOTES

� �/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.

� �END OF FOOTNOTE


.

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