Loan Warehousing And The Claim of Right

 

Tax returns are generally filed in one-year increments.

That raises an accounting question: what if the transaction being accounted for stretches over more than one year?

A variation is:

Set aside whether the whether the transaction resolved in the same period. Was there doubt as to a material fact affecting the transaction? If one were to redo the accounting knowing what one knows now, would there be a different answer?

This is the backdrop for the claim of right doctrine. Judge Brandeis referred to it in North American Oil Consolidated v Burnet (1932):

If 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.”

You can immediately see a couple of requirements:

(1) The taxpayer is later required to return the money.

(2) The taxpayer, however, initially received the money without restriction upon its use.

If you are preparing a tax return and learn of the above, what do you do?

(1)  Amend the original tax return?

(2)  Deduct the repayment in the year of repayment?

It might not seem significant upon first hearing, but it can be. Here are two common ways it can be significant:

(1) The original year (that is, the year the income was reported) is closed under the statute of limitations.

(2) Tax rates have changed substantially between the years.

Congress finally passed a Code section codifying the claim of right doctrine in 1954:

26 U.S. Code § 1341 - Computation of tax where taxpayer restores substantial amount held under claim of right

(a) General rule If—

(1) an item was included in gross income for a prior taxable year (or years) because it appeared that the taxpayer had an unrestricted right to such item;

(2) a deduction is allowable for the taxable year 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

(3) the amount of such deduction exceeds $3,000,

then the tax imposed by this chapter for the taxable year shall be the lesser of the following:

(4) the tax for the taxable year computed with such deduction; or

(5) an amount equal to—

(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).

This is a rare find in the tax Code, as Congress actually expanded the claim of right to make it more taxpayer friendly. The Code still allows a deduction in the year of repayment, but it also allows a recalculation using the original year’s tax rates. If tax rates have decreased (overall or yours personally), the recalculation of the original year may be the better way to go.

Let’s look at Norwich Commercial Group v Commissioner.

Here is the first sentence of the decision:

P overreported more than $7 million in income on its 2007 through 2013 federal income tax returns."

Big number. It caught my attention.

Norwich was a residential mortgage loan originator. It engaged in warehouse lending, a term that may sound mysterious but is really not. Here is what warehousing means in a lending context: 

• Norwich (call it the warehouse) borrows money, likely on a line of credit, to start the transaction. 
• The warehouse lends the money to a customer (in this case, a home buyer) in exchange for a promissory note. 
• The warehouse sells the promissory note to an investor. The money received from the sale is (almost certainly) deposited with the lender the warehouse itself borrowed the money from. 
• The lender does its calculations: how much is owed, how much interest is due and other charges, if any. It subtracts this amount from the amount deposited. Whatever is leftover is returned to the warehouse as gross profit (in this context called: mortgage fee income).

If you think about it, this is an inventory accounting of sorts, except that the inventory is money lent.

So, Norwich was a warehouse.

Liberty was Norwich’s primary lender. There were others, but let’s sidestep as they are not necessary to understand the tax issue at play.

Norwich had to design an accounting procedure for its mortgage fee income. It did the following: 

• First, all mortgage deposits were posted to Mortgage Fee Income.
• Second, the amounts kept by Liberty reduced Mortgage Fee Income.
• Third, Norwich would adjust Mortgage Fee Income to whatever Liberty said it was.
• Fourth, the difference was assumed to be Unsold Mortgages.

I get it, but Norwich should backstop its critical accounts.

Let’s see:

(1)  Cash

a.     Well, that is easy to backstop with a bank statement.

(2)  Loan payable to Liberty.

a.     Again: easy. Liberty should be able to tell them that number.

(3)  Unsold Mortgages.

a.     Liberty cannot help Norwich here, as these have not entered Liberty’s accounting system. They are off the radar as far as Liberty is concerned.

We have identified the weak spot in the accounting, as Unsold Mortgages are just a subtraction. Best practice would involve keeping detail – more or less, as required – to have a reality check on the running balance.

In 2014 Norwich started using new accounting software.

It could not reconcile certain accounts.

COMMENT: This is my shocked face.

Norwich contacted Liberty, who in turn provided detail and balances to help with reconciliations. One of those numbers was collateral held by Liberty to secure the line of credit. The collateral included everything, including loans in process or otherwise but not yet sold by Norwich.

If that sounds a lot like Norwich’s Unsold Mortgages account, that is because it is.

Liberty’s number was significantly less than Norwich’s – by over $7 million. Mind you, all this stuff was collateral for the line of credit. If the actual Unsold Mortgages balance was substantially less than previously reported, Norwich might be undercollateralized. The term for this is “out of trust,” and it could also cause problems for Liberty on the regulator side.

BTW Liberty did not initially believe that Norwich was correct or that the situation was urgent. Norwich tried repeatedly to schedule meetings with Liberty. Liberty in turn delayed, expecting nothing to be amiss.

We will fast forward through the banking side of this.

Norwich filed its claim of right refund – for $7.5 million – on its 2014 tax return.

The IRS denied the refund entirely.

You know this went to Court.

And the arguments are easy to predict:

Norwich: We had an unrestricted right to that income in prior years. It was not until 2014 that we discovered otherwise. Under claim of right, 2014 is the proper year for the deduction.

IRS: Everything here is a loan. Norwich issued loans. Norwich borrowed on loans. When originated loans were sold, Norwich in turn paid back its loans. Everything that happened here circles around loans of one type or another. The claim of right has nothing to do with loans.

Both sides had a point.

Here is the Court:

This, the Commissioner focuses on the origin of the funds rather than the origin of the transaction ….”

I agree. The business activity required extensive use of loans, but the intended result of all the loans was to generate a profit, not to maintain a loan into perpetuity.

The Court noted that everybody - including Liberty - thought that Norwich was entitled to the money when Norwich received it.

The repayment was also deductible as an ordinary and necessary business expense and was not barred by another Code section.

2014 was also the correct year for the deduction. It was the year Norwich found the error, which discovery was memorialized in paperwork between Norwich and Liberty. Norwich agreed to either (1) provide more collateral or (2) pay down its line of credit with Liberty.

The Court did tweak some numbers, but overall Norwich prevailed in its claim of right refund request.

Our case this time was Norwich Commercial Group v Commissioner, T.C. Memo 2025-43.

Recurring Proposal For Estate Beneficiary’s Basis In An Asset

There is an ongoing proposal in estate taxation to require the use of carryover basis by an inheriting beneficiary.

I am not a fan.

There is no need to go into the grand cosmology of the proposal. My retort is simple: it will fail often enough to be an unviable substitute for the current system.

You might be surprised how difficult it can be sometimes to obtain routine tax reports. I have backed into a social security 1099 more times than I care to count.

And that 1099 is at best a few months old.

Let’s talk stocks.

Question: what should you do if you do not know your basis in a stock?

In the old days – when tax CPAs used to carve numbers into rock with a chisel – the rule of thumb was to use 50% of selling price as cost. There was some elegance to it: you and the IRS shared equally in any gain.

This issue lost much of its steam when Congress required brokers to track stock basis for their customers in 2011. Mutual funds came under the same rule the following year.

There is still some steam, though. One client comes immediately to mind.

How did it happen?

Easy: someone gifted him stock years ago.

So?  Find out when the stock was gifted and do a historical price search.

The family member who gifted the stock is deceased.

So? Does your client remember - approximately - when the gift happened?

When he was a boy.

All right, already. How much difference can it make?

The stock was Apple.

Then you have the following vapid observation:

Someone should have provided him with that information years ago.

The planet is crammed with should haves. Take a number and sit down, pal.

Do you know the default IRS position when you cannot prove your basis in a stock?

The IRS assumes zero basis. Your proceeds are 100% gain.

I can see the IRS position (it is not their responsibility to track your cost or basis), but that number is no better than the 50% many of us learned when we entered the profession.

You have something similar with real estate.

 Let’s look at the Smith case.

Sherman Darrell Smith (Smith) recently went before the Tax Court on a pro se basis.

COMMENT: We have spoken of pro se many times. It is commonly described as going to Tax Court without an attorney, but that is incorrect. It means going to Tax Court represented by someone not recognized to practice before the Tax Court. How does one become recognized? By passing an exam. Why would someone not take the exam? Perhaps Tax Court is but a fragment of their practice and the effort and cost to be expended thereon is inordinate for the benefits to be received. The practitioner can still represent you, but you would nonetheless be considered pro se.

Smith’s brother bought real property in 2002. There appears to have been a mortgage. His brother may or may not have lived there.

Apparently, this family follows an oral history tradition.

In 2011 Smith took over the mortgage.

The brother may or may not have continued to live there.

Several years later Smith’s brother conveyed an ownership interest to Smith.

The brother transferred a tenancy in common.

So?

A tenancy in common is when two or more people own a single property.

Thanks, Mr. Obvious. Again: so?

Ownership does not need to be equal.

Explain, Mr. O.

One cannot assume that the real estate was owned 50:50. It probably was but saying that there was a tenancy in common does not automatically mean the brothers owned the property equally.

Shouldn’t there be something in writing about this?

You now see the problem with an oral history tradition.

Can this get any worse?

Puhleeeze.

The property was first rented in 2017.

COMMENT: I suspect every accountant that has been through at least one tax course has heard the following:

The basis for depreciation when an asset is placed in service (meaning used for business or at least in a for-profit activity) is the lower of the property’s adjusted basis or fair market value at the time of conversion.

One could go on Zillow or similar websites and obtain an estimate of what the property is worth. One would compare that to basis and use the lower number for purposes of depreciation.

Here is the Court:

Petitioner used real estate valuation sources available in 2024 to estimate the rental property’s fair market value at the time of conversion.”

Sounds like the Court did not like Smith researching Zillow in 2024 for a number from 2017. Smith should have done this in 2017.

If only he had used someone who prepares taxes routinely: an accountant, maybe.

Let’s continue:

But even if we were to accept his estimate …, his claim to the deduction would fail because of the lack of proof on the rental property’s basis.”

The tenancy in common kneecapped the basis issue.

Zillow from 2024 kneecapped the fair market value issue.

Here is the Court:

Petitioner has failed to establish that the depreciation deduction here in dispute was calculated by taking into account the lesser of (1) the rental property’s fair market value or (2) his basis in the rental property.”

And …

That being so, he is not entitled to the depreciation deduction shown on his untimely 2018 federal tax return.”

Again, we can agree that zero is inarguably wrong.

But such is tax law.

And yes, the Court mentioned that Smith failed to timely file his 2018 tax return, which is how this mess started.

Here is the Court:

Given the many items agreed to between the parties, we suspect that if the return had been timely filed, then this case would not have materialized.”

Let’s go back to my diatribe.

How many years from purchase to Tax Court?

Fifteen years.

Let’s return to the estate tax proposal.

Allow for:

• Years if not decades
• Deaths of relevant parties
• Failure to create or maintain records, either by the parties in interest or by municipalities tasked with such matters
• Soap opera fact patterns

And there is why I object to cost carryover to a beneficiary.

Because I have to work with this. My classroom days are over.

And because – sooner or later – the IRS will bring this number back to zero. You know they will. It is chiseled in stone.

And that zero is zero improvement over the system we have now.

Our case this time was Smith v Commissioner, T.C. Memo 2025-24.

Penalties For Cash Reporting Failures

 

It would be a vast understatement to say that the plucky Rebellion had software issues this busy season.

We saw (some of) it coming … given the merger and all. Short of Excel and Word, there was little overlap between our softwares - that is, our preparation software, research software, time reporting, invoicing and receipt, monitoring the accounting practice and whatnot.

We are still working through the shock.

And I see a Tax Cout decision issued about a week ago concerning software.

I can tell you before reading it how the Court will decide:

Software – unless involving matters exceeding the minds of mortal men – will not save one from penalties. If one purchases and installs software, one is under obligation to learn and master it.

My thoughts?

I am divided. An ordinary taxpayer does not – should not - need my services. Reach a certain point though, and a tax professional becomes as necessary as a primary physician or a dentist.

Still, the Code has become increasingly complex since I came out of school. The very computerization that has allowed professionals to streamline and systematize their work has simultaneously allowed the Congressional tax committees to draft and score increasing complex and near-unworkable changes to the Code. Far too many of these changes can potentially reach ordinary taxpayers. That taxpayer would probably not know that he/she wandered into a minefield. He/she would learn of it when the penalty notice arrived, however. The IRS (and too often the courts) presume that you have a graduate degree in taxation – ignorance of the law is no excuse and all that flourish. They do not care that you don’t.

Dealers Auto Auction of Southwest LLC (Dealers) was an Arizona company selling vehicles through auction houses. It frequently received cash in the ordinary conduct of its business. Not surprisingly, the cash from a sale would often exceed $10,000.

There is a Code section involved here:

          Section 6050I

(a)  Cash receipts of more than $10,000

Any person

(1)  Who is engaged in a trade or business, and

(2)  Who in the course of such trade or business, receives more than $10,000 in cash in 1 transaction (or 2 or more related transactions),

shall make the return described in subsection (b) with respect to such transaction (or related transactions) at such time as the Secretary may by Regulations prescribe.

Once Sec 6050I is triggered, the company files Form 8300 with the IRS. It is an information return (no taxes go with it), but there are penalties for failure to file the return.

Not surprisingly, it has its own rules and subrules.

You know the Forms 8300 were an issue for Dealers.

They bought software (AuctionMaster) to deal with it.

They bought the software after flubbing the 2014 Form 8300 filings. The IRS assessed penalties of over $21 grand, and Dealers realized that buying software was cheaper than paying penalties.

And … the IRS was back in 2016.

Why?

Dealers filed 116 Forms 8300. The IRS argued that Dealers should have filed 382.

The IRS wanted over $118 grand in penalties.

Yipes!

Here is the Court:

Dealers Auto was not immediately aware of its failures. Instead, it was not until the Commissioner began the examination that Dealers Auto became aware of its noncompliance.”

Dealers was blindsided.

It took immediate steps:

·       It contacted the software provider and learned that improved aggregation features were available starting in 2017 (the year following the audit year).

·       Dealers quizzed the auditor on the subtleties of Form 8300 and its filing requirements.

·       Dealers changed its procedures and internal control for filing 8300s.

·       Dealers changed to electronic filing of the 8300s. They let the software cook.

No way the IRS was going to retract that $118 grand-plus assessment, though.

Dealers appealed the penalty. It wanted abatement for reasonable cause.

COMMENT: So would I, frankly.

Dealers’ argument was straightforward: we relied on software, and the software malfunction was outside of our control.

The IRS responded: there was no malfunction. You never mastered the software. If you had, you would have realized that it was not functioning as you thought.

Harsh, methinks. Probably honest, though.

Here is the Court:

Dealers Auto failed to establish that there was a software failure.”

The instructions for the software suggest that the software prepared Forms 8300 for printing, but Dealers Auto asserts that the software files the forms on the user’s behalf.”

Even assuming Dealers Auto met its burden to show a failure beyond the filer’s control, the record does not support a finding that Dealers Auto acted reasonably before or after the failure. For example, Dealers Auto did not establish that it was correctly using the software or that data was being entered correctly into the system.”

Dealers Auto argues that it reasonably believed the software was working as intended because it was generating some information returns. But the record shows that Dealers Auto software prepared only 116 Forms 8300 in 2016. The record also shows that Dealers Auto was required to file at least 212 Forms 8300 in 2014.”

This is going poorly.

What do I see?

I see a small business that was surprised in 2014. It responded with technology, but its familiarity with technology appears limited. It got surprised again. Normally that would indicate recidivism, but I don’t think that is what happened here. I think Dealers had only so many resources to throw at a problem. In addition, they may not have realized the extent of the problem if they were quizzing the IRS auditor on the ins and outs.

What did the Court see?

While it is not necessary to show that Dealers Auto made every data entry correctly, the record offers the Court no insight as to Dealer Auto’s installation, training, or use of the software.”

Here it comes:

Dealers Auto failed to establish that it has reasonable cause for its failure to file information returns for 2016.”

What disappoints me about cases like this is the failure to reward a taxpayer’s effort. Dealers tried. It bought software. It was filing, albeit not as much as it was supposed to. Should it have expended more money and resources on the matter? Clearly, but then I should have played in the NFL and retired as a Hall of Famer. The IRS is punishing Dealers like a scofflaw who did not care, made things up and never intended to follow the rules. To me, applying the same penalties to both situations is abusive.

Our case this time was Dealers Auto Auction of Southwest LLC v Commissioner, T.C. Memo 2025-38.