Sec. 1341: What is the claim-of-right doctrine?

By Adam Hales, CPA, and Dennis Tingey, CPA, Washington, D.C.

Editor: Annette B. Smith, CPA

The law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97, enacted Dec. 22, 2017, made numerous changes to the U.S. tax rules affecting businesses and individuals. For corporations, the prior 35% top corporate rate was reduced permanently to 21% for tax years beginning after 2017. The TCJA also provided relief for qualified passthrough business income — specifically, a deduction of up to 20% of the qualified business income from a partnership, S corporation, or sole proprietorship. These tax rate reductions will increase interest in an often-overlooked section of the Code, Sec. 1341, Computation of Tax Where Taxpayer Restores Substantial Amount Held Under Claim of Right, often referred to as the claim-of-right provision.

Sec. 1341

Tax rates matter, especially in the context of Sec. 1341. Sec. 1341 relief can apply when an item of income reported in an earlier tax year (at a higher tax rate) is returned in a subsequent year (at a lower tax rate) if it is determined that the taxpayer did not have an unrestricted right to the item of income when reported. The application of Sec. 1341 provides an alternative computation of tax that attempts to place the taxpayer in roughly the same economic position it would have been in had it not included the item as gross income in the earlier year.

For Sec. 1341 to apply, an item must:

  • Be included in gross income for a prior tax year (or years) because it appeared that the taxpayer had an unrestricted right to the item;
  • Be allowable as a deduction in the current tax year because it was established after the close of a prior year (or years) that the taxpayer did not have an unrestricted right to the item; and
  • Be a deduction in excess of $3,000.

Example: Taxpayer reported $10,000 of gross income in 2017, subject to tax at a corporate rate of 35%. The $10,000 of gross income was reported because it appeared the taxpayer had an unrestricted right to the income under the contract with its customer. A contractual dispute arose between the taxpayer and its customer. The dispute was resolved, and the taxpayer returned the $10,000 of income to the customer in 2018. The $10,000 payment to the customer in 2018 would result in an ordinary and necessary business deduction under Sec. 162 at a corporate tax rate of 21%.

Sec. 1341 relief

Absent relief under Sec. 1341, the taxpayer would be taxed at a 35% rate on the $10,000 of income previously reported, while the deduction otherwise available for the repayment would only offset income taxed at a 21% rate. Therefore, without Sec. 1341 relief, the taxpayer would incur an additional tax burden of at least $1,400 (i.e., 14% reduction in corporate tax rate × $10,000 repayment).

For the taxpayer in the example, the requirements of Secs. 1341(a)(1)-(3) would appear to have been met. The taxpayer included the $10,000 as an item of gross income for a prior tax year (2017) because it appeared that the taxpayer had an unrestricted right to the item. In 2018, the taxpayer restored the $10,000 to its customer. Since the $10,000 payment represented a Sec. 162 deduction, Sec. 1341(a)(2) applies as a deduction that is allowable in 2018 because it was established after the close of the 2017 tax year that the taxpayer did not have an unrestricted right to the income. Lastly, the Sec. 1341(a)(3) requirement is satisfied since the $10,000 deduction exceeds $3,000.

Accordingly, the alternative tax computations provided in Secs. 1341(a)(4) and (5) would apply to the taxpayer. These computations are "designed to put the taxpayer in essentially the same position [it] would have been had [it] never received the returned income" (Dominion Resources, Inc., 219 F.3d 359, 363 (4th Cir. 2000)). Thus, these computations seek to mitigate any inequities otherwise caused to the taxpayer by the change in tax rates.

When does Sec. 1341 relief apply?

Determining whether relief is available under Sec. 1341 often is more complicated than the simplified fact pattern discussed above. Under Sec. 1341(a)(1), the phrase "it appeared that the taxpayer had an unrestricted right to such item" can be difficult to apply after considering what the term "appeared" means in this context. For instance, amounts included in income due to fraud or embezzlement presumably would fall outside the provisions of Sec. 1341 since it would be difficult to claim a taxpayer appeared to have an unrestricted right to amounts obtained from fraud or embezzlement. Sec. 1341(a)(2) also can limit the relief provided by Sec. 1341. For example, certain amounts repaid (such as fines or penalties) may not give rise to a deduction in the year of payment, due to other Code provisions, such as Sec. 162(f); accordingly, these amounts are not eligible for Sec. 1341 relief.

Notwithstanding these limitations, the relief provisions of Sec. 1341 may be available to taxpayers in various circumstances. The legislative history of Sec. 1341 supports this view by indicating that Sec. 1341 is a relief provision intended to mitigate inequities created by, among other things, a change in tax rates.

The TCJA's effect

The change in tax rates under the TCJA likely will lead more taxpayers to analyze the potential availability of Sec. 1341. Given the change in tax rates, taxpayers should consider the impact of Sec. 1341 on various tax situations in which amounts previously reported in gross income under an unrestricted right are returned because it was established after the close of the prior year (or years) that the taxpayer did not have an unrestricted right to the item. Taxpayers that can avail themselves of this relief provision can use the alternative tax computations found in Sec. 1341 to mitigate inequities caused to the taxpayers by the change in tax rates.

EditorNotes

Annette B. Smith, CPA, is a partner with PricewaterhouseCoopers LLP, Washington National Tax Services, in Washington, D.C.

For additional information about these items, contact Ms. Smith at 202-414-1048 or annette.smith@pwc.com.

Contributors are members of or associated with PricewaterhouseCoopers LLP.

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