When a taxpayer reports income in one year (because at the time they thought they had an unrestricted right to it) but then has to repay that income in a future tax year, the question arises as to how to include the amount repaid in their tax return in the year of repayment. The question is important, as a situation such as this could result in the taxpayer paying more tax if the income was taxed at a higher rate in the earlier year but the repayment is taxed at a lower rate in the repayment year due to either a shift in tax brackets or change in tax rates. IRC section 1341 provides relief to taxpayers when the amount of the repayment exceeds $3,000.
When a repayment occurs, rather than amend the prior year return you are to deduct the amount on the tax return in the year of repayment. If and where it is deducted in the tax return depends on the type of payment and the amount.
Repayment of $3,000 or Less
If the repayment is in the amount of $3,000 or less, section 1341 doesn't apply and the repayment is generally deducted on the same form or schedule on which it was previously included. For example:
- If it had been included as self-employment income on Schedule C, it is deducted on Schedule C.
- If it had been included as capital gain on Schedule D, it is deducted on Schedule D.
- If it was social security or railroad retirement benefits, it will be indicated on SSA-1099 or RRB-1099 Box 4 reducing the current year's total benefit. (If SSA-1099 or RRB-1099 Box 5 is a negative number, i.e., more was repaid than received, see below for instructions on how to handle the form.)
Prior to 2018, wages, taxable unemployment compensation, and other nonbusiness ordinary income could be deducted on Schedule A as a miscellaneous deduction subject to the 2% of AGI limitation. This deduction was eliminated with the Tax Cuts and Jobs Act of 2017 and is unavailable for tax years 2018 and forward, so repayments of these kinds of prior year income in the amount of $3,000 or less cannot be deducted anywhere in the tax return.
Repayment of more than $3,000
If the taxpayer had to repay more than $3,000 that was included in their income in an earlier year, the taxpayer may:
- reduce their income, or
- deduct the amount repaid under Other Itemized Deductions on Schedule A (Form 1040), or
- take a refundable credit against tax.
Whether the repayment is deemed a reduction in income, an itemized deduction, or a tax credit depends upon the type of income.
Wages, taxable unemployment compensation, nonbusiness ordinary income
If the income exceeds $3,000 and was previously reported as wages, taxable unemployment compensation, or other nonbusiness ordinary income, the taxpayer can either include the repayment on Schedule A under Other Itemized Deductions or calculate a tax credit, whichever is more favorable. (For the tax credit, see the instructions below.)
To include the repayment on Schedule A, from the Main Menu of the tax return (Form 1040) select:
- Itemized Deductions
- Other Miscellaneous Deductions
- Repayment under Claim of Right - Enter the amount repaid.
Social Security or Railroad Retirement Benefits
If a taxpayer repaid social security or railroad retirement benefits, the amount repaid will be reflected in the year of repayment on Form SSA-1099 or RRB-1099, respectively, in Box 4, reducing the taxable benefits in Box 5. If the amount repaid is more than the gross benefits that were received in Box 3, Box 5 will be negative.
If the negative amount is $3,000 or less it cannot be deducted anywhere in the tax return. If it exceeds $3,000 the taxpayer can either include it on Schedule A under Other Itemized Deductions or calculate a tax credit, whichever is more favorable.
Calculating and entering the tax credit
To determine the whether an itemized deduction or a tax credit is most beneficial to the taxpayer, calculate the return using both methods as follows:
- Figure the tax for the current year with an Other Deduction on Schedule A for the amount repaid (using the steps above).
- Figure the credit for the current year as follows:
- Figure the tax for the current year without the Other Deduction on Schedule A. (Be sure to include in the return the social security or railroad retirement benefits received.)
- Refigure the tax for the earlier year, reducing the income by the amount that was repaid in the current year.
- Subtract the earlier year tax refigured under Step 2b from the actual tax for the earlier year. The difference is the amount of the credit in the current year. If the credit is more beneficial compared to the tax as figured in Step 1, enter the credit in the tax return (Form 1040) here:
- Payments, Estimates & EIC
- Other Payments or Refundable Credits
- IRC 1341 Repayment Amount - enter the amount from Step 2c. The credit will carry to Schedule 3 annotated "IRC Section 1341".
Note: This is a guide to entering repayments and credit for section 1341 claim of right into the TaxSlayer Pro program. This is not intended as tax advice.