Study: Tax Changes Could Raise Billions

Q:

Mr. Kerstetter:

A tax preparer at H&R Block mentioned to me that the Schedule A deduction for state and local taxes for employees should only be for net taxes, taxes that are paid on the state tax return.  Thus for 2004 taxes, one should prepare their state income tax return first then place the tax paid on the 2004 state tax return onto the Schedule A for the 1040.

I have not heard that this is the “correct” way to report state taxes.

What I am familiar with is to deduct on Schedule A taxes withheld, then count as next year’s income when the W-2G comes.  Or, if taxpayer does not itemize, no income in reportable from the W-2G.

What is the correct method, if there is one?

A:

You are right.  State taxes are deductible on a purely cash basis.  Whatever was paid in during the year can be claimed on that year’s Federal Sch. A.  If the person does receive some of that previously deducted money back, it is considered income on the 1040 for the year in which the refund was actually received or applied to a future state tax year. 

Just because a person itemized on the previous year’s 1040 doesn’t automatically make subsequent refunds taxable.  Under the Tax Benefit Rule, if the state tax deduction didn’t actually result in any actual additional Federal tax savings, refunds of those taxes are not required to be reported as taxable income.  I see this situation a lot when the taxable income figure was negative on the return where the state tax payments were claimed. 

As much as I often poke fun at H&R Blockheads, I can only assume that the preparer with whom you were speaking was sleeping through the section of their training course that covers Schedule A, because that has been the proper procedure for at least the past 30 years I have been in this business.

There are times when the net state taxes are used in some situations.  I prepare a lot of multi-state income tax returns, where we often need to claim a credit against the clients home state taxes for the taxes paid to the other nonresident states.  In those cases, we can only use the actual tax as shown on the other state form.

I hope I’ve cleared this up for you.  I also hope you aren’t seriously considering allowing that Block employee actually prepare your income tax returns.  If this person is so wrong about a very basic simple tax matter, there’s no telling how many other areas s/he is ignorant about.

Good luck.

Kerry Kerstetter

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