Question

Ted, a cash basis taxpayer, received a $150,000 bonus in 2018 when he was in the 35% marginal tax bracket. In 2019, when Ted was in the 24% marginal tax bracket, it was discovered that the bonus was incorrectly computed, and Ted was required to refund $40,000 to his employer. As a result of the refund, Ted can reduce his 2019 tax liability by $14,000 (.35 × $40,000).

a. True
b. False

Answer 1

Ted cannot reduce his 2019 tax liability by $14,000 due to the $40,000 refund at a 35% rate from 2018; instead, his tax benefit is based on the 2019 marginal tax rate of 24%, resulting in a $9,600 reduction.

Step-by-step explanation:

The statement is false. Ted, a cash basis taxpayer, cannot reduce his 2019 tax liability by $14,000 just because he refunded $40,000 in 2019. Instead, his tax benefit is determined by the tax rate of the year in which the refund was applied, which is 2019. Since Ted was in the 24% marginal tax bracket in 2019, his tax benefit would be $9,600 (24% × $40,000), not $14,000 as initially claimed.

Marginal tax rates apply to the highest dollar of income earned. They do not apply retroactively to money earned or refunded in a different tax year. Therefore, the tax benefit of a refund will be calculated at the marginal tax rate for the year the refund is made. Understanding this helps in grasping the impact deductions, like refunds, have on the taxable income for the year they occur.