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Repayment of Claim of Right Income

The repayment of claim of right income is a deduction that is allowed to the extent the repayment is not deducted in arriving at adjusted gross income in the current taxable year. If the amount of repayment is more than $3,000, the deduction is the amount of the repayment. If the amount of the repayment is $3,000 or less, the deduction is the amount of repayment less (i) 2% of adjusted gross income minus (ii) all other federal miscellaneous itemized deductions subject to the 2% limitation. No deduction is allowed if the taxpayer calculates the federal income tax in the year of repayment under the provisions of Code section 1341(a)(5). In that case, a taxpayer will recover the tax previously paid on the repaid income under G.S. 105-266.2.

For federal income tax purposes, a taxpayer required to repay all or a portion of income received in a prior year under a claim of right may claim a credit on their federal income tax return if the income repaid is substantial (more than $3,000) and the benefit received by claiming the credit is greater than that received by claiming a deduction for the repayment. The taxpayer is also considered to have made a payment of North Carolina income tax on the repayment. The payment, which is applied against the tax liability for the year in which the repayment was made, is the amount by which the tax was increased in the earlier year because the income was included in gross income minus the amount the tax for the current year was decreased because the repayment was deductible. Individuals may claim the payment on the individual income tax return by including the payment on the same line as S corporation payments. (Note: For tax years 2014 and 2015, taxpayers claiming a credit on the federal return for the repayment of income may not take a deduction on the North Carolina return.)

Example: In 2015, a single taxpayer reported North Carolina taxable income of $69,500 on which he paid tax of $3,966. The taxpayer’s only income was sales commissions. In 2016, it is determined that the commissions were erroneously computed for tax year 2015. Accordingly, the taxpayer pays back $25,000 of the commissions. Federal adjusted gross income for 2016 without regard to a deduction for the repayment is $10,000; therefore, the taxpayer claims a credit on the federal return for the amount of tax paid in 2015 on the income. The tax payment to be claimed on the 2016 North Carolina return is determined as follows:

NC Tax on $69,500 = $3,996
NC Tax on $44,500 ($69,500 - $25,000) = $2,559
Additional tax paid on $25,000 = $1,437
Less: Decrease in tax for deduction = $ 0
Payment to be claimed on the 2016 North Carolina Return = $1,437

If the amount of repayment is more than $3,000, the taxpayer may elect to claim a deduction on the federal return instead of the credit described above. If the repayment is $3,000 or less, then the taxpayer can only claim a deduction. When a deduction is claimed for federal purposes, where the deduction is claimed on the federal return dictates how the North Carolina return is impacted. In most cases, the taxpayer deducts the repayment on the same form or schedule that the taxpayer reported the income (Schedule C, Schedule D, Schedule E or Schedule F). If the deduction is reported on these forms, the taxpayer receives the benefit of the deduction without further action because income and losses from those schedules are included in federal adjusted gross income, which is the starting point of the North Carolina return. If the income was originally reported as wages, unemployment compensation or other nonbusiness income, the deduction is claimed on Schedule A on the federal return. In that case, the taxpayer has to take further action on the North Carolina return to receive the benefit of the deduction.

The taxpayer may include the amount of repayment in North Carolina itemized deductions if the taxpayer deducted the repayment as part of itemized deductions on the federal return. If the amount of repayment deducted in federal itemized deductions is more than $3,000, enter the amount from line 28 of federal Schedule A on North Carolina Form Schedule S, Part C, line 22. If the amount of repayment deduction is $3,000 or less, the repayment deduction is reported as part of line 23 of federal Schedule A. The sum of deductions reported on lines 21 through 23 on federal Schedule A is deductible only to the extent that they exceed 2% of the taxpayer’s adjusted gross income. To determine the amount to deduct on North Carolina Form Schedule S, Part C, line 22, the taxpayer must make the following calculation:

1. Enter the repayment deduction included in line 23 of federal Schedule A. 1. _____
2. Enter amount from line 26 of federal Schedule A (2% of adjusted gross income). 2. _____
3. Enter amount from line 24 of federal Schedule A. 3. _____
4. Subtract line 1 from line 3. 4. _____
5. Subtract line 4 from line 2 (if negative, enter zero). 5. _____
6. Subtract line 5 from line 1 (if negative, enter zero). Enter this amount on Form D-400, Schedule S, Part C, line 22. 6. _____