and Considerations in the Claim of Right Doctrine
Mark A. Segal
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:
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;
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).
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.
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.
IRC Section 1341
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.
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
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
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.
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.
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).
cited as relevant to determining whether amounts were deductible
as refunds or reflected a lowering of rates or profits include
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,
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.
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.
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.
facts being likened to those of Mid-American Energy Company
[271 F.3d 740 (8th Cir. 2001)] and distinguished from
those of Dominion Resources.
A. Segal, LLM, CPA, is a professor of accounting
at the University of South Alabama, Mobile.