Declining tax rates—such as those ushered in by the Tax Cuts and Jobs Act—can come with hidden consequences. Taxpayers who are required to return income in a year with a lower tax rate than which it was initially reported will effectively be taxed on income that they do not retain. The deduction or credit available under IRC section 1341 can correct this inequity, but only if certain elements are present in the repayment. The authors detail the application of section 1341 and the necessary requirements.
The reduction in income tax rates brought about by the Tax Cuts and Jobs Act of 2017 (TCJA) will have a positive impact on both businesses and individual taxpayers. Any reduction in rates, however, whether resulting from legislation or a taxpayer’s individual circumstances, may require careful consideration of Internal Revenue Code (IRC) section 1341. This provision provides relief to taxpayers who have received payments reported as income in one tax year but are required to return that income in a later tax year.
Under the claim of right doctrine, income must be reported when the taxpayer has an unrestricted right to the income. If it is later determined that the taxpayer does not have a right to the income and it is returned, a deduction for the repayment is permitted in most circumstances. Without other alternatives, however, claiming such a deduction in a period of declining tax rates can create an inequity. Consider a taxpayer who reported an employee bonus in Year 1, when the applicable tax rate was 40%, and is later required to return the bonus in Year 2, when the applicable tax rate is 10%. Although the taxpayer is allowed to deduct the repayment of the bonus in Year 2, without further adjustment he will have paid an effective tax of 30% on the income that was not retained.
IRC section 1341 was enacted to correct this inequity. It provides a taxpayer with two alternatives: 1) claim a deduction for the amount of income repaid as allowed under IRC section 162, section 165, or other sections; or 2) claim a tax credit for the amount of income tax previously paid when the income was reported [IRC section 1341(a)]. In the above example, the employee would forgo the deduction in Year 2 and claim a credit for the tax paid in Year 1.
This article explains the application of IRC section 1341 in years of either income or net operating loss, and it notes certain caveats that should be recognized when making repayments that qualify for the credit.
Application of IRC Section 1341
To apply IRC section 1341 to the repayment of an item previously included in income, the item must have been included because it “appeared from all facts available … that the taxpayer had an unrestricted right to such item” [Treasury Regulations section 1.1341-1(a)(2)]. In addition, the repayment must result in an allowable deduction that exceeds $3,000 [IRC section 1341(a)(3)]. For repayments meeting these conditions, the taxpayer is entitled to choose between a deduction in the year of repayment or, if more beneficial, a credit for taxes paid in the year the income was reported. The credit is calculated by comparing the tax liability that was actually incurred in the reporting year with the tax liability that would have resulted if the income in question had been excluded from that year. Although the credit is based on the reporting year data, it is applied against taxes in the year of repayment.
Consider the following example: ABC Corporation reports $150,000 taxable income for 2016 and pays $41,750 tax under the rates in effect that year. In 2018, ABC is required to return $50,000 of the income it reported in 2016. Without the repayment, ABC reports $100,000 in income and a $21,000 tax liability (based on the 21% flat rate effective for 2018). IRC section 1341 allows the taxpayer to choose the greater tax benefit obtained by deducting the $50,000 or by claiming a credit for the reduction of taxes that occurs when the $50,000 is excluded from income for 2016.
As Exhibit 1illustrates, the $10,500 tax savings from claiming the deduction in 2018 is significantly less than the $19,500 credit. The credit is treated as a payment made on the last day of the period prescribed for estimated tax payments for the year 2018 and thus can create a refund (without interest) in the event that it exceeds the current tax liability. Although not illustrated here, taxable income in the 2016 reporting year must also be adjusted for any intervening changes, audit adjustments, or assessments that have been made between the reporting year and the repayment year.
Claiming Section 1341 Deduction versus Tax Credit
It is worth noting that this result is driven by the marginal tax rates. The marginal rate of 39% in 2016 was significantly higher than the flat rate of 21% in 2018. If this trend in rates were reversed, the deduction would yield the preferred outcome.
For tax years in which the deduction for repayment creates or increases a net operating loss (NOL) that is carried back to the reporting year, there may be no current year tax benefit from the deduction, as it will simply increase the NOL. In such a case, the NOL, without a deduction for repayment, is carried back before calculating the credit [Treasury Regulations section 1.1341-1(d)(4)(iii)]. Continuing the above example, consider if ABC had reported an NOL of $20,000 in 2018 without a deduction for the $50,000 repayment. The calculation of the credit would consider the effect of the $20,000 NOL carryback before the exclusion of the repaid income.
Exhibit 2 illustrates the application of the NOL carryback before considering the exclusion of the $50,000 in the reporting year. The $7,800 is refunded with the filing of the carryback, and the section 1341 credit is based on the further reduction of income with the exclusion of the $50,000 repayment. This results in an $18,500 refundable credit in 2018 [see Treasury Regulations section 1.1341-1(d)(4), example 3].
Application of Net Operating Loss (NOL) Carryback
Careful consideration of the repayment at the time of restitution may avoid certain pitfalls. The pivotal elements to consider are the type of income that is restored, whether the repayment is mandatory, whether it is otherwise deductible, and whether there is a direct payment made to the proper party.
What type of income is restored?
There is significant clarity in IRC section 1341 regarding income that is not eligible for the credit upon repayment. Items not covered include bad debt expense, refunds for the return of inventory or goods held for sale, and litigation costs related to contesting the repayment [IRC section 1341(b)(2), Treasury Regulations section 1.1341-1(g)-(h)].
The taxpayer must have an unrestricted right to the income in the reporting year, and that right must be apparent from all facts available. Thus, when taxpayers have reported income that was fraudulently obtained, the courts have generally assumed that the taxpayers knew at the time of reporting that they did not have an unrestricted right to the income. In Robb Evans & Associates, LLC v. U.S. (850 F. 3d 24, 2017), the First Circuit Court noted that, “if the taxpayers acquired the funds at issue by fraud, they could not have thought that they had an unrestricted right to those funds.”
Is the repayment mandatory?
The IRS has indicated that repayments qualifying under IRC section 1341 must be mandatory. It is not necessary for there to be litigation as long as the payment is legally enforceable. Furthermore, a voluntary payment is not qualified for the section 1341 credit, even though it may be deductible (Revenue Ruling 58-456 and 72-78). Early in the litigation history of this section, the Tax Court disagreed with the argument that a repayment “made in good faith and in the exercise of sound business judgment” was sufficient for the application [Berger v. Comm’r, 37 T.C. 1026, 1032 (1962)]. It was determined then that the “payee must have at least the ability to legally compel the repayments.”
The taxpayer must have an unrestricted right to the income in the reporting year, and that right must be apparent from all facts available.
The credit must be based on an actual repayment of income and not an incidental loss. Deductions for theft losses incurred as a result of fraudulent arrangements (e.g., Ponzi schemes) are not sufficient to trigger IRC section 1341; it is applicable only when the source of the deduction is the taxpayer’s obligation to restore the income. In Revenue Ruling 2009-09, the IRS clarified that deductions arising from losses due to theft or embezzlement do not arise out of an obligation to restore income and thus do not satisfy the requirements of this section. Not only must the deduction be based on a return of income for which the taxpayer initially had an unrestricted right, but the repayment must occur out of a true obligation for restitution.
This outcome differs when an investor in a fraudulent arrangement is required to make a clawback payment. Many investors in the notorious schemes of recent decades (e.g., the Madoff scheme) were required to return previously distributed investment income. The IRS clarified in Revenue Procedure 2009-20 that while the theft loss does not qualify, clawback payments are considered a return of claim-of-right income that qualifies for section 1341.
The credit is also not available for the repayment of a canceled debt that was previously reported by the debtor as income from the discharge of indebtedness. The IRS identifies such payments as unqualified for section 1341 and indicates that a taxpayer must amend the return in the year of reporting income from the discharged debt to obtain relief (Service Center Advice 200235030). In essence, this is repayment of debt as opposed to restoration of income.
Is the repayment otherwise deductible?
Section 1341 does not independently create a deduction; to obtain its benefits, the repayment must qualify as a deduction under another provision of the IRC. Most often, taxpayers claim the deduction as a trade or business expense under section 162 or as a loss under section 165 (Chief Counsel Advice 201125040).
The courts have denied the application of section 1341 when the repayment of previously reported income did not qualify for a deduction. The case of Nacchio v. U.S. (824 F.3d 1370, 2016) provides an informative example. In this case, the taxpayer attempted to claim a section 1341 credit on restitution payments made to the government as a result of his conviction for insider trading in a separate criminal trial. The government prevailed by making the argument that Nacchio’s payments were not deductible under section 162 as a trade or business expense, since section 162(f) disallows payments “to a government for the violation of any law”; nor could there be a deduction under section 165 due to the public policy doctrine, which prevents deductions for losses that frustrate national or state governmental policies. The Federal Circuit confirmed that section 1341 benefits are only available for otherwise deductible repayments.
Is a direct payment made to the proper party?
In Nacchio, the court also defined “restitution” as a payment made directly to the victim of a crime to restore the loss. In this case, the government created a fund that was distributed by the Department of Justice to the eligible victims of Nacchio’s fraud. This did not qualify as restitution under IRC section 1341 because whether and how the funds were distributed was at the government’s discretion, and the amount of funds going to a recipient was unrelated to the loss that recipient claimed to have suffered. This indirect manner of compensating victims caused the court to view these payments as a punishment for Nacchio rather than a full restoration to victims.
The case of Florida Progress Corporation & Subsidiaries v. Comm’r (348 F.3d 954, 2003) also illustrates the need to make a direct repayment. Florida Progress is a utility company that is subject to rate regulation by the local government. When the rates are set, income tax expense is included as a cost element. The company found itself in a period of declining tax rates in the mid-1980s, when the corporate rate dropped from 46% in 1986 to 39.5% in 1987 and 34% in 1988. Thus, the company experienced a windfall in 1987 and 1988, as it collected customer payments based on the higher tax rates while its actual tax liability was declining.
Florida Progress was required by regulators to return this windfall to its customers. The repayment was made by applying a rate reduction or bill credit to customers’ bills going forward, and the company claimed a section 1341 credit for the rate reduction. The problem for Florida Progress was that the court viewed the rate reduction as a decrease in revenue rather than a deductible expense. It was determined that a bill credit provided to customers was not equivalent to a repayment. This conclusion was supported by the fact that there was no attempt to directly compensate individual customers for the over-collection. In fact, the rate reduction affected future energy consumption rather than past energy consumption, and thus there was no direct correlation between customers who had overpaid and their subsequent reimbursement.
Section 1341 does not independently create a deduction; to obtain its benefits, the repayment must qualify as a deduction under another provision of the IRC.
Note that IRC section 1341(b)(2) specifically exempts public utilities from the restriction that disallows the credit when refunds are made for “inventory or goods held for sale.” Thus, if the form of repayment had been proper, Florida Progress should have been eligible for the credit.
The optimal method of repayment in these circumstances is a direct out-of-pocket restoration of income. As illustrated by Florida Progress, a bill credit may not be sufficient. Similar circumstances in Andrews v. Comm’r (T.C. Memo 1992-668) make the same point. The taxpayer had received disability insurance payments for several years when it was later determined that she was eligible for Social Security disability during those years. The insurance company claimed a right of offset and withheld a portion of subsequent disability payments until it had recouped the overpayment. In considering the taxpayer’s claim that the offset was a repayment of previously reported income, the Tax Court denied the application of IRC section 1341 and rejected the contention that “there can be a constructive restoration when no actual repayment is made.”
The opinions in Nacchio, Florida Progress, and Andrews make it clear that the form of repayment should be carefully considered and that restitution should be repaid directly to the original source of the income.
Factors to Consider
The provisions of IRC section 1341 become increasingly important in an environment of declining tax rates. Caution should be exercised during such times to fully exploit the opportunity for utilizing the tax credit. When a repayment of previously reported income is legally compelled, proper consideration must be given to the type of income, the deduction for the repayment, the form of payment, and its direct reach to the appropriate party. When these factors are properly considered, the likelihood of successfully claiming the credit is greatly increased.