Lessons from Heiting v. the United States: Utilizing Claim-Of-Right Deductions

In the recent case, Heiting v. the United States, an appellate court denied a claim-of-right deduction in accordance with Section 1341 of the Internal Revenue Code. The case originated from an effort by a taxpayer to receive a tax refund from the Internal Revenue Service. Following a denial of the refund by the Internal Revenue Service, the taxpayer initiated a lawsuit pursuing a tax refund of the taxes paid on an unauthorized stock sale made by the grantor trust. 

Claim-of-Right Deductions

The claim of right deduction is a regulation that governs how income recognition is time. The law decides when income is taxed instead of whether it can be taxed. The regulation results from Congress’s implementation of an annual accounting period. If a person who pays taxes receives earnings under a claim of right and no restrictions exist regarding the disposition, the individual has received income to which he or she is required to return. This is true even though the person may claim that he or she has no entitlement to retain the funds.

How the Case Arose

In 2015, the trustee sold the restricted stock and triggered a taxable gain on a sale of more than $5 million. The plaintiff noted the gain on their 2015 personal tax return and subsequently paid taxes on it. The trustee later became aware that the stock sale was prohibited and purchased the same number of shares of restricted stock in early 2016 with proceeds from the prohibited transaction that occurred in 2015. 

After the acquisition of the restricted stock in 2016, the taxpayers attempted to raise the claim-of-right doctrine and claimed a deduction on their return from 2016. Following the claim-of-right doctrine, a taxpayer is required to report income in the year when it was received even if a taxpayer could be required to return income at a later date but would then be entitled to a deduction the year of the repayment. 

The Supreme Court has considered the doctrine on several occasions. To diminish inequities in the doctrine’s application, Congress passed section 1341 which afforded an alternative to the deduction in the year of repayment. To qualify for 1341(a) relief, a taxpayer is required to establish that an item was included in gross income for a previous taxable year because it appeared the taxpayer had unrestricted access to such an asset, and a deduction is permitted for the taxable year because it was created following the close of previous taxable years that the taxpayer lacked the unrestricted right to assets, and the amount of the deduction is greater than $3,000. If these elements are shown, the tax imposed for the tax year is either the tax for the taxable year computed with such deduction or the tax for the taxable year computed without such deduction based on what is less. The appellate court later denied protection under 1341.

Contact an Experienced Estate Planning Attorney

Estate planning can raise several nuanced issues. If you or your loved one needs the assistance of an experienced attorney, do not hesitate to contact Ettinger Law Firm today for assistance. 

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