What happens if a taxpayer takes a tax deduction in a prior year for a theft or casualty loss, but thereafter recovers the property? Similarly, what happens if a taxpayer has an apparent right to taxable income in a prior year that is ultimately refunded in a subsequent year? These simple questions that arise from time to time can lead to surprisingly complex, and sometimes inequitable, results. Income tax timing issues that span more than a single tax year are usually resolved by reference to the “Claim of Right Doctrine” or the “Tax Benefit Doctrine.”
The Claim of Right Doctrine applies when an individual receives taxable income in Year 1, but thereafter is required to repay such amounts in Year 2 (or any subsequent tax year). Pursuant to Section 1341, if a taxpayer has an apparent, unrestricted right to taxable income includable in Year 1, and the taxpayer is later required to repay income in Year 2 (or any subsequent tax year) in an amount greater than $3,000, then the taxpayer can take a deduction in Year 2 equal to the greater of: the marginal amount of tax paid on such income in Year 1; or the marginal value of the deduction in Year 2. Section 1341(b)(1) provides that the Year 2 deduction is refundable if the deduction exceeds income in Year 2.
The converse situation yields different results. The Tax Benefit Doctrine applies when a taxpayer takes a deduction in Year 1 (thereby receiving a tax benefit), but in Year 2 (or any subsequent tax year) learns that the deduction was improper, or recovers the deducted item. If the deduction was improper at the time it was made because the taxpayer should have known of its impropriety, and if the statute of limitations is still open on the return, then the taxpayer has an obligation to amend the incorrect return and pay taxes, penalties, and interest accordingly. If the deduction was proper at the time it was made (such as a theft loss that was later recovered by the police and returned to the taxpayer), then the taxpayer cannot amend the Year 1 return regardless of the statute of limitations, but must include the amount of the prior deduction as income in Year 2, even though the taxpayer’s marginal tax rate may be greater than it was in Year 1. Finally, there is a federal circuit split regarding an improper deduction in Year 1 that is discovered in a year after the statute of limitations on the original return has expired. In most circuits, such amounts never need to be recovered under the Tax Benefit Doctrine. In the Fifth and Ninth Circuits, however, there is case law holding that such amounts need to be included as taxable income in the year discovered regardless of the expiration of the statute of limitations.