Taxation & Estate Planning

CLAIM OF RIGHT DOCTRINE

By Charles Rubin

A recent tax case reminds of us an often overlooked income tax Code Section that can provide significant benefits to taxpayers - Code Section 1341. This Code Section is tied into the claim of right doctrine.

The claim of right doctrine typically applies where a taxpayer receives an income item in one year and reports it as income, even though there is a chance that the taxpayer will have to repay the amount in a future year. If the amount is repaid in a future tax year, the doctrine allows the taxpayer an income tax deduction in the year of REPAYMENT.

Oftentimes, the deduction in a later year is worth less in overall tax savings than the extra taxes imposed in the earlier year from the income. For example, tax rates may have been higher in the earlier year of income inclusion, so more taxes were paid in the earlier year than are saved from the deduction in the later year of repayment. Code Section 1341 provides relief, when it applies, by allowing further tax savings in the year of repayment to cover the shortfall in recovered income tax.

In Alcoa, Inc., and Affiliated Corporations, F/K/A Aluminum Company of America v. IRS, 100 AFTR 2d ¶ 2007-5506 (CA 3, 11/28/2007), the taxpayer tried a novel approach to Code Section 1341. Essentially, Alcoa claimed that it could have deducted environmental remediation costs in earlier tax years as it produced product, but it didn't. Later, under new environmental protection laws, Alcoa was forced to expend many millions of dollars on remediation costs relating to sites used for production in the earlier tax years. Since, due to a reduction in corporate tax rates, those deductions were not worth as much in tax savings in the years they were expended as the deductions would have been worth in the prior tax years if they had been deducted in those earlier years, it sought a $12+ million refund under Section 1341.

The appeals court found that Section 1341 did not apply, in large part because it could not equate Section 1341's requirement for an inclusion of an item in gross income in the earlier tax year as being the same thing as not taking a deduction against gross income in the prior tax year.  To rule otherwise would have opened the door to Section 1341 to taxpayers almost any time that it a taxpayer is faced with an expense it pays in a later year that can be related in any way to the fact that the taxpayer did not pay that expense in a prior year.

Full post as published by Rubin on Tax on December 02, 2007 (boomark / email).