Claim of Right Doctrine
The Tax Cuts and Job Act of 2017 (TCJA) lowered the top corporate tax rate from 35% to 21%. That’s a good thing for business owners. Except when it isn’t. Consider the situation where you paid tax on income or property you received pre-TCJA, but in a later, post-TCJA year, you had to return the property. You might be entitled to a tax deduction for the value of the property returned, but your deduction is at 21% when the tax paid was at 35%.
Are you required by law to recognize income even if you don’t have a fixed right to the asset and might have to return it? Must you report it as income and pay taxes on it? What happens to the tax you paid if you do, in fact, have to return the property? The claim of right doctrine addresses these issues. If you are facing a tax dilemma in this complicated area, contact an experienced and knowledgeable tax attorney who can advise you of your options and represent your interests with the IRS. Call Lehman Tax Law at 561-368-1113.
Claim of right Under IRC 1341
The applicable section of the Internal Revenue Code is section 1341, Computation of Tax Where Taxpayer Restores Substantial Amount Held under Claim of Right. This section allows a deduction, known as a 1341 credit, for income you reported but later had to return. To prove you held the income under a claim of right, you’ll need to establish you thought you had an unrestricted right to the property. You can prove this by showing:
- You received the asset
- You exercised unlimited control over it
- You held it and treated it as your own
If a deduction is available to you, you could deduct the amount paid from your taxes. If the amount repaid is greater than $3,000, you can claim a tax credit instead. Tax credits are generally preferable to deductions, as they give you a dollar-for-dollar reduction in your tax liability, as opposed to merely lowering your taxable income.
Claims of Right and the Tax Cuts and Jobs Act
As noted in the introduction, the TCJA knocked down the top corporate tax rate from 35% to 21%. If you reported income received pre-TCJA and returned it post-TCJA, assuming you can take the claim of right deduction, your deduction would be at a lower tax rate than the rate of tax initially paid. Because of this discrepancy, the law allows you to recalculate as though you did not report income in that earlier year. Lehman Tax Law can advise you to make sure you get the proper deduction or credit.
The proper tax year for taking the credit depends on the accounting method you use. If cash accounting, the credit applies in the tax year when the repayment was made. For accrual accounting, you’ll have to determine in which tax year the credit is a proper deduction.
Revenue Ruling 2004-29 warning against the misuse of Section 1341
Revenue rulings are official IRS interpretations of the Internal Revenue Code, related statutes and regulations. Revenue Ruling 2004-29 clarifies that section 1341 only applies when a taxpayer properly reports an amount of income in one taxable year and later repays all or a portion of that same amount in a later taxable year because the taxpayer, in fact, did not have an unrestricted right to that income.
The Revenue Ruling warns against taxpayers making what it considers to be frivolous positions or meritless arguments for the 1341 credit. The IRS claims it will vigorously enforce the law by confirming if you filed all required returns and correctly computed tax and interest. The IRS will also determine whether civil and criminal penalties should apply. Civil penalties can be as high as $25,000, and criminal sentences can amount to $100,000 in fines and up to five years in prison. Tax preparers can be subject to these high fines as well, along with up to three years imprisonment.
In this ruling, the IRS expressed the intent to crack down on taxpayers who falsely claim they do not have a right to some income they receive, and so don’t pay income tax on it. In other words, the claim of right doctrine can be used when repaying amounts previously reported as income, but it cannot be used to exclude some item from gross income and thereby reduce one’s federal income tax liability.
Get Professional Legal Help With Claim of Right Issues
The claim of right doctrine is a complex area of U.S. tax law. You may be able to avail yourself of this document to your benefit, but only if you use it correctly under qualifying circumstances. For advice on applying the claim of right documentation or representation in a dispute with the IRS over the doctrine, call Lehman Tax Law at 561-368-1113 for a complimentary consultation with a skilled and knowledgeable U.S. tax law attorney.