Clarifying the Claim of Right Doctrine

What are the tax consequences for the year of repayment?

The claim of right doctrine is an income recognition principle that the receipt of money representing gross income remains gross income even if the taxpayer may be under a contingent obligation to repay it on a future date. In North American Oil Consolidated v. Burnet, 286 U.S. 417 (1932), the Supreme Court first explained it:

The net profits earned by the property in 1916 were not income of the year 1922 -the year in which the litigation with the government was finally terminated. They became income of the company in 1917, when it first became entitled to them and when it actually received them. 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.

In U.S. v. Lewis, 340 U.S. 590 (1951), the Supreme Court held that income recognized under a claim of right but later repaid is deducted in the year of repayment:

Respondent Lewis brought this action in the Court of Claims seeking a refund of an alleged overpayment of his 1944 income tax. The facts found by the Court of Claims are: In his 1944 income tax return, respondent reported about $22,000 which he had received that year as an employee's bonus. As a result of subsequent litigation in a state court, however, it was decided that respondent's bonus had been improperly computed; under compulsion of the state court's judgment he returned approximately $11,000 to his employer. Until payment of the judgment in 1946, respondent had at all times claimed and used the full $22,000 unconditionally as his own, in the good faith though "mistaken" belief that he was entitled to the whole bonus.

On the foregoing facts the Government's position is that respondent's 1944 tax should not be recomputed, but that respondent should have deducted the $11,000 as a loss in his 1946 tax return…

Income taxes must be paid on income received (or accrued) during an annual accounting period. Cf. I. R. C., 41, 42; and see Burnet v. Sanford & Brooks Co., 282 U.S. 359, 363. The "claim of right" interpretation of the tax laws has long been used to give finality to that period, and is now deeply rooted in the federal tax system. See cases collected in 2 Mertens, Law of Federal Income Taxation, 12.103. We see no reason why the Court should depart from this well-settled interpretation merely because it results in an advantage or disadvantage to a taxpayer.

Non-§1341 Claim of Right Repayments

Because the later deduction may not decrease tax by the same amount as the tax originally imposed on the income, Congress added §1341 to the Code in 1954 to provide relief. §1341 does not apply if the amount repaid is $3,000 or less; in that case, the taxpayer simply deducts the amount in the year of repayment.

Internal Revenue Manual (IRM) 21.6.6.2.10.1 (10-09-2003) states the following with respect to these deductions:

The repayment is deducted, in general, on the same form or schedule on which it was previously included. If it had been included as self-employment income on Schedule C, Profit or Loss from Business, it is deducted on Schedule C. If it had been included as capital gain on Schedule D, Capital Gains and Losses, it is deducted on Schedule D. If it was reported as wages, taxable unemployment compensation, or other non-business ordinary income, it is deducted on Schedule A, Itemized Deductions.

The non-§1341 Schedule A deduction is a 2% miscellaneous itemized deduction; therefore, it is nondeductible for federal tax purposes through 2025 but may be deductible on some state income tax returns. §67(b)(9) only excludes §1341 deductions, discussed later, from being a 2% miscellaneous itemized deduction.

§1341 Claim of Right Repayments

If the repayment exceeds $3,000, the taxpayer must apply §1341. The taxpayer must calculate their repayment year's tax using two methods, and then they must use the method that results in the least tax for the repayment tax year.

IRM 21.6.6.2.10.2 (05-8-2023) provides a clear outline of the calculation method and how to report the result of the §1341 calculation.

In Method 1, the taxpayer computes the repayment year's tax with a deduction for the amount repaid.

In Method 2, the taxpayer computes the repayment year’s tax using a four-step process:

1. Compute the repayment year’s tax without deducting the amount repaid.

2. Recalculate the tax for the prior year of inclusion without the amount that was repaid in the repayment year.

3. Subtract the recalculated tax under step 2 from the actual tax for the earlier year. The difference is the §1341 credit.

4. Subtract the §1341 credit under step 3 from the tax under step 1.

If the tax under Method 1 is less, the repayment is deducted on the same form or schedule on which it was previously included in the repayment year. If taken as an itemized deduction, it is a miscellaneous itemized deduction not subject to the 2% of adjusted gross income (AGI) floor, as discussed previously.

If the tax under Method 2 is less, the §1341 credit figured under that method is entered on Schedule 3, line 13b, as a refundable credit in the repayment year.

Claim of Right Example

Jason received a $10,000 signing bonus in tax year 2022 and was required to repay it in tax year 2023. What are the tax consequences of that 2023 repayment?

Prior to any repayment considerations, assume his 2023 tax was $22,000. Under Method 1, Jason increases his itemized deductions by $10,000; however, his taxable income only decreases by $5,000 because he has insufficient deductions to itemize without the claim of right repayment. Assuming Jason’s marginal tax rate is 24%, his recalculated 2023 tax is $20,800 ($22,000 less $1,200, which is 24% of $5,000).

For Method 2, assume Jason’s marginal rate in 2022 was 32%, and there were no downstream income tax effects from the reduction in AGI and taxable income. The §1341 credit is $3,200 (32% of $10,000). His recalculated 2023 tax is $18,800 ($22,000 less $3,200).

Since Method 2 results in the lowest 2023 tax, Jason includes a $3,200 §1341 credit on his 2023 Schedule 3 on line 13b.

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