Based on what you have represented it is my opinion that you are entitled to the statutory mitigation afforded under Internal Revenue Code Sec. 1341(a)(4) & (5). This is so because you had an apparent claim of right to income from the DI carrier and there was no restriction on its use.
Accordingly, for 2005 your tax liability is the lesser of;
(1) your tax computed with the deduction for the repayment taken into account, or
(2) the tax computed without the deduction for the repayment (i.e. only repayments related to the 2003 and 2004 DI receipts included into income are excluded from this computation) reduced by the decrease in tax liabilities in 2003 and 2004 resulting from the exclusion of the DI payments previously recognized as ordinary income in those years.
Thus, you may choose whichever calculation method results in the lowest tax liability. Remember, for purposes of the 2nd calculation, only consider the portion of the repayment related to the 2003 and 2004 amounts. The portion fo the repayment related to the 2005 DI receipts will still be deducted in either computation method.
Here is an example of both method calculations:
Example: C receives salary of $400,000 from X Corp. in 1998 and includes it in gross income. C's tax liability for 1998, taking into account other income and deductions, is $150,000. In 1999, X Corp.'s accountants determine that C's department generated a loss in 1998 and C repays $100,000 of his 1998 salary in 2000 under a provision in his employment contract that reduces his salary if his department generates a loss. C's tax liability after deducting the repayment under IRC Sec. 1341(a)(4) is $145,000 (i.e. method 1 calculation).
C's tax liability for 2000, ignoring the $100,000 deduction, is $180,000. C's tax liability for 1998, ignoring the $100,000 inclusion, is $122,000. Thus, the decrease in 1998 tax liability resulting solely from the exclusion of the $100,000 is $28,000 ($150,000 - $122,000). C's tax liability for 2000 under IRC Sec. 1341(a)(5) is $152,000 ($180,000 - $28,000) (i.e. method 2 calculation).