A taxpayer was unsuccessful in attempting to recover taxes via a claim of right deduction under IRC §1341 in the case of Heiting v. United States, US DC WD Wisconsin, Case No. 3:19-cv-00224, a holding upheld on appeal.[1]

Claim of Right

The claim of right provision under the IRC is a relatively obscure provision, though one that most advisers will eventually run across in their practice.  The provision is meant to provide some relief from the strict annual accounting for income taxes in certain situations where a taxpayer recognizes income that later must be repaid by the taxpayer.

The general rule for the claim of right doctrine is found at §1341(a) which provides:

(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).

For purposes of paragraph (5)(B), the corresponding provisions of the Internal Revenue Code of 1939 shall be chapter 1 of such code (other than subchapter E, relating to self-employment income) and subchapter E of chapter 2 of such code.

An example of the type of situation that normally triggers the claim of right is the case where a new employee receives a signing bonus that is conditioned on the employee remaining employed with the employer for a period of years.  The employee includes the signing bonus in income in the year in which the bonus is received.  If, in a later year, the employee leaves employment and repays a portion of the bonus, §1341(a) is triggered.  The employee would have the choice of taking a deduction in the year of repayment or reducing his/her tax in the year of repayment by a credit equal to the amount of tax computed as being previously paid when this amount was included in income in the prior year.

Sale of Stock Trust Was Not Allowed to Sell

The issue in the Heiting case is a bit different, involving the couple’s grantor trust which had a third-party corporate trustee.  The third-party trustee sold assets that were not allowed to be sold under the terms of the trust.  As the opinion describes:

The trust agreement granted the trustee broad discretion to invest, reinvest, or retain trust assets. Dkt. 11, Article II (selecting investment option C). But the trust agreement prohibited the trustee from doing anything with the stock of two companies: Bank of Montreal Quebec (BMO) and Fidelity National Information Services, Inc. Id., Article IX, Article X. Despite the prohibition, the trustee sold all of the trust’s BMO and Fidelity stock in October 2015. The sale resulted in a taxable gain of $5,643,067.50. Proceeds from the sale remained in the trust.[2]

The trustee did not notice the problem in the year the stock was sold, but did notice the issue and take corrective action in the following year:

In January 2016, the trustee realized that the sale of BMO and Fidelity stock was prohibited by the trust agreement. The trustee repurchased the stock with the trust’s assets. The Heitings revoked the trust in February 2016.[3]

Taxpayer’s Position That Claim of Right Applied and IRS Objection

Since the trust was a grantor trust, the Heitings were treated as the owners of all assets in the trust and paid tax on the gain on sale on their 2015 return.  On their 2016 return the couple claimed a deduction under the claim of right rule of §1341(a) for the repurchase of the stock.  In their view, as the sale was not allowed under the trust document, the subsequent repurchase was effectively a repayment of the proceeds that led to the taxable gain.[4]

The IRS did not agree with that view and denied the deduction.  The taxpayers paid the tax due and then brought suit in United States District Court to obtain a refund of the taxes paid.

IRC §1341(a) has three criteria that must be met to be able to take advantage of the provision.  Two of them all parties agreed were met:  the amount in question exceeded $3,000 and in 2015 the amounts in question were in the taxpayers’ revocable trust and appeared to be available to the taxpayers without restriction.[5]

But the IRS argued that the taxpayers could not meet the requirement found at IRC §1341(a)(2).  The government’s position was that the Heitings were not actually required to return the proceeds of the stock sale.  As the opinion notes:

According to the government, once the BMO and Fidelity stock was sold, the Heitings had the unrestricted right to do what they wanted with the proceeds, because they had unrestricted rights over the assets in the revocable trust. Indeed, the Heitings revoked the trust in 2016.[6]

The Heitings argued that, since the trust prohibited the sale of those stocks, the trustee had to repurchase the stock—and as deemed owner under the grantor trust rules, the tax consequences fell on them.  But the Court did not agree with their view:

But the Heitings’ argument is fundamentally unsound as a matter of trust law.

Neither the trustee nor the Heitings were actually obligated to repurchase the BMO and Fidelity shares. Under the Wisconsin Trust Code, “[w]hile a trust is revocable, the trustee may follow a direction of the settlor that is contrary to the terms of the trust.” Wis. Stat. § 701.0808(1). So the Heitings, without amending the trust, could have instructed the trustee to do anything with the proceeds of the stock sale. Under the trust agreement itself, the trustee had to follow the Heitings’ directions in taking any action regarding BMO and Fidelity stock— not only in selling it, but in buying it back as well. See Dkt. 11, Article IX, Article X. And, by the terms of the trust agreement, the Heitings could have amended or revoked the trust at any time, as they did in 2016.

The Heitings also contend that when they learned about the trustee’s unauthorized stock sale, they had no choice in how to respond. They say that “a beneficiary of a trust cannot ignore a breach and profit from it simply because the trustee fails to remedy that breach.” Dkt. 20, at 9. They cite no authority for this proposition. It’s long been the law in Wisconsin that a beneficiary can consent to a trustee’s action, thereby ratifying conduct that would otherwise breach the trustee’s duty to the trust. See, e.g., In re Spengler, 596 N.W.2d 818, 825– 26, 228 Wis. 2d 250 (Ct. App. 1999); see also Koult v. Kaufer, 159 N.W. 806, 809, 164 Wis. 136 (1916) (if trustee improperly invests trust assets, beneficiary “may retain the property and thereby ratify the wrong”). The trustee’s obligations to the Heitings simply cannot be imputed to the Heitings themselves as though the Heitings were somehow irrevocably bound to the terms of their own revocable trust. [7]

The case that that the taxpayers attempted to rely upon (First National Bank of Chicago v. United States, 551 F. Supp. 157 (N.D. Ill. 1982)) differed from the current case in a number of factors, a key one being the trust in that case was not a grantor trust:

Moreover, First National Bank differs from this case in two key respects. First, the trust in that case was not a grantor trust; instead, the trust itself was the taxpayer, so the entity obligated to return the restricted income and the taxpayer eligible for a § 1341 credit were one and the same. Second, the stock repurchase in First National Bank was court-ordered after one of the beneficiaries sued over the unauthorized stock sale. Id. at 158. The Heitings’ trustee had no comparable legal obligation, and neither did the Heitings themselves.[8]

Since there was no obligation to return the funds, the Heitings could not make use of the claim of right provisions of IRC §1341(a).  As the opinion concludes:

The unauthorized sale of the BMO and Fidelity stock may have caused the Heitings to recognize and pay tax on a substantial gain that they would have rather deferred. But § 1341 provides no remedy because they did not have to repurchase the stock. Their recourse, if any, lies against the trustee, not the IRS.[9]

Appeal of the Decision

The Heitings decided to appeal this decision to the Seventh Circuit Court of Appeals, which released its decision on October 18, 2021.[10]  Unfortunately for the taxpayer, the Appeals Court arrived at the same result as the trial court.

The panel noted that, fundamentally, the taxpayers never established that the trust did not have an unrestricted right to the sales proceeds:

We have no allegation here that “it was established” that the trust did not have an unrestricted right to the item of income in this case. The Heitings have alleged only that the trustee's sale of the restricted stock was contrary to the trust agreement. At most, that alleges a potential restriction, which originated at the time of the transaction in 2015. But the Heitings make no allegations that they, as the sole beneficiaries of the trust, demanded the restoration of the stock or otherwise communicated an intent to pursue any of their rights for the breach of the trust agreement. The existence of a potential claim against the income is not enough to “establish” that the trust lacked an unrestricted right to the income.[11]

The panel agreed the cases and law cited by the taxpayers did not help their case.  And, as the court notes, the taxpayers never did seek relief from the trustee:

Moreover, the statutory authority is unhelpful for an even more fundamental reason, which is that the beneficiaries never sought any relief at all from the trustee, nor did they allege an intent or even a threat to do so. As we discussed earlier, although the Heitings were the beneficiaries of the trust with the authority to approve or disapprove of the actions of the trustee, the complaint contains no allegation that they ever challenged the purchase of the restricted stock or made any demand of the trustee with respect to that sale of the restricted stock. At most, then, the reference to the Wisconsin statutory rights alleges that the Heitings could have pursued a legal remedy if they in fact were displeased with the trustee's actions in breach of the trust. That mere possibility is, as we have shown, insufficient to “establish” that the trust lacked an unrestricted right to the proceeds of the sale of the restricted stock. Accordingly, the district court properly determined that the requirements of § 1341(a)(2) were not met and we need not consider the government's alternative argument that the Heitings did not, and could not, plead that their “restoration” of income was a deductible expense to them, as required under § 1341.[12]

[1] Heiting v. United States, US DC WD Wisconsin, Case No. 3:19-cv-00224, January 23, 2020, https://ecf.wiwd.uscourts.gov/doc1/20515387251 (Pacer registration required, retrieved January 25, 2020)

[2] Heiting v. United States, p. 2

[3] Heiting v. United States, p. 3

[4] Heiting v. United States, p. 3

[5] Heiting v. United States, p. 4

[6] Heiting v. United States, p. 5

[7] Heiting v. United States, pp. 5-6

[8] Heiting v. United States, p. 7

[9] Heiting v. United States, p. 7

[10] Kenneth Heiting et al. v. United States, CA7, Case No. 19-cv-224, October 18, 2021, https://www.taxnotes.com/research/federal/court-documents/court-opinions-and-orders/seventh-circuit-affirms-dismissal-of-claim-of-right-refund-suit/7bch1 (retrieved October 19, 2021)

[11] Kenneth Heiting et al. v. United States, CA7, Case No. 19-cv-224, October 18, 2021

[12] Kenneth Heiting et al. v. United States, CA7, Case No. 19-cv-224, October 18, 2021