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The need to review state income tax refunds and determine whether
they were generated by a credit associated with SITPs will cause
additional administrative burden and disclosures going forward.

Although Rev. Rul. 58-25 reiter- receiving the refund (the partners or related to the SITP when calculating
ates the position that state taxes on net members) are not the same. However, their state taxable income.
income are not deductible in arriving in similar circumstances the courts have A state income tax refund received
at an individual taxpayer’s AGI, in the ruled otherwise. from a state using an income exclusion
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case of a PTE, no provision was made In Maines, the Tax Court held that a will not be taxable at the federal level if
for the computation of AGI. There- New York qualified Empire zone enter- a standard deduction was taken. If an
fore, as the ruling concludes, while net prise (QEZE) real property tax credit for itemized deduction was taken, the general
business income taxes imposed on an which a partnership paid and deducted rules regarding state income tax refunds
individual, either directly or through property taxes and the individual partners will apply. Under the federal tax-benefit
an unincorporated business, are not received a refundable credit was includ- rule, a refund is not taxable to the extent
deductible in computing AGI, net busi- ible in the partner’s federal gross income it did not provide a federal benefit in a
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ness income taxes imposed on and paid under the tax-benefit rule. The court prior year. In an exclusion state, a refund
by a PTE are deductible in computing held that it was of no consequence that may relate to composite payments, esti-
the taxable income of the PTE, and the the partnership paid and deducted the mated income tax payments, or withhold-
partners or members are not precluded property taxes, while its partners received ing tax payments. Therefore, provided
from claiming the standard deduction. the refundable credit. As the Maines case none of these items were deducted when
Therefore, SITPs are deductible in ar- demonstrates, Sec. 111 is not limited to calculating federal taxable income, the
riving at an individual’s AGI, so long cases where the same person receives both federal tax-benefit rule would apply, and
as they are imposed upon and paid by the deduction in the earlier year and the the state income tax refund could be ex-
a PTE. recovery in the later year. cluded from federal taxable income.
A PTE owner who is allowed a fed- Alternatively, a taxpayer receiving a
If a state income tax refund eral deduction for an SITP and receives a state income tax refund resulting from
is received, is it considered state income tax refund in the same year an income tax credit created by an SITP
federal gross income in the may have to include the state income could be required to include that refund
following year? tax refund as federal gross income in the in federal taxable income in the year of
One significant question that remains year of receipt. Several factors should be receipt. The state income tax refund may
unanswered by the notice is whether reviewed to make that determination, have provided a federal benefit, as the
refundable PTE tax credits are includ- including whether the state benefit asso- SITP gave rise to a federal deduction,
ible in income under the Sec. 111 ciated with the SITP is provided through and the taxpayer would no longer be al-
tax-benefit rule. The tax-benefit rule a state income tax credit or income exclu- lowed to exclude the refund under the
is a federal tax concept partially codi- sion, as well as the state ordering rules for tax-benefit rule.
fied under Sec. 111, which generally payments and credits. The tax-benefit rule implications
requires a taxpayer to include in gross While SITPs made by PTEs are for an SITP creating a state income tax
income recovered amounts that the deductible at the federal level, the state credit versus a state income exclusion can
taxpayer deducted in a prior tax year to benefit that is passed to the S corpora- be demonstrated in the table “Illustration
the extent those amounts reduced the tion shareholders or partners varies by of Tax-Benefit Rule” on page 44.
taxpayer’s tax liability in the prior year. state. Some states provide a state income While the exclusion state generates
Some practitioners have argued that tax credit that is allocated based on their a state income tax refund of $12,000, it
Sec. 111 does not apply with respect to share of what the PTE paid on the is related to estimated tax payments that
SITPs because the taxpayer claiming the owner’s behalf, while other states allow did not provide a federal tax benefit, since
deduction (the PTE) and the taxpayer the PTE owners to exclude the income a standard deduction was taken on the

18. Maines, 144 T.C. 123 (2015). 19. Sec. 111(a).

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