Pro-Taxpayer Decision on Claim-of-Right Relief

A recent decision by the Court of Federal Claims, (2004), Penzoil-Quaker Co., 62 Fed. Cl. 689 has recent decision by the Court of Federal seemingly extended Sec. 1341’s benefit to more taxpayers. That taxpayer-friendly case dealt with oil sales income and subsequent price-fixing settlement payments.

Background

Claim of right: Under the “claim of right” doctrine, a taxpayer is required to recognize as income in the year received, cash or property that is free of restrictions. This is true even though the taxpayer may be obligated to return such “income” later. A taxpayer might be required to make restorative payments under a number of circumstances, including a mistake of fact, contractual indemnification clause or determination by a regulatory body.

When the taxpayer subsequently discovers that it had no right to the income and, thus, must provide reimbursement, it is entitled to a deduction for the amount of the repayment, in the year of repayment. According to the Supreme Court, a taxpayer cannot amend a prior-year return, even if the statute of limitations is still open. In Lewis, 340 US 590 (1951), the Court stated, “[i]ncome taxes must be paid on income received (or accrued) during an annual accounting period…The ‘claim of right’ interpretation of the tax laws has long been used to give finality to that period, and is now deeply rooted in the federal tax system.” Presumably, if a taxpayer were simply able to amend the prior-year’s return, the claim-of-right doctrine would be unnecessary.

Because the taxpayer is entitled to a deduction only in the year of repayment, it may face an inequity. The deduction might not provide tax relief equal to the tax on the income originally included.

Sec. 1341: To mitigate this inequity, Congress enacted Sec. 1341, Computation of tax where taxpayer restores substantial amount held under claim of right, in 1954. Under this provision, a taxpayer can forgo the deduction in the year of repayment and reduce the tax liability for that year by the liability generated by the previous inclusion. In other words, the taxpayer can realize the benefit of the deduction at the same tax rate that applied in the prior year, when the item was originally claimed as income. This accords the taxpayer a great benefit, essentially making it whole but for time-value-of-money considerations. Sec. 1341 applies to items both ordinary and capital.

Meeting the Requirements

To use Sec. 1341, five requirements must be met:

1. The repayment “item” must have been included in gross income in a previous tax year;

2. The item was included in gross income because the taxpayer appeared to have an unrestricted right to it;

3. A deduction (for the repayment) is allowable in the later year;

4. It was established after the close of the year of inclusion that the taxpayer did not have an unrestricted right to the item or portion thereof; and

5. The amount of the deduction exceeds $3,000.

First requirement: The Sec. 61 definition applies to determine whether the item was an item of gross income. Further, this definition is interpreted and applied broadly, as long held by the Supreme Court; see, e.g., Glenshaw Glass Co., 348 US 426 (1955).

Second requirement: Historically, the IRS and some courts have interpreted the second provision very narrowly. Taxpayers have been precluded from obtaining Sec. 1341 treatment if the income was included under an absolute right, and repayment was the result of a subsequent event other than a determination that no right actually existed. As discussed in Penzoil-Quaker, the courts have drawn a distinction between an apparent right and an absolute, or actual, right. For example, an absolute or actual right exists when repayment under a contractual provision is required as the result of a future event; at the time the income is recognized, the taxpayer had an absolute, unrestricted right to the income. It may seem like simply a matter of semantics, but the courts have often struggled over the appropriate application of the word “appear.”

In Penzoil-Quaker, however, the court dismissed the very restrictive interpretation historically applied by Treasury and, instead, concluded that an apparent right includes an actual right.

The court determined that the broader interpretation, using “apparent” right, was more consistent with Congressional intent than the historical, more restrictive approach. Sec. 1341 is, after all, a remedial statute. Further, the canons of construction dictate broad interpretation to implement Congressional goals; and, when a statute’s language is unclear, any doubts are to be resolved in the taxpayer’s favor.

Third requirement: Two conditions must be met for a deduction to be “allowable” under Sec. 1341; according to Regs. Sec. 1.1341-1(a)(1), the deduction must:

1. Result from “the restoration to another of an item which was included in the taxpayer’s gross income…under a claim of right”; and

2. Occur under a Code provision other than Sec. 1341.

Thus, Sec. 1341 does not provide relief for incidental expenses or attorneys’ fees, as these expenses do not result from “restoration to another.” Although these expenses may otherwise be deductible, they do not suffice for Sec. 1341 purposes.

Fourth requirement: This requirement focuses on whether it has been established that the taxpayer did not have an unrestricted right to the income item. Although a judicial finding of liability to return income is not required, it must be clear that the taxpayer has a true liability of repayment (i.e., the payee must be able to legally compel repayment for the payer to deduct the repayment under Sec. 1341). In Barrett, 96 TC 713 (1996), a taxpayer did not admit liability, but was a party to a settlement made at arm’s length and in good faith; the Tax Court held that the “establishment” requirement was met. The settlement gave the payee the ability to legally compel reimbursement. Thus, the taxpayer must be obligated to make the payment; it cannot simply be voluntary.

Fifth requirement: The amount of the deduction allowable (as defined in Sec. 1341) must exceed $3,000. A question arises for a deduction that is capital in nature: If a taxpayer is subject to the Sec. 1211 limit on capital losses, is it then barred from Sec. 1341 treatment? Regs. Sec. 1.1341-1(c) states that “the determination…shall be made without regard to the net capital loss limitation imposed by section 1211.” The taxpayer is, of course, still limited by Sec. 1211, but not precluded from Sec. 1341 treatment.

Conclusion

Penzoil-Quaker is one in a long line of decisions attempting to determine the application of Sec. 1341. The circuits are split as to the interpretation; the most notable discrepancy stems from the second requirement and the application of the word “appear.” Additionally, the Tax Court has held that an absolute unrestricted right to income prevents relief under Sec. 1341; the Court of Federal Claims interpreted the “apparent” verbiage very narrowly in Cinergy Corp., 55 Fed. Cl. 489 (2003). However, in Penzoil-Quaker, it reconciled its previous interpretation with its focus on Congressional intent for a remedial statute, thus allowing more potential determinations of tax under equitable Sec. 1341.

From Jessica K. Blosser, MST, CPA, and David W. Freeland, CPA, Columbus, OH