If a couple files a joint return and pays tax on the income they earn, but after they divorce it turns out that one of the spouses has to repay monies received in error, can the other spouse recoup their portion of the prior tax paid on the income? The claim of right doctrine may help in this type of case. The Mihelick v. United States, No. 17-14975 (11th Cir. 2019) case addresses this fact pattern.

Facts & Procedural History

This case involved a husband and wife. They both worked for a family-controlled business. They ended up getting divorced.

Before the divorce was finalized, the husband was sued by a minority shareholder who claimed that the husband paid himself too much for his work for the business. The wife was not part of the lawsuit.

The husband settled the lawsuit by agreeing to repay $600,000 of the compensation he had earned. The husband took at $300,000 claim of right deduction. The IRS allowed the deduction.

The wife paid the husband $300,000 and she took a $300,000 claim of right deduction. The IRS disallowed the deduction for the wife. Litigation ensued. The trial court held for the government, which resulted in the present court opinion on appeal.

The Claim of Right

The claim of right allows taxpayers to make a correction in the current tax year for tax paid in error in a prior closed tax year.

In most cases, the claim of right includes an item of income the taxpayer received and paid tax on in a prior year. The claim of right allows the taxpayer to take a tax deduction or credit in the later open year to account for the taxes paid in the earlier closed year if he has to refund the income in the later year.

To qualify for a claim of right deduction or credit, the:

  • the income must have been included in a prior year’s gross income because it appeared that the taxpayer had an unrestricted right to such item.
  • the taxpayer must have later learned that she actually did not have an unrestricted right to that income.
  • the amount the taxpayer did not have an unrestricted right to must have exceeded $3,000.
  • the amount the taxpayer did not have an unrestricted right to had to be deductible under another provision of the tax code.

Each of these elements must be met to qualify for the claim of right.

Legal Obligation to Repay the Debt

The IRS often challenges claim of right deductions and credits. There have been several court cases resulting from these challenges.

Many of the reported cases involve taxpayers who repaid amounts in a later year, even though they were not legally obligated to return the monies. Kappel v. United States, 437 F.2d 1222 provides an example.

Kappel received distributions from employees’ pension trusts, paid an income tax on the distributions in violation of the terms of the trust, put the funds back in the trusts in a later year, and then deducted the amount of the tax paid. The court concluded that the taxpayer had no legal obligation to restore the funds and, as such, was not entitled to a claim of right.

The IRS made similar arguments in the present case. Specifically, the IRS argued that the wife did not have an obligation to repay the $300,000. That may have been true. The taxpayer-wife was not even a party to the lawsuit.

The appeals court made the following observation:

Mihelick [the wife] also paid an attorney to advise her of her rights, and that attorney told her that she had an “obligation” to pay Bluso [the husband]. Under these circumstances—and particularly in light of the desirability of fostering settlements without litigation— Mihelick did not need to wait to be sued before settling and paying for her payment to be considered involuntary. Because the record reflects Mihelick reasonably anticipated litigation and settled in good faith in the shadow of litigation, her $300,000 payment was involuntary for purposes of § 1341.

The court concluded that the wife was entitled to the claim of right deduction.

The Takeaway

This case helps taxpayers who find themselves making payments in advance of litigation. The case is particularly helpful if there was some facts establishing a belief that the spouse was liable for the repayment.

Taxpayers should be able to point to facts showing that they believed they were obligated to repay the funds. In this case, the taxpayer-wife was able to point to her attempts to not pay the $300,000 prior to the time she settled with her ex-husband. These facts help establish that the repayment was not voluntary, which establishes entitlement to the claim of right.

It should also be noted that the taxpayer-wife may have been able to pursue innocent spouse relief for the earlier year given these facts. With innocent spouse relief, she may have been relieved of liability for the earlier year and entitled to a tax refund for the taxes paid. This may afford another remedy if the claim of right is not available.

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