Trust terms do not create legal obligation for claim-of-right purposes

A married couple were not entitled to a claim-of-right refund under Sec. 1341(a) where stock was sold at a gain by their grantor trust in one year and was repurchased in the next, because the restriction on the sale of the stock in the trust agreement was only a potential restriction on the stock’s sale and not an actual legal restriction.

Background

In January 2004, Kenneth and Ardyce Heiting created a revocable trust that was treated as a grantor trust, with a bank as the trustee. As a grantor trust, the trust itself filed no tax returns, and the Heitings reported the trust’s gains and losses on their own returns.

Under the terms of the trust, the trustee had broad authority over the trust assets in general, but that power was explicitly limited with respect to two particular categories of assets: For Bank of Montreal Quebec common stock and Fidelity National Information Services Inc. common stock, the trustee had “no discretionary power, control, or authority to take any action(s),” including any sale or purchase of that stock, absent the Heitings’ express authorization.

Nonetheless, in October 2015, the trustee sold restricted stock held in the trust and incurred a taxable gain of $5.6 million on the sale, which the Heitings included in gross income on their 2015 tax return and paid taxes on. The trustee afterward realized that it was prohibited from selling the stock by the trust agreement. To remedy its error, in January 2016 the trustee purchased the same number of shares of the restricted stock with the sale proceeds from the earlier transaction.

On their 2016 income tax return, the Heitings sought to invoke the claim-of-right doctrine in Sec. 1341 to claim a deduction related to the repurchase. Under the claim-of-right doctrine, as set out in Sec. 1341, a taxpayer must report income in the year in which it was received if it appears the taxpayer has an unrestricted right to the income, even if the taxpayer could be required to return the income later if it is established the taxpayer did not have an unrestricted right to the income, but if repayment is required in a later year, the taxpayer is entitled to a deduction for the repayment of the income in the year of that repayment or, as an alternative, to recompute the taxes for the year the taxpayer received the income. In order to establish a claim for relief under Sec. 1341(a), taxpayers must plead that:

• An item was included in gross income for a prior tax year (or years) because it appeared that the taxpayer had an unrestricted right to the item;
• A deduction is allowable for the tax year because it was established after the close of the prior tax year (or years) that the taxpayer did not have an unrestricted right to the item or to a portion of the item; and
• The amount of the deduction exceeds $3,000.

The IRS rejected the Heitings’ claim for refund, stating that under the exception in Sec. 1341(b)(2), the statute did not apply to “the sale or other disposition of the Stock in trade of the taxpayer.” The Heitings filed a refund suit in district court.

In district court, the IRS moved to dismiss the case because the Heitings failed to state a claim upon which relief could be granted. The IRS abandoned its argument that the couple were not entitled to a refund based on the exception in Sec. 1341(b)(2). Instead, in support of its motion, the IRS argued that under Sec. 1341, the Heitings were entitled to a credit only if they were legally obligated to return the proceeds of the prohibited stock sale and that, under the facts of the case, they were not obligated to do so. The district court granted the IRS’s motion to dismiss, and the Heitings appealed that decision to the Seventh Circuit.

The Seventh Circuit’s decision

The Seventh Circuit upheld the district court’s decision that the Heitings were not entitled to a refund under Sec. 1341. The court concluded that the Heitings did not meet the second requirement of Sec. 1341(a)(2) because there was only a potential restriction on the trust’s sale of the stock, so the trust retained an unrestricted right to the income when the stock was repurchased by the trust.

The IRS conceded that the first element of Sec. 1341(a) was satisfied because the trust had received an item of income, the $5.6 million gain on the sale of the restricted shares, and that income was taxable to the Heitings because the revocable trust was a disregarded entity for tax purposes. However, according to the IRS, the second element of Sec. 1341(a) was not met because the Heitings had failed to show that they did not have an unrestricted right to the income from the stock sale and that they were under a legal obligation to restore that income to its actual owner. The IRS reasoned they did have an unrestricted right to the income because they had the power to approve a restricted stock sale and retain any proceeds from the sale. The IRS asserted that the trustee’s purchase of stock in 2016 was an attempt to reverse the effect of the 2015 stock sale but that there was no question that the taxpayers had the right to the income from the 2015 sale.

The Heitings in turn contended that because the tax obligations of the trust were at issue, not their own tax obligations as individuals, the determination should focus on whether the trust had an unrestricted right to the sale income in 2015 and 2016. The Heitings admitted that they had an unrestricted right to the funds as the sole beneficiaries of the trust because they had the absolute authority to choose to accept the funds and authorize the trust’s actions. Nonetheless, they argued that the proper focus was on the trust’s actions and whether the trust retained an unrestricted right to the funds, arguing that they merely stepped into the shoes of the trust in including the trust income on their taxes. The court did not address whether the Heitings stepped into the trust’s shoes because, even considering only whether the trust itself had an unrestricted right to the funds, the court found the Heitings could not succeed.

The Seventh Circuit stated that the “insurmountable problem” with the Heitings’ argument was that the couple did not adequately show that the trust had a legal obligation to restore the items of income. Under Sec. 1341(a)(2), the Heitings had 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 the income in question. The language of Sec. 1341(a)(2) has been interpreted to mean that the taxpayer is required to have a legal obligation to restore the income, not merely a voluntary choice to restore it. The Seventh Circuit, quoting Mihelick, 927 F.3d 1138, 1146 (11th Cir. 2019), found 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.” The court, again citing Mihelick, stated that the involuntary legal obligation to restore the income can be shown by a court judgment requiring the repayment or a good-faith settlement of a claim.

In the Seventh Circuit’s view, the Heitings did not allege in their complaint that the trust did not have an unrestricted right to the item of income in this case; instead, they only alleged that the trustee’s restricted stock sale was contrary to the trust agreement, which, at most, was a potential restriction originating at the time of the transaction in 2015. The court concluded that the existence of this potential claim against the income was not enough to “establish” that the trust lacked an unrestricted right to the income, and the Heitings, as sole beneficiaries of the trust, had not demanded the restoration of the income, which would have turned the potential claim into an actual claim that would have stripped the trust of its unrestricted right to the income.

In support of their position, the Heitings cited First National Bank of Chicago, 551 F. Supp. 157 (N.D. Ill. 1982), but the Seventh Circuit determined that that case weighed against the Heitings’ position. It found that in First National,the district court had held that a trust beneficiaries’ dispute of a sale by the trust was only a potential restriction, which was not a restriction on use for purposes of the claim-of-right analysis. The district court based this determination on Healy, 345 U.S. 278, 284 (1953), in which the Supreme Court stated, in a claim-of-right analysis, “a potential or dormant restriction … which depends upon the future application of rules of law to present facts, is not a ‘restriction on use.'” The Seventh Circuit stated that the First National court thus had made clear that an initial objection by a beneficiary to the sale, or the limitations of the trust agreement itself, were not in themselves sufficient to demonstrate that the taxpayer did not have an unrestricted right to the item of income.

According to the Seventh Circuit, this was the situation in the Heitings’ case, as the couple, as beneficiaries, had not challenged the restricted stock sale and had merely alleged in their complaint that the sale of the restricted stock violated the terms of the trust agreement. This, the court concluded, was “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” (slip op. at 10). Therefore the Sec. 1342(a) requirement that the taxpayer not have an unrestricted right to the income was not met, and the taxpayers were not entitled to a refund based on their purported restoration of the income under the claim-of-right doctrine.

Reflections

Even if there had been an actual restriction on the sale of the stock by the Heitings’ trust, the couple might still not have gotten their requested refund. As the court alluded to in its decision, it would likely agree with the IRS’s argument that a restoration, as required under Sec. 1341, had not occurred.

The Heitings argued that the trustee’s sale and subsequent repurchase of the restricted stock falls within the language of Sec. 1341(a) as a taxable transaction that was “reversed” in the year after the sale by a trustee that was legally obligated to do so. This characterization of the transactions implied that the purchase was a “reversal” of the original sale and was a retraction of the sale, undoing it cleanly and putting the parties to the transaction in the same place as before it.

However, the court agreed with the IRS that the timing of the two transactions rendered that characterization inaccurate and found that a sale of stock in one time period cannot be simply “reversed” by purchasing the stock back at a different time, because the fluctuation in prices will often result in a greater loss or gain over that time. Thus, the repurchase of the stock (which, in the Heitings’ case, was made at lower price than what the stock was sold for) could not be viewed as a restoration under Sec. 1341(a).

Heiting, No. 20-1324 (7th Cir. 10/18/21)