Pro-taxpayer decision on claim-of-right relief.

• Author: Blosser, Jessica K.

A recent decision by the Court of Federal Claims, Penzoil-Quaker Co., 62 Fed. Cl. 689 (2004), has seemingly extended Sec. 1341's benefit to more taxpayers. That taxpayer-friendly case dealt with oil sales income and subsequent price-fixing settlement payments.

Background

Claim of right: Under the "claim of right" doctrine, a taxpayer is required to recognize as income in the year received, cash or property that is free of restrictions. This is true even though the taxpayer may be obligated to return such "income" later. A taxpayer might be required to make restorative payments under a number of circumstances, including a mistake of fact, contractual indemnification clause or determination by a regulatory body.

When the taxpayer subsequently discovers that it had no right to the income and, thus, must provide reimbursement, it is entitled to a deduction for the amount of the repayment, in the year of repayment. According to the Supreme Court, a taxpayer cannot amend a prior-year return, even if the statute of limitations is still open. In Lewis, 340 US 590 (1951), the Court stated, "[i]ncome taxes must be paid on income received (or accrued) during an annual accounting period ... The 'claim of right' interpretation of the tax laws has long been used to give finality to that period, and is now deeply rooted in the federal tax system." Presumably, if a taxpayer were simply able to amend the prior-year's return, the claim-of-right doctrine would be unnecessary.

Because the taxpayer is entitled to a deduction only in the year of repayment, it may face an inequity. The deduction might not provide tax relief equal to the tax on the income originally included.

Sec. 1341: To mitigate this inequity, Congress enacted Sec. 1341, Computation of tax where taxpayer restores substantial amount held under claim of right, in 1954. Under this provision, a taxpayer can forgo the deduction in the year of repayment and reduce the tax liability for that year by the liability generated by the previous inclusion. In other words, the taxpayer can realize the benefit of the deduction at the same tax rate that applied in the prior year, when the item was originally claimed as income. This accords the taxpayer a great benefit, essentially making it whole but for time-value-of-money considerations. Sec. 1341 applies to items both ordinary and capital.

Meeting the Requirements

To use Sec. 1341, five requirements must be met:

1. The repayment "item" must have been included...