In the recent case of Heiting v. United States, the Seventh Circuit Court of Appeals denied the taxpayer’s claim-of-right deduction pursuant to Internal Revenue Code section 1341. The case stemmed from the taxpayer’s attempt to obtain a tax refund from the IRS. After the IRS denied the refund, the taxpayer filed a lawsuit seeking a tax refund of the taxes they had paid on an unauthorized sale of stock by a grantor trust.
Our Freeman Law Insights blog has previously covered the claim-of-right doctrine and section 1341 in depth. See, e.g., The Claim-of-Right Doctrine & Section 1341. We have also covered related concepts, such as the rescission doctrine.
The Formation of the Revocable Trust—a “Grantor” Trust for Federal Tax Purposes
In 2004, the taxpayers (the “Heitings”) created a Joint Revocable Trust. The trust was administered by the trustee, BMO Harris Bank. Because the Heitings could revoke the trust agreement at any time during their lifetime, the trust was considered a “grantor trust” for federal tax purposes. As a grantor trust, it filed no tax returns, and the taxpayers reported the trust’s gains and losses on their own returns.
(Note that under Seventh Circuit precedent, “[t]he main thrust of the grantor trust provisions is that the trust will be ignored and the grantor treated as the appropriate taxpayer whenever the grantor has substantially unfettered powers of disposition.”)
Under the terms of the trust, the trustee had broad authority as to the trust assets in general. However, that power was restricted with respect to two particular assets: (1) Bank of Montreal Quebec Common Stock (“BMO”) and (2) Fidelity National Information Services, Inc. Common Stock (“FIS”) (collectively, the “restricted stock”).
With respect to the restricted stock, the trustee had “no discretionary power, control or authority to take any action(s) with regard to any shares … including, but not limited to, actions to purchase, sell, exchange, retain or option the Stock.” That is, the trustee lacked the authority to sell or purchase the restricted stock absent the Heitings’ express authorization.
The Trustee’s Unauthorized Sale of Restricted Stock
Despite the trust’s restriction, in October of 2015 the trustee sold the restricted stock, triggering a taxable gain on the sale of more than $5 million. The Heitings dutifully included the gain on their 2015 personal tax return and paid taxes on it. The trustee, later realizing that the stock sale was prohibited, purchased the same number of shares of that restricted stock in early 2016 with the sale proceeds from the prohibited 2015 transaction.
The Claim-of-Right Doctrine
Following the purchase of the restricted stock in 2016, the taxpayers invoked the claim-of-right doctrine, as codified in 26 U.S.C. § 1341, claiming a deduction on their 2016 return. Under the claim-of-right doctrine, a taxpayer must report income in the year in which it was received, even if the taxpayer could be required to return the income at a later time but would then be entitled to a deduction in the year of that repayment.
The Supreme Court has addressed the doctrine several times – for example, in United States v. Skelly Oil Co., 394 U.S. 678, 680 (1969) – and has specifically discussed its potential for inequitable outcomes.
To alleviate inequities in the application of the doctrine, Congress enacted § 1341, which provided an alternative to the deduction in the repayment year: the option to recompute taxes for the year of receipt of the income.
In order to qualify for relief under § 1341(a), a taxpayer must plead that: “(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)(1)–(3).
If these elements are established, then the tax imposed for the tax year is the lesser of “the tax for the taxable year computed with such deduction,” or “the tax for the taxable year computed without such deduction, minus … the decrease in tax … 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).” 26 U.S.C. § 1341(a)(4)–(5).
The Lower Court’s Ruling
The district court held that the Heitings were entitled to a credit on the taxes under § 1341 only if they were legally obligated to return the proceeds of the restricted stock sale. But the district court denied such relief for a specific reason: “the complaint alleged no such obligation.”
On appeal, the government conceded that the Heitings met the first requirement under § 1341(a) because they alleged the receipt of an item of income in 2015—the $5.6 million gain received on the sale of the restricted shares, which was taxable directly to them because the revocable trust was properly disregarded for tax purposes. The government maintained, however, that the second element of § 1341(a) was not met.
First, as it did in the district court, the government argued that the Heitings failed to adequately allege that, after the close of tax year 2015, they did not have an unrestricted right to the income from the sale of the restricted stock held in their trust, and were under a legal obligation to restore that income to its actual owner. The government asserted that the trustee simply bought stock in 2016 in an attempt to reverse the effect of the earlier, 2015, transaction. But, the government argued, the taxpayers’ right to the income from the earlier transaction was never in question.
Finally, the government argued that the Heitings did not, and could not, plead that their “restoration” of income was a deductible expense to them, as required under § 1341.
Courts have recognized that the taxpayer bears the burden of proving his eligibility for section 1341 treatment. Under § 1341(a)(2), the Heitings were thus required to show that the repayment in the later year occurred 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. The language requiring that “it was established” that the taxpayer did not have an unrestricted right to the item has been interpreted as requiring a legal obligation to restore the item of income; a voluntary choice to repay, in other words, is not enough.
Some courts have held that to meet that requirement, taxpayers must demonstrate that they “involuntarily gave away the relevant income because of some obligation, and the obligation had a substantive nexus to the original receipt of the income.” Mihelick v. United States, 927 F.3d 1138, 1146 (11th Cir. 2019). That involuntary legal obligation to restore the item of income can be shown by a court judgment requiring the repayment, but a good-faith settlement of a claim can also suffice. Id.
Reviewing the pleadings, the appellate court noted that the “insurmountable problem” for the taxpayers was “that the complaint d[id] not adequately allege that the trust had a legal obligation to restore the items of income—the restricted stock—as is required under § 1341(a)(2).” In other words, the court provided:
We have no allegation here that “it was established” that the trust did not have an unrestricted right to the item of income in this case. The Heitings have alleged only that the trustee’s sale of the restricted stock was contrary to the trust agreement. At most, that alleges a potential restriction, which originated at the time of the transaction in 2015. But the Heitings make no allegations that they, as the sole beneficiaries of the trust, demanded the restoration of the stock or otherwise communicated an intent to pursue any of their rights for the breach of the trust agreement. The existence of a potential claim against the income is not enough to “establish” that the trust lacked an unrestricted right to the income.
The appellate court continued,
The Heitings . . . merely argue that the sale of the restricted stock was in violation of the terms of the trust agreement. That is precisely the type of potential or dormant restriction, dependent on the future application of law to fact, that is insufficient to indicate that a right to the item of income was not an unrestricted one.
As a result, the Seventh Circuit Court of Appeals denied relief under the claim-of-right doctrine.