Claim of Right Doctrine of Section 1341
By Under the claim of right doctrine, a taxpayer who receives income under a claim of right that is free of restrictions must include the amount in income in the year of receipt. That is the case even if the taxpayer may, in a future year, be required to return to the payor the amount included in income. If the amount is returned within the same tax year, the rescission doctrine can apply to prevent taxation. Where the amount included in income is repaid after the year of inclusion, a deduction may be available to reduce current year income for the amount repaid. In some cases a deduction in the year of repayment does not produce as much reduction in tax liability as the amount of tax paid in the year of inclusion (due to changes in tax rates or limits on the use of the deduction). Section 1341 addresses that potential whipsaw by allowing taxpayers to elect to reduce the tax liability in the current year by the amount of tax generated in the previous year by the inclusion of such amount in income.
For Section 1341 to apply, the following five requirements must be met:
(1) The item was included in gross income in a previous year;
(2) The inclusion occurred because the taxpayer appeared to have an unrestricted right to the item;
(3) In a later year, the taxpayer is entitled to a deduction;
(4) The deduction is allowed because it was established after the close of the year of inclusion that the taxpayer did not have an unrestricted right to the item; and
(5) The amount of the deduction exceeds $3,000.
Often the primary hurdle to utilizing Section 1341 is requirement 3 above. Section 1341 does not apply unless the Code provides a deduction for the repayment of the amount previously included in income. Cases such as Uhlenbrock v. Commissioner, 67 T.C. 818 (1977), confirm the amount repaid and deducted must be directly connected to the item that was previously included in gross income. Whether Section 1341 is applicable is fact dependent. Also, Section 1341 does not apply to (1) deductions attributable to repayments of items included in gross income in a previous year on account of the sale or disposition of inventory; (2) deductions attributable to bad debts; (3) dealers’ reserve credits; (4) legal fees and expenses incurred in resisting the repayment; and (5) the repayment of amounts that were not previously included in income.
John G. Hodnette is an attorney with Fox Rothschild, LLP in Charlotte.