More Facts Needed to Determine Claim of Right Entitlement

UILC: 1341.02-00

LEGEND:

[2] Whether settlement payments made by A entitle it to use the special computation of tax set forth in I.R.C. section 1341.

CONCLUSION

[3] We cannot determine, based on the available information, whether A is entitled to the benefits of section 1341. In order to make this determination, further factual development is needed as to any allegation of fraud or wrongdoing in the audit results of A by B, especially for the period from Year 1 to Date 3. Also, further factual development is needed as to whether A knew or could have known, based on the available information, that A was not paying B the entire amount of royalties to which B was entitled. Section 1341 requires an appearance of an unrestricted right to income. This requirement would not be met if there was fraud or other intentional wrongdoing on A's part resulting in an underpayment to B or if A could have known, based on the available facts, that B was being underpaid.

FACTS

[4] A held oil and gas contracts under which it was obligated to pay royalties to B. B was entitled to receive its share of the fair market value of the oil and gas produced from the property. B audited A and disputed the amount of royalties that A had paid since Year 1. In Year 2, A paid $X to B to settle the dispute.

[5] A letter from B to A covering the period from Date 3 through Date 4 states that "A's royalty payment procedures for gas sales . . . have resulted in royalty underpayments." Such underpayments resulted from the failure to properly value gas dispositions for royalty computation purposes. There is no allegation of fraud or intentional wrongdoing.

[6] The subsequent global settlement agreement provided that A would pay B $X to settle all obligations and liabilities between the parties as to A's royalty obligations.

[7] In Year 2, A deducted the $X as a business expense under section 162. However, A now claims that it should be allowed to use the computation of tax described in section 1341(a) for that year. The Service proposes to disallow A's claim because it does not qualify for the treatment set forth in section 1341.

LAW

[8] Section 1341 was enacted to eliminate the inequity occasioned by such claim of right cases as North American Oil Consolidated v. Burnet, 286 U.S. 417 (1932), and United States v. Lewis, 340 U.S. 590 (1951). In North American, the Supreme Court held that if a taxpayer receives earnings under a claim of right without restriction as to its disposition, it has received income which it is required to report, even though it may later be adjudged liable to restore it. 286 U.S. at 424. Section 1341 enables taxpayers to ameliorate the sometimes harsh result of the claim of right doctrine, which requires reporting the income in the year of receipt. If it is later determined that the income must be repaid or restored, section 1341 gives taxpayers the ability in the year of restoration, to put themselves in the same position as if the income had never been reported.

[9] The legislative history of section 1341 indicates that it was enacted to adequately compensate a taxpayer for the tax it paid for a prior year when it subsequently has been obliged to restore amounts included in gross income in the prior year because it appeared that it had an unrestricted right to such amount. H.R. Rep. No. 1377, 83d Cong., 2d Sess., 86-87 (1954); S. Rep. No. 1622, 83d Cong., 2d Sess., 118, 451 (1954). See also 108 Cong. Rec. S22531 (daily ed. October 5, 1962) (statement of Senator Kerr). Thus, the purpose of section 1341 was to place such a taxpayer at least in no worse a tax position than he would have been had he never received the income originally. Rev. Rul. 72-551, 1972-2 C.B. 508, 509.

[10] Section 1341(a) provides that (1) if 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; and (2) a deduction is allowable for the current taxable year because it was established after the close of such prior year (or years) that the taxpayer did not have an unrestricted right to such item; and (3) the amount of such deduction exceeds $3,000, then the tax liability is the lesser of:

     (i) the tax for the taxable year computed with such deduction,

[12] Section 1341(b)(2) provides an exception to section 1341(a). Section 1341(a) does not apply to any deduction allowable with respect to an item which was included in gross income by reason of the sale or other disposition of stock in trade of the taxpayer (or other property of a kind which would properly have been included in the inventory of the taxpayer if on hand at the close of the prior taxable year) or property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business.

ANALYSIS

ITEM INCLUDED IN GROSS INCOME IN A PREVIOUS YEAR

[13] At issue in this case are royalty underpayments. Oil and gas development occurs through arrangements similar to partnerships. In the case of owners of mineral bearing property, the owners in effect contribute mineral development rights in exchange for a royalty to be paid out of production, usually a one-eighth interest. The lessee pays the share of production attributable to royalties and excludes this income both for income tax purposes and in computing the amount of gross income eligible for percentage depletion. Section 611(b)(1); Helvering v. Twin Bell Oil Syndicate, 293 U.S. 312 (1934). The royalty holders are treated as having an "economic interest" in the property entitling them to a share of production, and they compute percentage depletion on this share of income allocated to them.

[14] Therefore, because the royalties payable to B are excluded from A's gross income, the underpaid royalties in this case were an item included in A's income for purposes of section 1341. This is to be contrasted with underpaid expenses, which affect only taxable income and do not cause gross income to be overstated. Section 1341 does not apply to taxpayers who have missed an opportunity to take a business expense deduction; there is no evidence that Congress intended "item included in gross income" to be read so broadly. Cal- Farm Insurance Co. v. United States, 647 F. Supp. 1083, 1091-92 (E.D. Cal. 1986).

[15] Even if there was fraud or wrongdoing with respect to the underpaid royalties, they still would be includible in income. Rev. Rul. 65-254, 1965-1 C.B. 50; Rev. Rul. 61-185, 1961-2, C.B. 9 (The proceeds of an embezzlement constitute gross income to the embezzler in the year of embezzlement).

ITEM INCLUDED UNDER A CLAIM OF RIGHT; TAXPAYER APPEARED TO HAVE AN UNRESTRICTED RIGHT TO THE ITEM

[16] Treas. Reg. section 1.1341-1(a)(2) defines "income included under a claim of right" to mean an item included in gross income because it appeared from all the facts available in the year of inclusion that the taxpayer had an unrestricted right to the income. This section further notes that section 1341 requires that it be established, after the year of inclusion, that the taxpayer did not have an unrestricted right to the item of income in the year of inclusion.

[17] The Service's position is that the appearance of an unrestricted right test incorporates a requirement that the facts which are subsequently determined to have undermined the taxpayer's right to the income in the earlier years must have been in existence in the earlier year (but not known or knowable during the earlier year). That is, for section 1341 to apply to the repayment of an item of income, a taxpayer must be found not to have been completely entitled to the item in the taxable year in which it is included in the taxpayer's gross income. Accordingly, there must be a factual or legal uncertainty concerning the taxpayer's right to the item of income in that year.

[18] Furthermore, if the taxpayer's right to the income is absolute and undermined by facts arising in a year subsequent to the year the income was received, the taxpayer does not satisfy the appearance of an unrestricted right test. Also, of course, section 1341 does not apply if a taxpayer has no right whatsoever to income in the taxable year it is included in the taxpayer's gross income, and the taxpayer voluntarily pays the income back in a subsequent taxable year.

[19] Thus, for example, although the proceeds of embezzlement constitute gross income in the year of embezzlement, they are held without any semblance of entitlement whatsoever and therefore a restoration of embezzled amounts does not come within the general rule of section 1341. Rev. Rul. 68-153, 1968-1 C.B. 371; Rev. Rul. 65-254, 1965-1 C.B. 50.

[20] Section 1341 does not apply to any "ill-gotten" gains. See, e.g., Wood v. Commissioner, 863 F.2d 417 (5th Cir. 1989). For example, in McKinney v. United States, 574 F.2d 1240 (5th Cir. 1978), cert. denied, 439 U.S. 1072 (1979), taxpayer embezzled from his employer, repaid the money and sought to take advantage of section 1341's tax recomputation. In holding against the taxpayer, the court noted that when the item was embezzled funds, it is clear that it could not appear to the taxpayer that he had any right to the funds, much less an unrestricted right to them. 574 F.2d at 1243. See also Rev. Rul. 68-153, supra; Rev. Rul. 65-254, supra.

[21] Similarly, in Parks v. United States, 96-2 U.S.T.C. paragraph 50,645 (W.D. Pa. 1996), the court stated that "[I]f the taxpayer commits fraud to obtain income, this court would not accept that such conduct can create the appearance of an unrestricted right to an item of income." Id. at 86,287.

[22] Based on the facts as we understand them, at least with respect to the period from Date 3 through Date 4, there does not appear to be any willful misconduct or fraud by A. A letter dated * * * from B to A sets forth the results of the royalty computation and payment analysis for this period. The letter disagrees with how A computed its royalty liability but does not allege any intentional wrongdoing. We do note, though, that we do not have information about any results indicating royalty underpayments for the period from Year 1 to Date 3, and this would need to be explored before a determination can be made whether A engaged in any fraudulent conduct.

[23] * * * Rev. Rul. 68-153, 1968-1 C.B. 371. Section 1341 requires income inclusion under a claim of right because it appeared from all the facts available in the year of inclusion that the taxpayer had an unrestricted right to the income. Therefore, knowledge that income rightfully belongs to someone else precludes the use of section 1341. Thus, if A could have known, based on the available facts, that B was being underpaid, section 1341 would not apply because the appearance of an unrestricted right test would not be satisfied. However, it is likely that section 1341 relief would be available if B's right to additional royalty payments arises from facts and circumstances in existence during the period of underpayment, which were not known to A or knowable by A.

WAS THE SETTLEMENT PAYMENT A RESTORATION OF UNDERPAID ROYALTIES

[24] The determining factor when characterizing damages received in the settlement of a claim or cause of action "is the nature of the basic claim from which the compromised amount was realized." Raytheon Production Corp. v. Commissioner, 1 T.C. 952 (1943), aff'd, 144 F.2d 110, 114 (1st Cir.), cert. denied 323 U.S. 779 (1944).

[25] In this case a claim for underpaid royalties resulted in the settlement agreement, and the agreement, para. 2, provides that all claims, refunds, etc. between the parties as to A's royalty obligations are satisfied, released, discharged etc. We believe that under the facts of this case the settlement agreement compromises an underlying claim for underpaid royalties, and accordingly, for purposes of section 1341, the settlement amount paid by A restores royalties previously included in gross income by A.

WAS THE SETTLEMENT PAYMENT DEDUCTIBLE BECAUSE IT WAS ESTABLISHED AFTER THE YEAR OF THE ITEM'S INCLUSION IN INCOME THAT TAXPAYER DID NOT HAVE AN UNRESTRICTED RIGHT TO THE ITEM

[26] Section 1341 requires that there be a legal obligation to restore the funds before a taxpayer is entitled to use the tax recomputation. The Code states that "it was established . . . that the taxpayer did not have an unrestricted right to such item. . . ." Thus, voluntary repayments are outside the scope of section 1341. Cal-Farm Ins. Co. v. United States, 647 F.Supp. 1083, 1092 (U.S.D.C., E.D. Cal. 1986). The Service accepts a settlement, in lieu of a judgment, as sufficiently involuntary and as meeting the "established" requirement of section 1341.

[27] For section 1341 to apply to the repayment of an item of income, there must be a factual or legal uncertainty concerning the taxpayer's right to the item of income in that year. Thus, section 1341 does not apply if a taxpayer has an absolute right to income in the taxable year it is included in the taxpayer's gross income, but the taxpayer voluntarily pays the income back in a subsequent taxable year, nor does section 1341 apply if a taxpayer has a right to income based on facts existing at the close of the taxable year of inclusion, but loses the right to that income in a subsequent year based on a subsequent event. The appearance of an unrestricted right test of section 1341 means that the facts which are subsequently determined to have undermined the taxpayer's right to the income in the earlier years must have been in existence in the earlier year (but not known or knowable during the earlier year). Rev. Rul. 67-48, 1967-1 C.B. 50. You need to determine whether the facts establish that A discovered after the years of income inclusion that it did not have an unrestricted right to income in the amount of the underpaid royalties. Is it correct as we understand the facts that B audited A's royalty computations and payments and disagreed with the factual elements used in the computation?

[28] As to the deductibility of the settlement payment, deductions in similar contexts to those at issue have been allowed as either section 162 business expenses or as section 165 losses. See. e.g., United States v. Skelly Oil Co., supra; McKinney v. United States, 574 F.2d at 1241 (taxpayer embezzled from employer and repaid funds; government does not dispute a business loss deduction). In Barrett v. Commissioner, 96 T.C. 713 (1991), nonacq. AOD CC-1992-008 (Mar. 23, 1992), taxpayer purchased stock based on insider information and then sold it for a profit. Following private civil suits, he paid third parties in settlement. Although the Service did not agree with the court that the taxpayer was eligible to use section 1341, there was no disagreement over treating the settlement payment as a section 162 deduction.

DEDUCTION EXCEEDS $3,000

[29] The deduction at issue exceeds $3,000, and thus meets this qualification.

SECTION 1341(b)(2) INVENTORY EXCEPTION

[30] Killeen v. United States, 63-1 U.S.T.C. paragraph 9351 (U.S.D.C., S.D.Cal., 1963), involved an income splitting arrangement in which one party failed to pay over the correct share of the profits to the other party. Because the correct amount was not paid over, the taxpayer later had to restore to his joint venturer money which was due him from the profits. Once the funds were received by the taxpayer and should have been sent to the other party, the funds were no longer considered included in the income of the taxpayer due to the sale or other disposition of stock in trade or other property includible in inventory. Rather, the income at issue was withheld in contravention of an income splitting agreement. Consequently, in this case the taxpayer was permitted to use section 1341.

[31] The present case involves a royalty agreement between A and B that is similar to the income splitting arrangement in Killeen, supra. Thus, the section 1341(b)(2) exception does not apply because the income at issue was included in A's gross income by reason of A's withholding of royalties owed to B, not by reason of a sale or other disposition by A of inventory or stock in trade.

CASE DEVELOPMENT, HAZARDS AND OTHER CONSIDERATIONS:

[32] * * *

                                   DEBORAH A. BUTLER