The U.S. Congress passed the Tax Cuts and Jobs Act (TCJA) in late 2017, substantially overhauling the Internal Revenue Code of 1986. The TCJA highlighted the importance of several often-overlooked provisions in the Tax Code. Notably, the TCJA increased the importance of Section 1341, a provision designed to mitigate inequities created by the claim-of-right doctrine.
What is the Claim-of-Right Doctrine?
Fundamentally, the claim-of-right doctrine is a rule that governs the timing of income recognition. That is, it dictates when income is taxable rather than whether it is taxable. The claim-of-right doctrine stems from Congress’s adoption of an annual accounting period as an integral part of the Tax Code.
As the Supreme Court recognized in United States v. Lewis, 340 U.S. 590 (1951), “[i]ncome taxes must be paid on income received (or accrued) during an annual accounting period.” Thus, a taxpayer must generally calculate the tax due on events taking place during the taxable year without regard to events in prior or subsequent years
In North American Oil Consolidated v. Burnet, then-Justice Brandeis outlined the claim-of-right doctrine. There, Brandeis articulated the doctrine, alluding to its potential inequities:
If a taxpayer receives earnings under a claim of right and without restriction as to its disposition, he has received income which he is required to return, even though it may still be claimed that he is not entitled to retain the money, and even though he may still be adjudged liable to restore its equivalent.
As Justice Brandeis explained in North American Oil, should it later appear that the taxpayer was not entitled to the money, he would generally be entitled to a deduction in the year of repayment; the taxes due for the year of receipt would not, however, be affected.
But, of course, the tax benefit from the deduction in the year of repayment might differ from the increase in taxes attributable to the receipt in the earlier year—for example, tax rates might have changed, or the taxpayer might be in a different tax ‘bracket.’ But, at least as the doctrine was originally formulated, these differences were accepted as an unavoidable consequence of the annual accounting system.