Electric utility refunds qualify for sec. 1341 tax mitigation.

• Author: Conjura, Carol

In a recent private letter ruling, the IRS determined that a publicly regulated utility is entitled to claim benefits under Sec. 1341 for amounts paid to a purchaser of electricity to settle claims asserted against predecessor members of the publicly regulated utility's affiliated group. Letter Ruling 200901029 is potentially significant for all taxpayers but, as this item points out, is particularly significant to the utility industry. The ruling is interesting because it addresses how a reorganization affects Sec. 1341 and how the Sec. 1341(b)(2) inventory exception applies to utilities whose rates are subject to the market authority of the Federal Energy Regulatory Commission (FERC) rather than formal rate proceedings.

Background

When a taxpayer receives payments without restriction under a claim of right, the payments must be included in gross income. This is true even if the taxpayer discovers in a later year that it had no right to the payments in the earlier year and is required to repay the same amount. Upon repayment, a taxpayer is generally entitled to a deduction in the year of repayment; however, the deduction's tax benefit may be less than the tax cost of originally including the payments in gross income. That is, when subsequent repayments exceed income for the year of repayment or when the tax rate for the year of repayment on the remaining income (after subtraction of such repayments) is lower than the tax rate for the year in which the income was previously taxed, the deduction does not adequately compensate the taxpayer for the tax paid in the earlier year.

Sec. 1341 can mitigate this adverse impact of a tax overpayment when the deduction in the year of repayment of an item previously included in income does not provide as great a reduction in tax liability as the tax liability generated when the item was previously included in income. It does this by providing a special tax computation for the year of repayment in a way that gives the taxpayer the equivalent of a tax refund (without interest) for the earlier year. The benefit can also take the form of a refundable tax credit if there is no tax liability in the year of repayment.

Discussion

In Letter Ruling 200901029, the taxpayer asked the IRS to rule that it had met the specific Sec. 1341 requirements, including the requirement that sales income had been included in income based on only an apparent rather than an actual right to the income. Further, the taxpayer asked...