What is the Tax Benefit Rule?
The tax benefit rule is a feature of the United States tax system. Its main principle is that if a taxpayer recovers a sum of money that should have been paid in the past, they must pay tax upon it if it was not counted in their taxable earnings in a previous year. There are exceptions to this principle which, if exploited, can reduce tax bills substantially.
This explanation deals with the tax situation in the United States. Other countries may have similar rules under a different name. Alternatively, other countries may use the term "tax benefit rule" for a different concept.
The tax benefit rule is covered by section 111 of the Internal Revenue Code. This is the law in the United States that makes tax payments a legal requirement and gives the government the power to collect federal taxes. This law was revised substantially in 1986. It is part of the United States Code, which is the written record of federal law covering the US, organized by subject.
The key to the tax benefit rule is that US taxpayers are allowed to list many items as expenses. This lowers their taxable income and thus the amount of tax they pay. Such items are known as "write-offs."
In some cases, the taxpayer may in a later year recover this money. The tax benefit rule means that this money must now be classed as income for the current year. The general principle is that the taxpayer will pay more tax for the current year and make up for the fact that they didn't pay tax on this money originally. In practice, this may not match up perfectly as, for example, tax rates may have changed in the meantime.
One example of a situation covered by the tax benefit rule would be if a business listed an unpaid debt as an expense, lowering its taxable income, then recovered the money in a future tax year. Another example would be if somebody had to pay for repairs after an accident but later recovered the money in court from the person held responsible. The rule can also cover money a taxpayer receives as a tax refund, which can create a complicated situation.
The tax benefit rule only applies if there is a tax benefit. This means that in the year the money was listed as a deduction, the taxpayer wound up paying less tax as a direct result. In some cases this will not have been the case. For example, a taxpayer listing a deduction may have earned so little they wouldn't have paid tax anyway. In this situation, the taxpayer will not have to pay tax on the money if they recover it in the future. This will not happen by default and the taxpayer will have to detail the situation on their tax return for the year they recover the money.
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