Heiting and the Claim of Right Doctrine

In the Heiting v. United States[1] decision issued on October 18, 2021, the United States Court of Appeals for the Seventh Circuit affirmed a district court decision[2] to dismiss a couple’s claim for a refund of taxes, rejecting the taxpayers’ argument that the repurchase of restricted stock previously sold by their trustee was effectively a repayment of the proceeds that led to the taxable gain.

Facts

In January of 2004, Kenneth and Ardyce Heiting established a joint revocable trust (“Trust”) that was administered at all relevant times by the same corporate trustee (“Trustee”). Because the Heitings retained the power to revoke the trust during their lifetimes, the Trust was a grantor trust for federal income tax purposes. Due to the Trust’s status as a grantor trust, for federal income tax purposes:[3]

  1. the Trust was disregarded as a separate entity;
  2. the Heitings were treated as the owner of the assets of the Trust; and
  3. the income and deductions of the Trust were reported by the Heitings on their individual returns.

Under the terms of the Trust, the Trustee had broad authority as to the trust assets in general, except with respect to the stock of two publicly traded companies (“Restricted Stock”) that it had “no discretionary power, control or authority to take any action(s) with regard to any shares … including, but not limited to, actions to purchase, sell, exchange, retain or option [such Restricted] Stock” without the express permission of the Heitings.

In 2015, the Trustee sold the Restricted Stock without the required permission, apparently either without realizing that the Heitings’ permission was required or that such shares were the specific shares to which the restriction applied. The sale generated a $5.6 million gain that the Heitings included on their 2015 tax return, and the proceeds remained in the Trust. In 2016, the Trustee realized its error and repurchased the same amount of Restricted Stock with the Trust’s assets. The Heitings revoked the Trust in February of 2016. On their 2016 tax return, the Heitings sought to invoke the claim of right doctrine and claim a deduction under IRC Section 1341 for the 2015 taxes they had paid on the gain from the sale of the Restricted Stock. The IRS audited the Heitings’ 2016 tax return and denied the deduction on the basis that the deduction under Section 1341 was inapplicable to “the sale or other disposition of the Stock in trade of the taxpayer” under Section 1341(b)(2). To understand the arguments by the parties, one must understand the claim of right doctrine and Section 1341.

Claim of Right Doctrine and Section 1341

The claim of right doctrine, first enunciated by the United States Supreme Court in North American Oil Consolidated v. Burnet,[4] provides that taxpayers are required to include earnings in their taxable income when they receive or become entitled to receive such amounts, without restrictions as to such the disposition of such amounts. Generally, the lack of restriction on disposition portion means that the taxpayer can do what they want with the funds (i.e., spend), as compared to amounts subject to restrictions (such as in a fiduciary capacity for the benefit of another). This is true even if the taxpayer “is not entitled to retain the money, and even though he may still be adjudged liable to restore its equivalent.”[5]

Codified in 1954, Section 1341 provides relief to taxpayers when an item of income is reported in one tax year because it appeared that the taxpayer had an unrestricted right to such item but then must be repaid in a later tax year, if it is determined that the taxpayer did not have an unrestricted right to the item of income when reported in the earlier tax year.[6] Often these situations arise because the amount was paid by mistake, erroneously computed, or because a controversy regarding the payment is decided against the taxpayer.

Consider the following example:

As an inducement to signing an employment agreement, an employer paid an employee a $50,000 signing bonus in year 1, conditioned upon the employee’s continued employment until the end of year 4. Under the claim of right doctrine, because the employee actually received the funds and there were no restrictions on the employee’s use of such amounts, the full amount of the bonus was included by the employer on the employee’s W-2 and appropriately included in the employee’s taxable income on his or her income tax return in year 1. In year 3, the employee receives an employment offer from a different company that is too good to refuse and decides to leave the original employer. Pursuant to the provisions of the employment agreement, the employee must repay $20,000 of the signing bonus upon leaving the company. The employee repays the $20,000 in year 3, but how does he or she report the repayment on his or her year 3 tax return?

Under Section 1341, taxpayers are essentially allowed the greater of a deduction for the amounts repaid in the current year or a credit for the amount of tax paid in the previous year related to the repaid amount.[7] Often times these amounts are equal, with the most obvious difference occurring because of a change in income tax rates for the taxpayer between the applicable years.

In the example above, the $20,000 the employee repays in year 3 would generally entitle the employee to Section 1341 relief, such that the employee’s taxable income would essentially be reduced by either a deduction of $20,000 or a credit equal to the $20,000 multiplied by his or her year 1 income tax rate.[8]

District Court

The IRS did not make a Section 1341(b)(2) argument before the district court (or later on appeal), generally though, Section 1341(b)(2) prohibits taxpayers from claiming relief under Section 1341 for amounts attributable to inventory or similar property. Instead, the IRS argued that the Heitings were not entitled to Section 1341 relief because they were not actually required to relinquish the proceeds related to the sale of the Restricted Stock.[9] In order to qualify for relief under Section 1341, the taxpayer must have a legal obligation to return the disputed income.[10] According to the IRS, once the Restricted Stock was sold, the Heitings hand an unrestricted right to do what they wanted with the proceeds due to their broad powers over the assets of the Trust.

The Heitings argued that the Trustee had exceeded its authority under the Trust by selling the Restricted Stock, such that it had a legal obligation to use the proceeds to repurchase the Restricted Stock. According to the Heitings, this supposed obligation of the Trustee was imputed to them because they were treated as the owners of the Trust’s assets, due to the Trust’s status as a grantor trust. Furthermore, according to the Heitings, they could not ignore a breach of the trust agreement and profit from it.

The district court found that the Heitings’ argument was “fundamentally unsound as a matter of trust law.” Ouch. Citing the Wisconsin Trust Code, the district court stated that a trustee may follow a direction of the settlor that is contrary to the terms of the trust, while such trust remains revocable. In fact, the provisions of the Trust itself required the Trustee to follow the Heitings’ directions regarding the Restricted Stock, including buying such stock back. Therefore, while the Heitings did not instruct the Trustee to sell the Restricted Stock, they could have instructed the trustee to do whatever they wished with the proceeds from the sale. This was in addition to the fact that the Heitings could have amended or revoked the Trust at any time, which they did in 2016. Apparently, the district court did not think this sounded much like a legal obligation to repurchase the Restricted Stock.

As to the Heitings’ argument that they, as beneficiaries, could not ignore the breach and profit from it simply because the Trustee failed to remedy the breach, they failed to cite any authority related to such argument. Additionally, the district court cited to long standing Wisconsin law that allows a beneficiary to consent to a trustee’s actions and thereby ratify conduct which would otherwise breach the trustee’s duty to the trust. Thereby showing that the Heitings could have easily ignored and profited from the breach.

In making their argument that the Trustee’s supposed obligation to repurchase the Restricted Stock should be imputed to them, the Heitings relied heavily on First National Bank of Chicago.[11] First National Bank of Chicago also involved a trustee’s unauthorized sale of stock that the trustee subsequently repurchased with trust assets, but the district court found that it was not on point. First, the sole issue in First National Bank of Chicago was related to timing, whether the trust was entitled to a deduction in the years the stock was sold, or whether the trust had to claim a Section 1341 credit in a subsequent year when the stock was repurchased. Timing was not at issue for the Heitings. Second, the facts in First National Bank of Chicago differed in two key respects, the trust was not a grantor trust (such that the taxpayer obligated to return the restricted income and eligible for Section 1341 relief were one and the same) and the stock repurchase was court-ordered after one of the beneficiaries sued over the unauthorized stock sale.

The district court concluded by stating that the neither the Trustee nor the Heitings had a comparable legal obligation, and therefore they were not eligible for Section 1341 relief.

Seventh Circuit

The Seventh Circuit was similarly not impressed by the Heitings’ arguments on appeal. The Heitings tried to get the Court to focus on the Trust, and its obligations and right to the income as opposed to them individually. The Court, citing to much the same authority as the district court, found that “As the sole beneficiaries, the Heitings had an unrestricted right to the funds, because they had the absolute authority to choose to accept the funds and authorize the trust’s actions,” and that it did not need to address the issue of the Trust’s rights to the funds.

The IRS noted that due to changes in the price of the Restricted Stock (according to the New York Stock Exchange) between the date of sale in 2015 and the repurchase in 2016, the repurchase didn’t “cleanly” reverse the original sale, such that the parties to the transaction were placed in the same position as before the transaction. While the Court seemed to find this inequality between the two transactions persuasive, it stated that the real issue was the lack of any legal obligation to repurchase the Restricted Stock.

Under Section 1341(a)(2), the Heitings had to establish that the repayment in the later year occurred because the Trust did not have an unrestricted right to such income in the prior year. Citing to Batchelor-Robjohns v. United States,[12] the Court stated that to establish such required “a legal obligation to restore the item of income; a voluntary choice to repay is not enough.” That involuntary legal obligation could be shown by a court judgment requiring the repayment or a good-faith settlement of a claim.[13] The Court found that the allegation by the Heitings that the sale violated the trust agreement was, at best, a “potential allegation.”

Further, it found that the First National Bank of Chicago case weighed against the Heitings’ position stating that it “made clear … that an initial objection by a beneficiary to the sale, or the limitations of the trust agreement itself, were not in themselves sufficient to demonstrate that the taxpayer did not have an unrestricted right to the item of income.” Unlike in First National Bank of Chicago, where a beneficiary sued the trustee such that a court ordered the trust to repurchase the stock, the Heitings took no legal action against the Trustee. Accordingly, the Court found that the Heitings’ “potential allegation” was insufficient to indicate that the Trust did not have an unrestricted right to the income and therefore the trust did not have a legal obligation to repurchase the Restricted Stock.

Finally, the Court reviewed the Wisconsin statutes cited by the Heitings related to lawsuits against trustees. It found nothing sufficient to establish a legal obligation to repurchase the Restricted Stock, especially given that they never sought any relief from the Trustee, nor did they allege an intent or even a threat to do so. Accordingly, the Court affirmed the district court’s decision to deny the Heitings relief under Section 1341.

Conclusion

The Heitings lost on the facts. The fact is, the Trust never had a legal obligation to repurchase the Restricted Stock. Accordingly, they did not meet the statutory requirements of Section 1341. What could the Heitings have done differently? As noted by both courts, they could have, and possibly still could, sue the Trustee. Depending on the specific facts (such as the communications between the Heitings and the Trustee) there are several potential issues, including the statute of limitations, a deemed ratification of the Trustee’s conduct, or a deemed instruction to repurchase the stock. Of course, there could be other reasons they might not want to sue the Trustee, such as longstanding business or personal relationships. As the district court said, their potential recourse is against the Trustee, not the IRS. Given that the deduction in question here was $5.6 million, the Heitings should probably consider themselves lucky that the IRS did not assess penalties or interest.

[1] Heiting v. United States, 16 F.4th 242 (7th Cir. 2021).

[2] Heiting v. United States, US DC WD Wisconsin, Case No. 3:19-cv-00224.

[3] IRC §§ 676(a); Treas. Regs. §§ 1.671-2, 1.671-3, 1.678(a)-1.

[4] North Am. Oil Consol. v. Burnet, 286 US 417 (1932).

[5] Id.

[6] IRC § 1341(a)(1) & (2). Importantly Section 1341(a)(3) requires that the amount of the deduction (essentially the amount repaid in a later tax year) must exceed $3,000.

[7] IRC § 1341(a)(4) & (5). This is a simplification, as Section 1341 actually calculates the total tax for the applicable tax year instead of a reduction in taxes as I describe above.

[8] Once again, this is an oversimplification.

[9] The IRS also had a secondary argument, which the district court stated was “underdeveloped” relating to Section 1341 not granting a substantive right to a deduction. However, the district court did not have to consider the secondary argument because it found the primary argument persuasive.

[10] See Kappel v. United States, 437 F.2d 1222, 1226 (3d Cir. 1971) (Section 1341 “require[s] that a legal obligation exist to restore funds before a deduction is allowable”).

[11] First National Bank of Chicago v. United States, 551 F. Supp. 157 (N.D. Ill. 1982).

[12] Batchelor-Robjohns v. United States, 788 F.3d 1280, 1293–94 (11th Cir. 2015).

[13] Mihelick v. United States, 927 F.3d 1138, 1146 (11th Cir. 2019).