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Revenue Administrative Bulletin 1994-9
Approved: July 13, 1994
INDIVIDUAL INCOME TAX - TAXABILITY OF REPAYMENTS MADE UNDER THE CLAIM OF RIGHT
(Replaces Revenue Administrative Bulletin 1988-44)
RAB 94-9. This bulletin announces the Michigan income tax treatment of amounts repaid and deducted under the "claim of right" doctrine. The claim of right doctrine, Section 1341 of the Internal Revenue Code (IRC), is used to recompute tax liability when a taxpayer has previously included in gross income, under a claim of right, consideration that later must be repaid because the taxpayer did not, in fact, have a right to the income. Public Act 281 of 1993 [MCL 206.265; MSA 7.557(1265)] added section 265 to the Income Tax Act to define the "claim of right" credit for Michigan income taxpayers.
Federal Income Tax Treatment
Pursuant to Section 1341, an item of income included in gross income in a prior year because the taxpayer believed he or she had an unrestricted right to the income may be deducted from gross income in the year of the repayment.
To ensure that a taxpayer is adequately compensated for an amount repaid that exceeds $3,000, a taxpayer may compute his or her tax liability in the year of repayment by either:
Claiming the amount repaid in the year of repayment as an itemized deduction on Schedule A, or the schedule on which the income was previously reported, or
Claiming a credit in the year of repayment for the amount of tax attributable to the income in the prior tax year.
Repayments of $3,000 or less cannot be used to compute a credit against the federal income tax liability. The repayment can only be reported on the same form on which the income was previously reported in the year of the repayment.
Michigan Income Tax Treatment
Section 265 of the Income Tax Act [MCL 206.265; MSA 7.557(1265)] allows for a refundable credit against the Michigan income tax for an amount received under the claim of right doctrine and repaid in a subsequent tax year. The complete text of the amendment follows:
"(1) For the 1991 tax year and each tax year after 1991, a taxpayer may credit against the tax imposed by this act for the tax year an amount equal to the tax paid in any prior tax year attributable to income received by the taxpayer in any prior tax year and repaid by the taxpayer during the tax year if the taxpayer is eligible for a deduction or credit against his or her federal tax liability pursuant to section 1341 of the internal revenue code based on the repayment for the tax year. A credit under this section for a tax year is allowed only if the repayment for which a deduction or credit was taken pursuant to section 1341 of the internal revenue code is not deducted in calculating the taxpayer's adjusted gross income for the tax year."
Calculation of the Credit
The credit is calculated by multiplying the repayment used as an itemized deduction on Schedule A, or the repayment used to calculate a credit against the taxpayer's federal income tax, by the Michigan income tax rate. The Michigan income tax rate is the rate in effect during the tax year the income that was subsequently repaid was included in taxable income.
Since calculation of Michigan taxable income begins with federal adjusted gross income (AGI), a repayment that was included in the computation of a taxpayer's AGI cannot be used to calculate a credit against the Michigan income tax. A repayment that is not eligible for a deduction or credit on the taxpayer's federal return is not eligible for a credit on the taxpayer's Michigan income tax return.
Reporting the Credit
The credit is added to Michigan income tax withheld and reported on the MICHIGAN INCOME TAX WITHHELD line of the MI1040. A statement that the amount of withholding includes a credit for repayments made under the claim of right must be included on the withholding line. Verification of the amount repaid, a copy of the federal return and schedules, and a schedule showing the calculation of the credit must be attached to the Michigan income tax return.
Amended Michigan income tax returns can be submitted for amounts repaid during the 1991 and subsequent tax years.
Effect on Household Income
For purposes of computing a Michigan Homestead Property Tax Credit, Farmland Preservation Tax Credit or a Home Heating Tax Credit, a claimant may not deduct from household income an amount repaid under the claim of right doctrine.
In 1992 Sue Smith received $5,000 from Benefits Insurance Company, a private insurance carrier. Sue included the amount in adjusted gross income for the 1992 tax year. During 1993, it was determined that the $5,000 was payable through her employer's workers' compensation insurance carrier. As a result, Sue was reimbursed by the workers' compensation carrier and had to repay the $5,000 to Benefits Insurance Company.
For federal income tax purposes, Sue used the $5,000 repayment to calculate a credit against her 1993 federal income tax liability under Section 1341 of the IRC. For Michigan income tax purposes, Sue could claim a credit of $230 ($5,000 x 4.6%) against her Michigan income tax liability. Sue claimed the credit on the MICHIGAN INCOME TAX WITHHELD line of the 1993 MI1040 by adding the $230 credit to her Michigan income tax withheld and stating that the amount of the withholding included the $230 credit for repayments under Section 1341 of the IRC. Sue also attached a copy of her 1993 federal return, verification of the repayment and a schedule showing the computation of the Michigan credit.
In 1992 David Jones received $2,500 from Payout Insurance Company, a private insurance carrier, and included the amount in his adjusted gross income for the 1992 tax year. During 1993, it was determined that the $2,500 was payable through his employer's workers' compensation insurance carrier. As a result, David was reimbursed by the workers' compensation carrier and had to repay the $2,500 to Payout Insurance Company.
For federal income tax purposes, David was not able to claim the repayment as a credit against the federal income tax, nor as an itemized deduction, because David's total itemized deductions were less than the federal standard deduction. For Michigan income tax purposes, David would be allowed a credit of $115 ($2,500 x 4.6%).
David claimed the credit on the MICHIGAN INCOME TAX WITHHELD line of the 1993 MI 1040 by adding the $115 to his Michigan income tax withheld and stating that the amount of the withholding included the $115 credit. David attached verification of the repayment and a schedule showing computation of the credit.
During the 1992 tax year a taxpayer received a $5,000 capital gain which was reported on the 1992 federal Schedule D. In 1993 the taxpayer had to repay the $5,000 capital gain that was included in 1992 taxable income. Under Section 1341 of the IRC, the taxpayer claimed the $5,000 as a capital loss on the 1993 federal Schedule D. The taxpayer cannot take a credit on his/her 1993 Michigan income tax return since the amount repaid was included in adjusted gross income.