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

• Author: Beavers, James A.

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)...