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.[1]

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.

Section 1341 Generally

Congress first enacted Section 1341 of the 1954 Code in an effort to alleviate perceived inequities of the claim-of-right doctrine and the annual accounting period. In enacting section 1341, however, Congress did not intend to disturb the claim-of-right doctrine itself; rather, it provided an alternative where the statute’s approach would favor taxpayers.[2]

By its terms, Section 1341 potentially applies when a taxpayer repays money in a current year that belongs to someone else, and where that money was received by the taxpayer and included in his or her gross income in a prior year.

As an alternative to the deduction in the year of repayment, which prior law generally contemplated, section 1341(a)(5) permits certain taxpayers to recompute their taxes for the year of receipt.  Whenever section 1341(a)(5) applies, taxes for the current year are reduced by the amount that taxes were increased in the year or years of receipt (and reporting) because the disputed items were previously included in gross income.

In order to qualify for this treatment, a taxpayer must prove that an item was included in its gross income for prior tax years because of an apparent unrestricted right to such item. In addition, a taxpayer must show that in a later tax year, it no longer has an unrestricted right to that item and that the repayment was deductible under some other provision of the Code.

Where these requirements are met, section 1341 is designed to put the taxpayer in essentially the same position it would have been in had it never received the returned income.

Breaking Section 1341 Down

Section 1341 applies where:

(1) an item was 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….

26 U.S.C. § 1341(a).  Under these circumstances, the taxpayer is potentially entitled to either the equivalent of a refund for income tax paid in the earlier year, or a deduction from income in the year of repayment, whichever is more beneficial to the taxpayer.

In order to qualify for § 1341 relief, the taxpayer must also satisfy several non-textual requirements. For instance, “the taxpayer’s obligation to repay must arise out of the specific ‘circumstances, terms and conditions’ of the transaction whereby the amount was originally included in … income.” This is referred to as the “same circumstances” test. In addition, the deduction must be “allowable” under a provision of the Code other than § 1341.

As this indicates, section 1341 provides a potential avenue for relief from the claim-of-right doctrine’s otherwise harsh consequences.

[1] North Am. Oil Consolidated v. Burnet, 286 U.S. 417, 424 (1932).

[2] Skelly Oil Co., 394 U.S. at 682.