 Hello and welcome to this session in which we will explain the tax benefit rule. The tax benefit rule is a rule that you will need to understand whether you are a CPA candidate, accounting student or an enrolled agent. What does it mean? Simply put, well, if a tax payer deduct a certain expense in one year, let's assume this is year one, and in subsequent year gets reimbursed for that expense, well the reimbursed amount is counted as gross income. So that's the general rule. Simply put, in year one, you deducted an amount. In year two, you deducted means you got a deduction. It's an expense. In year two, you receive a reimbursement. Well, if you deducted this amount in year one and got benefit because expenses are beneficial to you as a taxpayer, then in year two, the amount is taxable. You might be saying, what's complicated about this? Well, you're going to see, you're just going to have to be very careful with certain rules, but that's the basic idea. If you understand this idea, well, we can work on the details. However, the added income can only be as much as the tax advantage the taxpayer initially received from the deduction. And this is where students start to basically kind of get a little bit confused. Well, simply put, your taxable amount that you included in year two cannot be greater than the tax benefit you initially obtained. That's basically what it means. It's how much the deduction benefited you. Well, the amount that the deduction benefited you in year one is the amount that's going to be taxable in year two. Well, the best way to illustrate this is to look at a few examples. Before we proceed any further, I have a public announcement about my company, farhatlectures.com. Farhat accounting lectures is a supplemental educational tool that's going to help you with your CPA exam preparation, as well as your accounting courses. My CPA material is aligned with your CPA review course such as Becker, Roger, Wiley, Gleam, Miles. My accounting courses are aligned with your accounting courses broken down by chapter and topics. My resources consist of lectures, multiple choice questions, true-false questions, as well as exercises. Go ahead, start your free trial today. So let's start to illustrate this concept by a simple, non-realistic example. Ted is a single taxpayer. Assume the standard deduction for year X1 for not any particular year is 30,000. Now we're going to have to assume here, you know what a standard deduction is. The standard deduction is a deduction given to you and here as a single taxpayer. Now again, this is a number that I gave. The government changes this number every year. Now for Ted, you remember, you could choose between your standard deduction or itemized deduction. Which one would you choose? You will choose the greater of these two. So let's assume for the itemized deduction, Ted has itemized deduction, other itemized deduction of 27,000 and in that same year, Ted paid state income tax of 5,000. So if you notice, if Ted add up all his standard deduction, they add up to 30,000 while the standard deduction that's given by the government is 30. Which one will Ted chooses? Ted will choose the 32,000. So on 20X1, Ted used the itemized deduction and was able to use 32,000 and itemized deduction to reduce his income. Ted got a refund from the state of 3000 because Ted overpaid his taxes in year X1. So in year X2, so on 20X2, the following year, Ted received a refund. Now why would that happen? That would happen because Ted, remember, Ted paid $5,000 in state income taxes. What he found out later after everything settled is he's only responsible for two. So the state issued him a $3,000 tax refund. So the question becomes how much of the refund is included in Ted's taxable income in X2? So how much of the 3000 would Ted include in his taxes? That's the question. Well, what was the benefit? What was the benefit? Well, here's the benefit. If Ted did not itemize, if Ted did not itemize, he would have received 30,000, just given by the government. This number is given because Ted itemized, he was able to increase his deduction by an additional 2000. So the additional benefit is only $2,000. Simply put, of the $3,000 of the check that the state government sends to Ted, Ted will have to include 2000 in X2 as taxable income, as taxable income. Why? Because the benefit was only 2000. The benefit was only 2000. Now let's assume Ted received a $750 check from the state government as a refund in X2. How much of that will be included? Nothing will be included because that was not more than the benefit because $750 is less than the benefit. He benefited only 2000. So really, the 750 should not be included in his taxes. Let's take a look at additional examples. Let's look at example one, tax benefit rule. In year X1, Blue Office Store, which operates as a sole proprietorship using a cruel accounting, made credit sales of office equipment worth $10,000 to a customer named Tony. So what happened? They debited the counter-receivable $10,000, credited sales $10,000. The cost of the equipment was $6,000. They said they were debited, cost of goods sold $6,000, credited inventory $6,000. In 2020 X2, the following year, Blue claimed the deduction for bad debt expense amounting to $10,000. This is specifically for Tony's office equipment. Simply put, by year X2, we gave up on Tony collecting the money. Therefore, we took a deduction. Can we take a deduction in year X2? Yes, we can. Why? Because we included the revenue in year X1. Why? Because we told you this is an accrual basis account, an accrual basis taxpayer. Therefore, if we included the sales, now we can take the deduction. Simply put, we'll take the deduction, bad debt expense of $10,000. Simply put, we debit bad debt expense of $10,000, credited the account receivable for Tony $10,000. Therefore, we took the expense of $10,000. This is X2. In X3, Tony won the lottery and repaid Blue for the $10,000 he owed. Out of nowhere, Tony said, you know what? I owe you $10,000 to the Blue office store. I'm going to send you the money. Well, we received the money. Is that money taxable? And the answer is yes. That money is taxable because it was taxable year one, then it was reversed in year two. Then when we receive the money in year three, we have to pay taxes on it. So Blue, the Blue owner fell under the 35% tax bracket in year X1. So in year X1, let me show you what happened. In year X1, they reported $10,000 of income and they paid 35% in taxes on it. They paid $3,500 in taxes. In X2, when they took the deduction, they took a deduction of $10,000, they got a tax benefit of 20%. So they got a benefit of $2,000. You see this? So between year X1 and year X2, it wasn't really good for them because they paid taxes of $3,500 and their deduction was $2,000. In year X3, their tax rate went back to $3,000. So they went back and they paid 35%. They ended up paying $3,500 in taxes. So that wasn't good at all in a sense that it's not only they paid taxes because of the changes in tax rate, it worked against them. Let's take a look at another example to illustrate the tax benefit role. In year X2, Sarah, cash basis taxpayer, claimed $2,100 itemized deduction for the state income taxes she paid. The deduction was not subject to any limitation. As a result, her itemized deduction exceeded the standard deduction by a total of 900. So the itemized was greater than the standard by 900. So that's basically the benefit. In 20X3, she received a refund check of $1,500 when she filed her state income tax return for the year 20X2. Well, in 20X2, Sarah fell in the 12% marginal tax rate, but in 20X3, she moved to 35%. So when she took the deduction in 20X2, well, her additional benefit was $900 times 12%. So let's do that. $900 times 12%. So she got a benefit of $108 because that's the year she took the deduction. In year X3, she's going to have to include $900 in income and she's going to have to pay taxes at a 35% rate, $315. So notice $315 minus $08, she is worse off $207 because of the changes in her tax rate. Let's take a look at the third example for the tax benefit role. In 20X2, Sue, cash basis taxpayer, experienced a bike accident resulting in an $8,000 worth of medical expenses. She claimed these expenses as an itemized deduction for medical expenses. That's great. However, due to the 7.5 adjusted gross income reduction, only $3,000 of the $8,000 was eligible to reduce her income taxes payable. Well, she paid $8,000. She was only able to deduct $3,000. Remember the medical expenses, there is a limit out how much you can deduct, the percentage of your AGI. In 20X3, Sue successfully pursued legal action against the individual responsible for her physical injury from the bike accident and received the $8,000 as reimbursement for her medical costs. Remember, she paid $8,000 of which she took $3,000 in medical expenses as a deduction, but in 20X3, she received the $8,000. Sue fell in the 22% marginal tax bracket in 20X2 and moved to the 12% tax bracket in 20X3. So let's see. So in 20X2, what was her benefit? In 20X2, she deducted $3,000 and she got a deduction of, see 3,000, yes 3,000, she fell in the, okay, times 22%. So she got a deduction, so if we take 3,000 times 0.22, she got a deduction a tax saving of 660. In 20X3, she's going to have to go back because she received the $8,000 in reimbursement, she's going to have to include that in her income because she got the benefit of $3,000. However, in 20X3, her tax rate is 12%, therefore she's going to have to pay taxes only 360. So 660 minus 360 overall, just because of the tax changes, she got a benefit overall of $300. Now no one's going to ask you about the benefit, I'm just showing you the difference in years, like what happened, that this could happen from year to year. Bear in mind that she received $8,000 of which 3,000 was itemized deduction that included in her income. How about the 8,000? I'm sorry, how about the remaining 5,000? How about the remaining 5,000? That's compensation for her injuries. Is that taxable? No, we learn about this. Compensation is not taxable. Compensation for physical injury is not taxable. What should you do now? Go to Farhat Lectures, whether you are a CPA candidate, an accounting student, an enrolled agent. The tax benefit rule is an important concept. On Farhat Lectures, you're going to have to work MCQs through falls. Look at the additional notes that's going to help you understand this concept. Good luck, study hard, and of course, stay safe.