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.

An S Corporation Nightmare

Over my career the preferred entities for small and entrepreneurial businesses have been either an S corporation or a limited liability company (LLC). The C corporation has become a rarity in this space. A principal reason is the double taxation of a C corporation. The C pays its own taxes, but there is a second tax when those profits are returned to its shareholders. A common example is dividends. The corporation has already paid taxes on its profits, but when it shares its profits via dividends (with some exception if the shareholder is another corporation) there is another round of taxation for its shareholders. This might make sense if the corporation is a Fortune 500 with broad ownership and itself near immortal, but it makes less sense with a corporation founded, funded, and  grown by the efforts of a select few individuals – or perhaps just one person.

The advantage to an S corporation or LLC is one (usually - this is tax, after all) level of tax. The shareholder/owner can withdraw accumulated profits without being taxed again.

Today let’s talk about the S corporation.

Not every corporation can be an S. There are requirements, such as:

·       It cannot be a foreign corporation.

·       Only certain types of shareholders are allowed.

·       Even then, there can be no more than 100 shareholders.

·       There can be only one class of stock.

Practitioners used to be spooked about that last one.

Here is an example:

The S corporation has two 50% shareholders. One shareholder has a life event coming up and receives a distribution to help with expenses. The other shareholder is not in that situation and does not take a distribution.

Question: does this create a second class of stock?

It is not an academic question. A stock is a bundle of rights, one of which is the right to a distribution. If we own the same number of shares, do we each own the same class of stock if you receive $500 while I receive $10? If not, have we blown the S corporation election?

These situations happen repetitively in practice: maybe it is insurance premiums or a car or a personal tax. The issue was heightened when the states moved almost in concert to something called “passthrough taxes.” The states were frustrated in their tax collection efforts, so they mandated passthroughs (such as an S) to withhold state taxes on profits attributable to their state. It is common to exempt state residents from withholding, so the tax is withheld and remitted solely for nonresidents. This means that one shareholder might have passthrough withholding (because he/she is a nonresident) while another has no withholding (because he/she is a resident).

Yeah, unequal distributions by an S corporation were about to explode.

Let’s look at the Maggard case.

James Maggard was a 50% owner of a Silicon Valley company (Schricker). Schricker elected S corporation status in 2002 and maintained it up to the years in question.

Maggard bought out his 50% partner (making him 100%) and then sold 60% to two other individuals (leaving him at 40%). Maggard wanted to work primarily on the engineering side, and the other two owners would assume the executive and administrative functions.

The goodwill dissipated almost immediately.

One of the new owners started inflating his expense accounts. The two joined forces to take disproportionate distributions. Apparently emboldened and picking up momentum, the two also stopped filing S corporation tax returns with the IRS.

Maggard realized that something was up when he stopped receiving Schedules K-1 to prepare his personal taxes.

He hired a CPA. The CPA found stuff.

The two did not like this, and they froze out Maggard. They cut him off from the company’s books, left him out of meetings, and made his life miserable. To highlight their magnanimity, though, they increased their own salaries, expanded their vacation time, and authorized retroactive pay to themselves for being such swell people.

You know this went to state court.

The court noted that Maggard received no profit distributions for years, although the other two were treating the company as an ATM. The Court ordered the two to pay restitution to Maggard. The two refused. They instead offered to buy Maggard’s interest in Schricker for $1.26 million. Maggard accepted. He wanted out.

The two then filed S corporation returns for the 2011 – 2017 tax years.

They of course did not send Maggard Schedules K-1 so he could prepare his personal return.

Why would they?

Maggard’s attorney contacted the two. They verbally gave the attorney – piecemeal and over time – a single number for each year.

Which numbers had nothing to do with the return and its Schedules K-1 filed with the IRS.

The IRS took no time flagging Maggard’s personal returns.

Off to Tax Court Maggard and the IRS went.

Maggard’s argument was straightforward: Schricker had long ago ceased operating as an S corporation. The two had bent the concept of proportionate anything past the breaking point. You can forget the one class of stock matter; they had treated him as owning no class of  stock, a pariah in the company he himself had founded years before.

Let’s introduce the law of unintended consequences:

Reg 1.1361-1(l)(2):

Although a corporation is not treated as having more than one class of stock so long as the governing provisions provide for identical distribution and liquidation rights, any distributions (including actual, constructive, or deemed distributions) that differ in timing or amount are to be given appropriate tax effect in accordance with the facts and circumstances.

Here is the Tax Court:

… the regulation tells the IRS to focus on shareholder rights under a corporation’s governing documents, not what the shareholders actually do.”

That makes sense if we were talking about insurance premiums or a car, but here … really?

We recognize that thus can create a serious problem for a taxpayer who winds up on the hook for taxes owed on an S corporation’s income without actually receiving his just share of distributions.”

You think?

This especially problematic when the taxpayer relies on the S corporation distributions to pay these taxes.”

Most do, in my experience.

Worse yet is when a shareholder fails to receive information from the corporation to accurately report his income.”

The Court decided that Maggard was a shareholder in an S corporation and thereby taxable on his share of company profits.

Back to the Court:

The unauthorized distributions in this case were hidden from Maggard, but they were certainly not memorialized by … formal amendments to Schricker’s governing documents. Without that formal memorialization there was no formal change to Schricker’s having only class of stock.”

I get it, but I don’t get it. This reasoning seems soap, smoke, and sophistry to me. Is the Court saying that – if you don’t write it down – you can get away with anything?      

Our case this time was Haggard and Szu-Yi Chang v Commissioner, T.C. Memo 2024-77.

 

Patents, Capital Gains and Hogitude

I have an acquaintance who has developed several patents.  He works for a defense contractor, so I suspect he has more opportunity than a tax CPA.

COMMENT: Did you know that tax advisors have tried to “patent” their tax planning? I suppose I could develop a tax shelter that creates partnership basis out of thin air and then pop the shelter to release a gargantuan capital loss to offset a more humongous capital gain…. Wait, that one has already been done. Fortunately, Congress passed legislation in 2011 effectively prohibiting such nonsense.

Let’s say that you develop a patent someday. Let’s also say that you have not signed away your rights as part of your employment package. Someone is now interested in your patent and you have a chance to ride the Money Train. You call to ask how about taxes.

Fair enough. It is not everyday that one talks about patents, even in a CPA firm.

Think of a patent as a rental property. Say you have a duplex. Every month you receive two rental checks. What type of income do you have?

You have rental income, which is to say you have ordinary income. It will run the tax brackets if you have enough income to make the run.

Let’s say you sell the duplex. What type of income do you have?

Let’s set aside depreciation recapture and all that arcana. You will have capital gains.

People prefer capital gains to ordinary income. Capital gains have a lower tax rate.

Patents present the same tax issue as your duplex. Collect on the patent - call it royalties, licensing fees or a peanut butter sandwich – and you have ordinary income. You can collect once or over a period of time; you can collect a fixed amount, a set percentage or on a sliding rate scale. It is all ordinary income.

Or you can sell the patent and have capital gains.

But you have to part with it, same as you have to part with the duplex. 

Intellectual property however is squishier than real estate, which make sense when you consider that IP exists only by force of law. You cannot throw IP onto the bed of a pickup truck.

Congress even passed a Code section just for patents:

§ 1235 Sale or exchange of patents.

(a)  General.

A transfer (other than by gift, inheritance, or devise) of property consisting of all substantial rights to a patent, or an undivided interest therein which includes a part of all such rights, by any holder shall be considered the sale or exchange of a capital asset held for more than 1 year, regardless of whether or not payments in consideration of such transfer are-

(1)  payable periodically over a period generally coterminous with the transferee's use of the patent, or (2) contingent on the productivity, use, or disposition of the property transferred.

The tax Code wants to see you part with “substantial rights,” which basically means the right to use and sell the patent. Limit such use – say by geography, calendar or industry line – and you probably have not parted with all substantial rights.

Bummer.

What if you sell to yourself?

It’s been tried, but good thinking, tax Padawan.

What if you sell to yourself but make it look like you did not?

This has potential. Your training is starting to kick-in.

Time to repeat the standard tax mantra:

pigs get fat; hogs get slaughtered

Do not push the planning to absurd levels, unless you are Google or Apple and have teams of lawyers and accountants chomping on the bit to make the tax literature.

Let’s look at the Cooper case as an example of hogitude.

James Cooper was an engineer with more than 75 patents to his credit. He and his wife formed a company, which in turn entered into a patent commercialization deal with an independent third party.

So far, so good. The Coopers got capital gains.

But the deal went south.

The Coopers got their patents back.

Having been burned, Cooper was now leery of the next deal. Some sharp attorney advised him to set up a company, keep his ownership below 25% and bring in “independent” but trusted partners.

Makes sense.

Mrs. Cooper called her sister to if she wanted to help out. She did. In fact, she had a friend who could also help out.

Neither had any experience with patents, either creating or commercializing them.

Not fatal, methinks.

They both had full-time jobs.

So what, say I.

They signed checks and transferred funds as directed by the accountants and attorneys.

They did not pursue independent ways to monetize the patents, relying almost exclusively on Mr. Cooper.

This is slipping away a bit. There is a concept of “agency” in the tax Code. Do exactly what someone tells you and the Code may consider you to be a proxy for that someone.

Maybe the tax advisors should wrap this up and live to fight another day.

The sister and her friend transferred some of the patents back to Cooper.

Good.

For no money.

Bad.

The sister and her friend owned 76% of the company. They emptied the company of its income-producing assets, receiving nothing in return. Real business owners do not do that. They might have a career in the House of Representatives, though.

Meanwhile, Cooper quickly made a patent deal with someone and cleared six figures.

This mess wound up in Tax Court.

To his credit, Cooper argued that the Court should just look at the paperwork and not ask too many questions. Hopefully he did it with aplomb, and a tin man, scarecrow and cowardly lion by his side.

The Tax Court was having none of his nonsense about substantial rights and 25% and no-calorie donuts.

The Court decided he did not meet the requirements of Section 1235.

The Tax Court also sustained a “substantial understatement” penalty. They clearly were not amused. 

Cooper reached for hogitude. He got nothing.

Is It Income If You Pay It Back?

You receive unemployment benefits.

You repay unemployment benefits.

Do you have taxable income?

To start with: did you know that unemployment benefits are taxable? I have long considered this a dim bulb in taxation. Taxing the little you receive as unemployment seems cruel to me.

Back to our question: it depends.

It depends on when you pay it back.

Let’s look at the Yoklic case.

Yoklic applied for unemployment benefits in 2012.  He received $3,360, and then the state determined that he was not entitled to benefits. The state sent him a letter in October, 2012 requesting repayment.

Yoklic sent a check in September, 2013.

And he left the unemployment off of his 2012 return. How could it be income, he reasoned, if he had to pay it back. It was more of a loan, or alternatively monies that he received and to which he was not entitled.

Makes sense.

But tax theory does not look at it that way.

Enter the “claim of right” doctrine. It is an oldie, tracing back to a Supreme Court case in 1932.

The problem starts with accounting periods. You and I file taxes every year, so our accounting period is the calendar year. Sometimes something will start in one period (say October, 2012) but not resolve until another period (say September, 2013).

This creates a tax accounting issue: what do you do with that October, 2012 transaction? Do you wait until it resolves (in this case, until September, 2013) before you put it on a tax return? What if it doesn’t resolve for years? How many years do you wait? Does this transaction hang out there until the cows come home?

Enter the claim of right. If you receive monies – and you are not restricted in how you can use the monies – then you are taxable upon receipt. If it turns out that you are restricted – say by having to repay the monies - then you have a deduction in the year of repayment.

If you think about it, this is a reason that a bank loan is not income to you: you are immediately restricted by having to repay the bank. There is no need to wait until repayment, as the liability exists from the get go.

Find a bag of money in a Brooks Brothers parking lot, however, and you probably have a different answer.

Unless you repay it by the end of the year. Remember: you have a deduction in the year of repayment. If you find the bag of money and the police require you to return it, then the income and deduction happen in the same year and they fizzle out.

What if you promise to return the bag of money by year-end, but you do not get around to it until January 5^th? You may have an argument here, albeit a weak one. You could reduce your promise to writing, say by signing a contract. That seems a better argument.

What did Yoklic do wrong?

He repaid the monies in the following year.

He had income in 2012.

He had a deduction in 2013.

The problem, of course, is that the 2012 income may hurt more than the 2013 deduction may help.

There is – by the way - a Code section that addresses this situation: Section 1341, aptly described as the “claim of right” section. It allows an alternate calculation to mitigate the income-hurt-more-than-the-deduction-benefited-me issue. We have talked about Section 1341 before, but let me see if I can find a fresh story and we can revisit this area again.

CTG University: Part One

Let's discuss a famous tax case, and then I will ask you how you would decide a second case based on the decision in the first.

We are going back to 1944, and Lewis received a $22 thousand bonus.  He reported it on his 1944 tax return. It turns out that the bonus had been calculated incorrectly, and he returned $11,000 in 1946. Lewis argued that the $11,000 was mistake, and as a mistake it should not have been taxed to him in 1944. He should be able to amend his 1944 return and get his taxes back. This had an extra meaning since his tax rate in 1946 was lower (remember: post-war), so if he could not amend 1944 he would never get all his taxes back.

The IRS took a very different stand. It pointed out that the tax Code measures income annually. While arbitrary, it is a necessary convention otherwise one could not calculate income or the tax thereon, as there would (almost) always be one or more transactions not resolving by the end of the year. Think for example of writing a check to the church on December 31 but the check not clearing until the following year. The Code therefore taxes income on a "period" concept and not a "transactional" concept. With that backdrop, Lewis would have a deduction in 1946, when he returned the excess bonus.

The case went to the Supreme Court, which found that the full bonus was taxable in 1944. The Court reasoned that Lewis had a "claim of right," a phrase which has now entered the tax literature. It means that income is taxable when received, if there are no restrictions on its disposition. This is true even if later one has to return the income. The reasoning is that there are no limits on one's ability to spend the money, and there is also no immediate belief that it has to be repaid. Lewis had a deduction in 1946.

Looks like the claim of right is a subset of "every tax year stands on its own."

Let's roll into the 1950s. There was a company by the name of Skelly Oil. During the years 1952 through 1957 it overcharged customers approximately $500 thousand. In 1958 it refunded the $500 thousand.

You can pretty much see the Lewis and claim-of-right issue.

But there was one more fact.

Skelly Oil had deducted depletion of 27.5%. Depletion is a concept similar to depreciation, but it does not have to be tied to cost. Say you bought a machine for $100,000. You would depreciate the machine by immediately expensing, allocating expense over time or whatever, but you would have to stop at $100,000. You cannot depreciate more than what you spent. Depletion is a similar concept, but without that limitation. One would deplete (not depreciate) an oil field, for example. One would continue depleting even if one had fully recovered the cost of the field. It is a nice tax gimmick.

Skelly Oil had claimed 27.5% depletion against its $500,000 thousand or so, meaning that it had paid tax on a net of $366,000.

Skelly Oil deducted the $505,000 thousand.

Skelly Oil had a leg up after the Burnet v. Sanford & Brooks and Lewis decisions, as every tax year was to stand on its own. It refunded $505,000, meaning it had a deduction of $505,000. Seemed a slam dunk.

The IRS said no way. The $505,000 had a trailer attached - that 27.5% depletion - and wherever it went that 27.5% went. The most Skelly Oil could deduct was the $366,000.

But the IRS had a problem: the tax Code was based on period reporting and not transactional reporting. The 27.5% trailer analogy was stunning on the big screen and all, but it was not tax law. There was no ball hitch on the $505,000 dragging depletion in its wake.

Here is the Supreme Court: 

[T]he Code should not be interpreted to allow respondent 'the practical equivalent of double deduction,' *** absent a clear declaration of intent by Congress."

The dissent argued (in my words):           

So what? Every year stands on its own. Since when is the Code concerned with the proper measurement of income?

Odd thing, though: the dissent was right. The Lewis decision does indicate that Skelly Oil had a $505,000 deduction, even though it might not have seemed fair. The Court reached instead for another concept - the Arrowsmith concept. 

[T]he annual accounting concept does not require us to close our eyes to what happened in prior years."

There is your ball hitch. The concept of "net items" would drag the 27.5% depletion into 1958. "Net items" would include revenues and deductions so closely related as to be inseparable. Like oil revenues and its related depletion deduction.

The Court gave us the following famous quote: 

In other situations when the taxes on a receipt do not equal the tax benefits of a repayment, either the taxpayer or the Government may, depending on circumstances, be the beneficiary. Here, the taxpayer always wins and the Government always loses."

And over time the Skelly Oil case has come to be interpreted as disallowing a tax treatment where "the taxpayer always wins and the Government always loses." The reverse, however, is and has always been acceptable to the Government.

But you can see something about the evolution of tax law: you don't really know the law until the Court decides the law. Both Lewis and Skelly Oil could have gone either way.

Now think of the tax law, rulings and Regulations being published every year. Do we really know what this law means, or are we just waiting our turn, like Lewis and Skelly Oil?

Paying Tax Twice On The Same Income

Let me set up a scenario for you, and you tell me whether you spot the tax issue.

There is a fellow who is involved with health delivery services. He is paid by an insurance company, and he in turn pays out claims against that reimbursement. Whatever is left over is his profit.

In the first year, he received reimbursements from Cigna. There were issues, and in a second year he had to repay those monies. There was of course litigation. It turned out he was right, and Cigna – in yet a third year – paid him approximately $258,000.

Is the $258,000 taxable to him?

There is a doctrine in the tax Code that every tax year stands on its own. One has to resolve all the numbers that go into income for that year, even if some debate about an "exact" number exists. More commonly this is an issue for an accrual-basis taxpayer, meaning that one pays tax on amounts receivable even before receiving cash. Fortunately one is also able to deduct amounts payable (with exceptions) before writing the check. This is generally accepted accounting and is the way that almost all larger businesses report their income.

There is an alternative way. One can report income when cash is received and deduct expenses when bills are paid. This is the cash basis of accounting, and it too is generally accepted accounting.

For the most part, cash basis is the domain of smaller businesses. Depending upon the type of business, however, it may not matter if one is large or small. For example, an inventory-intensive business is required to use accrual accounting.

Our taxpayer is Udeobong, and he uses the cash basis of accounting.

When Cigna paid him the first time, he would have reported income in year one - the year he received the check.

When he repaid Cigna in year two, he had two options:

(1) He could deduct the payment in that second year, as he was repaying amounts previously taxed to him; or

(2) He could file his taxes for the second year using Section 1341, known in tax-speak as the “claim of right.”

The Code recognizes that just deducting the repayment in a second year could be unfair.  Let me give you an example. Let’s say that you received a very large bonus in 2014, large enough for you to retire. You invest the money and live comfortably, but 2014 was your bellwether year and is never to be repeated. Something happens – say that there is clawback - and you have to return some of the bonus in 2016. Sure, you could deduct the repayment, but that repayment could overwhelm your income in 2016. It is possible that you would lose any tax advantage once your income goes negative. If one looks at the two years together (2014 and 2016), you would have paid tax on income you did not get to keep.

That is where Section 1341 comes in. The Code allows you to do a special calculation:

·        You start off with the tax you actually paid in 2014

·        You then do a pro forma calculation, subtracting the repaid amount from your income in 2014. This gives you a revised tax amount.

·        You subtract the revised tax amount from the actual tax you paid in 2014.

·        The IRS allows you to claim that difference as tax paid in 2016.

The Code is trying to be fair, and for the most part it works.

There is one more piece you need to know. Udeobong did not either deduct the repayment or use the claim-of-right in year two. He did ... nothing.

Is the $258,000 in year three taxable to him?

Unfortunately, it is.

But why?

Because the Code gives him two options: deduct the payment in year two or use the claim of right alternative.

COMMENT: You may be wondering if he could amend his year-one return. This is the technical problem with every tax year standing on its own. Unless there were exceptional circumstances, the Code takes the position   that he received and had control over the income in year one, even if something occurs later requiring him to repay some or all of that income. Since he had control in year one, he had income in year one. Should he repay in a later year, then the repayment is reported in the later year.

The Code does not give him a third option of excluding the $258,000 in year three.

So he has to pay tax again.

It is a harsh result. One can understand the reasoning without the conclusion feeling fair or just ... or right.  I am also frustrated with Udeobong. There is no mention that he used a tax advisor. He had no idea of what he walked into.

He tried to save professional fees, perhaps because he saw his tax return as a simple matter of cash in and cash out. I understand, and I do not – in general – disagree. Still, one has to be cognizant when something unusual happens, like swapping real estate, exercising stock options or repaying Cigna a lot of money. The combination of "unusual" and "a lot" probably means it is a good time to see a tax expert.