Question

Problem 5-55 (LO. 3) How does the tax benefit rule apply in the following cases? a. In 2018, the Orange Furniture Store, an accrual method sole proprietorship, sold furniture on credit for $1,00 to Sammy. The cost of the furniture was $600. In 2019, Orange took a bad debt deduction for the $1,000. In 2020, Sammy inherited some money and paid Orange the $1,000 he owed. Orange's owner was in the 35% marginal tax bracket in 2018, the 12% marginal tax bracket in 2019, and the 35% marginal tax bracket in 2020. Orange Furniture must includes 1,000 in gross income as the recovery of a prior deduction. The timing of the income and deductions cost Orange $ 230 b. In 2019, Marvin, a cash basis taxpayer, took a $2,000 itemized deduction for state income taxes paid; the deduction was not limited by the SALT cap. This increased his itemized deductions to a total that was $800 more than the standard deduction. In 2020, Marvin received a $1,500 refund when he filed his 2019 state income tax return. Marvin was in the 12% marginal tax bracket in 2019 but was in the 35% marginal tax bracket in 2020. How much must Marvin include in his gross income for 2020? 1,500 c. In 2019, Barb, a cash basis taxpayer, was in an accident and incurred $8,000 in medical expenses, which she claimed as an itemized deduction for medical expenses. Because of the 7.5%-of-AGI reduction, the expense reduced her taxable income by only $3,000. In 2020, Barb successfully sued the person who caused the physical injury and collected $8,000 to reimburse her for the cost of her medical expenses. Barb was in the 22% marginal tax bracket in 2019 12% in 2020. What amount, if any, will Barb include in her 2020 gross income?

Answer 1

Tax benefit rule states that if one person receives tax benefit from an item in a prior year, because of any deduction the same shall be taxable in the year when he recovers the said deduction

a. in the given case, sammy claimed a bad debt deduction of 1000 dollar when the tax rate was 12%, in 2019 but eventually recovered the amount of 1000 dollars, in 2020 when the tax rate was 35% it will be counted as income in 2020 and the tax payable on it shall be 1000*35% = 350. sammy already gained an advantage by paying 12% less on 1000 dollar in prior period that is 1000 * 12% that amounts to 120 Dollar, the net tax cost is 350 - 120 = 230 dollars

b. Marvin must include the amount of refund received in his gross income in 2020 that is 1500 dollars.

c. Since Barb has only reduced the income by 3000 dollars, subsequently when barb receives the reimbursement of 8000 dollars, only 3000 dollars shall be added back to the income since only that was reduced in the prior period.