Sec. 1341 roundup: court decisions and IRS advice offer little clarity.

• Jurisdiction: United States
• Date: 01 June 2008
• Author: Claybon, Alexa Mortenson

Recent judicial decisions and IRS advice have dealt with the claim-of-right doctrine. Generally, when a taxpayer receives income under a claim of right, the income must be included in the taxpayer's gross income (the amount giving rise to the tax cost). If the taxpayer later determines that it did not have a rightful claim to such income and repays an amount in a later tax year, the taxpayer may be entitled to a deduction (the amount giving rise to the tax benefit). If the tax benefit afforded by the deduction is less than the tax cost--that is, if the tax rate or other tax attributes differ between the year of receipt and the later year--the taxpayer may find relief under Sec. 1341.

This item discusses four recent judicial decisions and administrative pronouncements addressing Sec. 1341. Unfortunately, because the factual situations underlying the recent decisions are dissimilar, the cumulative result can be confusing for practitioners and taxpayers.

Pennzoil-Quaker State Co.

The Federal Circuit denied Pennzoil Sec. 1341 relief in Pennzoil-Quaker State Co., 511 F3d 1365 (Fed. Cir. 2008), rev'g 62 Fed C1 689 (2004). Pennzoil's suppliers sued the company, alleging price fixing to artificially lower the price Pennzoil paid for oil products. Pennzoil settled the lawsuit, paid the suppliers, and deducted the payments on its returns for the years at issue. Later, Pennzoil amended those returns and requested a refund of overpaid taxes under Sec. 1341. The IRS denied Pennzoil's request for refund, and Pennzoil filed suit in the Court of Federal Claims.

Pennzoil based its claim on the following arguments:

* Pennzoil had overstated its income from product sales in prior years (the income originally reported was greater because its cost of goods sold (COGS) was artificially low);

* Pennzoil was allowed a deduction for the settlement payments because it did not have a right to the overstated income in a later year; and

* The inventory exception (which disallows Sec. 1341 relief) applies only to sales returns, allowances, and similar items, as stated in Regs. Sec. 1.1341-1(f)(1), not to Pennzoil's settlement payments.

The Court of Federal Claims held that Pennzoil was eligible for Sec. 1341 relief.

On appeal by the government, the Federal Circuit reversed the decision of the Court of Federal Claims. The Federal Circuit determined that Pennzoil failed the judicially created "same circumstances" requirement and that, in addition, it was barred from relief under Sec. 1341 by the "inventory exception."

Under the same-circumstances requirement, in order for a taxpayer to be...