Factors and Considerations in the Claim of Right Doctrine

By Mark A. Segal

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According to the claim of right doctrine, taxpayers as a general rule must report a receipt that purports to be an income item for the period in which they have control over the item. If such an item must later be returned, the taxpayer generally will be entitled to take a deduction for the returned amount in the tax year of the return. Under this approach, a taxpayer will generally experience a net negative financial consequence when the taxpayer’s marginal tax rate applicable for the tax period in which the item was included in income exceeds the marginal rate for the period in which it is returned. In response to this situation, Congress enacted IRC section 1341, which provides that where:

(1) An item is included in gross income for a prior taxable year (or years) because it appeared that the taxpayer had an unrestricted right to such item;
(2) a deduction is allowable for the taxable year because it was established after the close of such prior taxable year (or years) that the taxpayer did not have an unrestricted right to such item or to a portion of such item; and
(3) the amount of such deduction exceeds $3,000,
then the tax imposed by this chapter for the taxable year shall be the lesser of the following:

  • the tax for the taxable year computed with such deduction; or
  • an amount equal to the tax for the taxable year computed without such deduction, minus
    the decrease in tax under this chapter (or the corresponding provisions of prior revenue laws) for the prior taxable year (or years) which would result solely from the exclusion of such item (or portion thereof) from gross income for such prior taxable year (or years).

Example. During 2003, a company receives a check in the amount of $10,000, based upon a percentage of profits a client earned. The company includes the $10,000 in its 2003 income. In 2004, the company discovers an error in its calculation of 2003 profits and refunds $4,200 during the year. In applying IRC section 1341, because the amount of the refund exceeds $3,000, the company has a choice of calculating its deduction for the $4,200 repayment based upon its marginal rate for 2004 or for 2003.

The IRC section 1341 treatment for repayments in excess of $3,000 holds advantages over an IRC section 162 deduction of the same amount. This results from the application of section 1341(a); in contrast, section 162 generally allows the deduction to be taken only on the tax return for the year of repayment.

Applying IRC Section 1341

Case law reveals several questions relevant to the application of section 1341. Did the taxpayer have an apparent or an actual right to the receipt in the period it was reported? According to the IRS, for section 1341 to apply, a crucial element is that the taxpayer has an actual right to the receipt rather than an apparent right. The Fourth Circuit, however, has opined that the language of the statute does not support the IRS contention, because one can have both an apparent right and an actual right to an item simultaneously [see Dominion Resources, Inc., 219 F.3d 359 (4th Cir. 2000)]. In fact, it is to be expected that these aspects coexist. Recently, in Cinergy Corp. [No. 99-750 (U.S. Ct. of Fed. Cl., 2003)], the court noted that “apparent” is at least ambiguous in that it is prone to diverse meanings.

Certain cases support the contention that the claim of right doctrine is limited to situations where the taxpayer lacks an absolute right to the item of income. The Tax Court has held that in order to invoke the claim of right doctrine the taxpayer must establish “[b]y a preponderance of the evidence that he was not entitled to the unrestricted use of the amount received in the prior year.” In Equitable Life Insurance Co. [340 F.2d 9 (8th Cir., 1965)], the court rejected application of the claim of right doctrine where the taxpayer redeemed government bonds prior to maturity and was required to refund part of the interest to the government. Application of the claim of
right doctrine was likewise denied where a company had to refund royalty payments received pursuant to a new lease agreement.

Nexus. The IRS has maintained, and certain courts have agreed, that in order for the claim of right doctrine to apply, a substantial nexus must exist between the “right to the income at the time of receipt and the circumstances necessitating a refund” (see Dominion Resources). This standard has been cited as consistent with the distinction between apparent and actual receipt, because if repayment is required due to events other than those inherent in the original payment, then the right to such payment would appear to be absolute. The recent Cinergy decision reflects this approach.

Cinergy concerned a successor corporation (to PSI Corporation) after a merger. PSI had previously collected amounts related to both current and future operations. These amounts increased PSI’s taxes because they had been included in the company’s income. Subsequent changes to the regulations caused regulatory authorities to require that PSI refund some of the funds that it had previously collected for deferred taxes. The company unsuccessfully sought to apply IRC section 1341 to the refunded amounts. In applying the nexus requirement to PSI’s refund, the court found that the refund did not arise from the same set of facts and circumstances in effect when the company had collected the amounts includible in income. Instead, the refund was attributable to independent circumstances: the occurrence of a rate reduction, consumer complaints, the company’s seeking a rate reduction, and regulatory action.

The court distinguished Cinergy from Dominion Resources by noting that the refund was not attributable to a change in the future tax liability; rather, the refund was attributable to a change in the company’s financial success and its attempts to restructure its balance sheet.

Another factor relevant to qualification for treatment under section 1341 is whether there is a nexus between some IRC section (besides section 1341) that supports the deduction. In Dominion Resources, IRC section 1341 was applicable because the repayments were attributable to overcharging customers and were made in a lump sum. A different result might have been reached if the payments had been made gradually over time to parties other than those who had overpaid; they might have been considered to constitute a downward adjustment of rates of future profits or revenue (see also Cinergy).

Factors cited as relevant to determining whether amounts were deductible as refunds or reflected a lowering of rates or profits include the following:

  • Whether the payments were made gradually over time or in a lump sum payment;
  • Whether the benefits of the rate reduction were matched to the customers who had actually been overcharged;
  • Whether the utility had segregated the funds or otherwise imposed limitations on its use of the money;
  • Whether interest was paid on the funds ultimately returned, and
  • Whether the utility set off the amount to be refunded against future amounts owed for goods or services, rather than actually returning money to customers.

In Florida Progress Corp., et al. v. Commissioner [No. 02-14910-CC; No. 02-14911-DD (11th Cir., 2003)], a public utility company was required to maintain a deferred income tax account for the purposes of holding the net amount of income tax anticipated to be payable in future years. The amount collected and placed in this account was based on a 46% tax rate for years 1975–1986. In 1986, the tax law was amended and the maximum corporate rate substantially reduced. As a result, the balance in the deferred tax account exceeded the balance needed for expected payment. The company was ordered to return the excess to its customers, which it did in the form of credits and repayments. The Court of Appeals ruled that IRC section 1341 was not applicable, based upon the following:

  • The deduction not being supported by another IRC section.
  • The court finding that the facts supported a rate reduction that impacted the amount of income reported for the periods of the rate reduction, rather than a refund that may have supported a deduction.
  • The facts being likened to those of Mid-American Energy Company [271 F.3d 740 (8th Cir. 2001)] and distinguished from those of Dominion Resources.

Mark A. Segal, LLM, CPA, is a professor of accounting at the University of South Alabama, Mobile.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 



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