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.