Opinion ID: 3025318
Heading Depth: 3
Heading Rank: 1

Heading: The Claim of Right Doctrine and Section 1341

Text: The United States Tax Code operates on an annual accounting system, under which “each year’s tax must be definitively calculable at the end of the tax year.” United States v. Skelly Oil Co., 394 U.S. 678, 684 (1969). Under the so-called “claim of right” doctrine, “[i]f a taxpayer receives earnings under a claim of right and without restriction as to its disposition, he has received income which he is required to return, even though it may still be claimed that he is not entitled to retain the money, and even though he may still be adjudged liable to restore its equivalent.” Id. at 680 (internal quotation omitted). Thus, a taxpayer must include in his tax return even those items of income which are subject to competing claims, so pollution that was eventually removed should be apportioned to each of the 47 years in question; and even if that were possible, it would then be necessary to calculate what it would have cost to remove the relevant pollutants under the economic and technological circumstances of each of those years. This is a highly speculative enterprise. For purposes of this discussion, however, we assume that Alcoa would be able to identify the exact amount it would have been able to exclude from income in each of the 47 years under review. 7 long as he has full control of those moneys at the end of the tax year. For many years, if a taxpayer filed a tax return but later was forced to relinquish some of the reported income, the taxpayer “would be entitled to a deduction in the year of repayment; the taxes due for the year of receipt would not be affected.” Skelly Oil, 394 U.S. at 680-81. This system had the potential to create inequities because a taxpayer might be forced to pay taxes on the item of income at a certain tax rate and take a deduction at a lower rate (because of an intervening change either in the taxpayer’s tax bracket or in the tax rates themselves). Id. at 681. The case which focused attention on these inequities is United States v. Lewis, 340 U.S. 590 (1951). In 1944, the taxpayer in Lewis had received a bonus from his employer, on which he had properly paid income taxes in the year of receipt. Two years later, in 1946, a state court ordered Lewis to repay his employer part of that bonus because it had been improperly computed. “Until payment of the judgment in 1946, [Lewis] had at all times claimed and used the full [bonus amount] unconditionally as his own, in the good faith though ‘mistaken’ belief that he was entitled to the whole bonus.” Id. at 591. The government argued that Lewis should deduct the amount he returned to his employer as a loss from his 1946 tax return; Lewis wished to recompute his tax for 1944. The Court sided with the government and held that under the wellestablished claim of right doctrine, the tax year in which the contested amount was received could not be reopened, whether this would “result[] in an advantage or disadvantage to a taxpayer.” Id. at 592. 8 In order to correct the inequities made apparent by the Lewis decision, Congress enacted section 1341, which, “as an alternative to the deduction in the year of repayment which prior law allowed, . . . permits certain taxpayers to recompute their taxes for the year of receipt.” Skelly Oil, 394 U.S. at 682. Section 1341 is designed to put the taxpayer in essentially the same position he would have been in had he never received the returned income in the first place. Dominion Res., Inc. v. United States, 219 F.3d 359, 363 (4th Cir. 2000). Under the title “Computation of tax where taxpayer restores substantial amount held under claim of right,” section 1341 provides in relevant part:

prior taxable year (or years) because it appeared that the taxpayer had an unrestricted right to such item;
because it was established after the close of such prior taxable year (or years) that the taxpayer did not have an unrestricted right to such item or to a portion of such item; and
then the tax imposed by this chapter for the taxable years shall be the lesser of the following: 9
deduction; or
(A) the tax for the taxable year computed without such deduction, minus (B) the decrease in tax under this chapter (or the corresponding provisions of prior revenue laws) for the prior taxable year (or years) which would result solely from the exclusion of such item (or portion thereof) from gross income for such prior taxable year (or years). 26 U.S.C. § 1341(a). The “net effect” of the provision is “that the taxpayer can recompute his taxes for the year in which he originally received the money, excluding from his income that amount which he later repaid.” Reynolds, 389 F. Supp.2d at 698. By allowing the taxpayer the choice between a simple deduction and a recalculation of the prior year’s tax liability, section 1341 ensures that any change in tax rates or in the taxpayer’s tax bracket is a tax neutral event with respect to the disputed item of income. For a taxpayer to qualify for the beneficial tax treatment of section 1341, (1) the taxpayer must have appeared to have an unrestricted right to an item included in gross income for a prior taxable year (i.e., must have included the item in income under a claim of right); (2) it must be established after the close of that 10 prior year that the taxpayer did not have an unrestricted right to the item; (3) the taxpayer must be entitled to deduct the amount of the item in the year in which the taxpayer restored the item; and (4) the amount of the deduction must exceed $3,000. Dominion Res., 219 F.3d at 363.3 The taxpayer bears the burden of proving his eligibility for section 1341 treatment. Kappel v. United States, 437 F.2d 1222, 1227 (3d Cir. 1971). In the District Court, the government conceded (as it does here) that Alcoa has met the third and fourth requirements of section 1341 because it was entitled to a deduction in 1993 that exceeded $3,000.4 The government contended, however, that Alcoa could not satisfy the first or second requirement for eligibility under the provision, i.e., (1) inclusion of an item in gross income under claim of right, and (2) later determination that the taxpayer did not have an unrestricted right to that item (restoration of that item). The government argued that Alcoa could not characterize as an “item . . . included in gross income” 3 In addition to this “general rule,” section 1341 includes certain exceptions, one of which – the “inventory exception” – is the object of a secondary dispute in this case. See 26 U.S.C. § 1341(b)(2). Because we do not reach the parties’ disagreement as to the interpretation of this exception we do not discuss it here. 4 Section 1341 does not itself create the right to a deduction in the year of the repayment. Rather, it is a prerequisite for section 1341 treatment that the taxpayer be entitled to a deduction for all or part of the repaid amount under some other Code section. Skelly Oil, 394 U.S. at 683. 11 the funds it did not spend in 1940-1987 on additional waste disposal activities. The government’s position was that “gross income” means “gross receipts”; “gross income” does not include money the taxpayer failed to spend. Alcoa disagreed, reasoning its “gross income” for the years in question was overstated because Alcoa’s cost of goods sold was understated. The government’s response to this argument was that, even if the amounts not spent by Alcoa could qualify as an “item included in gross income,” the claim of right doctrine applied only when the taxpayer was subject to an adverse claim at the time it included the item in gross income – whether or not the taxpayer was aware of the adverse claim at the time of the initial return. In the government’s view, section 1341 does not apply where the taxpayer had an actual and not simply an apparent right to the item, but later lost its right to the item through an intervening change in factual circumstances. Under this theory, even if Alcoa’s insufficient waste disposal expenses could qualify as an “item included in gross income,” Alcoa had an actual – not an apparent – claim to the funds it saved by failing to conduct proper waste disposal. This is so because there was no rival claim to those funds. Alcoa replied that something can be apparent and also be true; in Alcoa’s view, all a taxpayer must show to qualify under section 1341 is that the taxpayer lost the right to the item at some point before claiming the 12 deduction.5 The District Court, pursuant to the Reynolds decision, grudgingly accepted Alcoa’s argument that its insufficient environmental expenditures during the 1940-1987 period amounted to the inclusion of an item in gross income under an apparent claim of right. See Reynolds, 389 F. Supp. 2d at 702 (noting that the taxpayer had “skillfully co-opted the definition of gross income for its own means”). As for the requirement of a determination in a later year that the taxpayer did not have a claim of right to that item, however, the District Court held that Alcoa could not satisfy it and therefore could not avail itself of the beneficial treatment of section 1341.6 5 The question of whether an actual claim of right can qualify as an apparent one under the statute has caused some disagreement in the federal courts. Compare Dominion Res., 219 F.3d 359 (holding that a taxpayer may qualify for section 1341 treatment even if, during the year of receipt, he did in fact have an actual right to the item of income) with Cinergy Corp. v. United States, 55 Fed. Cl. 489 (Fed. Cl. 2003) (holding that section 1341 treatment presupposes that the taxpayer’s right to was “apparent,” not “actual,” in the year of receipt). 6 Because of the conclusion we come to in this appeal, we do not need to reach the question of whether the funds Alcoa did not spend in 1940-1987 on waste disposal qualify as “items included in gross income.” We note, however, that the argument presents significant difficulties. As a practical matter, the relationship between Alcoa’s expenditure in 1993, on the one hand, and whatever unspent moneys may have been 13