1. © 2021 Tax Materials, Inc. TheTaxBook News 1
Release Date: 10/21/21
Claim of Right Doctrine
Cross References
• IRC §1341
• Heiting, 7th Circuit Court of Appeals, October 18, 2021
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 in a following
tax year. If the taxpayer in fact is required to return the income, the taxpayer is entitled
to deduct such amount in the year it is returned. IRC section 1341 provides an alternative
to the deduction in the repayment year by allowing the taxpayer to recompute the tax for
the year the income was received. In order to qualify for relief under IRC section 1341(a),
the taxpayer must prove that:
1) An item was included in gross income for a prior tax year because it appeared that the
taxpayer had an unrestricted right to such item,
2) A deduction is allowable for the tax year because it was established after the close of
such prior tax year 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.
If the above three conditions are established, then the tax imposed for the tax year of re-
payment is the lesser of the tax for the tax year computed with such deduction, or the tax
for the tax year computed without such deduction, minus the decrease in tax for the prior
tax year which would result solely from the exclusion of such item (or portion thereof)
from gross income for such prior tax year.
The taxpayers in this case were the sole beneficiaries of a revocable trust. As such, the
trust itself did not file a tax return for income earned in the trust. Rather, the trust income
was reported directly on the taxpayer’s individual return. The trustee of the revocable
trust had broad authority to buy and sell trust assets, with the exception of two particular
stocks:
• Bank of Montreal Quebec Common Stock, and
• Fidelity National Information Services, Inc.
Stock from these two companies is collectively referred to as “restricted stock” for pur-
poses of this case. Thus, in contrast to the nearly limitless power as to other stocks in
the trust, with respect to the restricted stock, the trustee lacked the authority to take
any actions, including any sale or purchase of that stock, absent the taxpayer’s express
authorization.
In October of 2015, the trustee sold the restricted stock held in the trust without authori-
zation. As a result, the taxpayers reported a $5,643,067 taxable gain from the sale on their
2015 return. In January of 2016, after the trustee realized that the sale of the stock was
prohibited by the trust agreement, the trustee purchased the same number of shares of
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2. © 2021 Tax Materials, Inc. TheTaxBook News 2
that restricted stock with the sale proceeds from the earlier transaction. The taxpayers
then sought to invoke the claim of right doctrine under IRC section 1341 to claim a de-
duction on their 2016 return.The IRS rejected their claim stating that there was no legal
obligation to restore the item of income because the taxpayers had the ability to approve
the sale of the restricted stock and therefore authorize the sale and the retention of the
proceeds after the fact.
The taxpayers argued that because the issue is the tax obligations of the trust, not of
themselves as individuals, the proper focus must be on whether the trust had an unre-
stricted right to the income in the initial and subsequent tax years.They argued that the
trustee’s sale and subsequent repurchase of the restricted stock falls within the language
of IRC section 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.
The court stated the characterization of the purchase as a “reversal” of the original sale
implies that the second transaction was a retraction of the first, undoing it cleanly and
putting the parties to the transaction in the same place as before it. However, the timing
of the two transactions renders that characterization inaccurate. One of the restricted
stocks was sold for $59.27 per share in 2015 and repurchased for between $50.18 and
$52.46 in 2016.The other restricted stock was sold for $72.24 per share in 2015 and repur-
chased for between $58.93 and $60.70 in 2016.The court noted that the 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.
The court also noted that the complaint does not adequately allege that the trust had a
legal obligation to restore the items of income, as required under IRC section 1341(a)(2).
The taxpayers had to show that the repayment in the later year occurred because it was
established after the close of such prior tax year that the taxpayer did not have an unre-
stricted 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 in-
terpreted as requiring a legal obligation to restore the item of income. A voluntary choice
to repay is not enough.
The taxpayers 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 taxpayers made no allegations that they, as the
sole beneficiaries of the trust, demanded the restoration of the stock or otherwise com-
municated 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. At most, the taxpayers could have pur-
sued a legal remedy if they in fact were displeased with the trustee’s actions in breach of
the trust. That mere possibility, however, is insufficient to establish that the trust lacked
an unrestricted right to the proceeds of the sale.
The court ruled that the requirements of IRC section 1341(a)(2) were not met, and thus,
the taxpayers cannot deduct their “restoration” of income as a deductible expense under
IRC section 1341.
Claim of Right Doctrine continued