I.  Background

This TIR explains a new deduction, available for tax years beginning on or after January 1, 2005, that allows taxpayers who have paid Massachusetts personal income taxes in a prior year on income attributed to them under a “claim of right” to deduct the amount of that income from their gross income if it later develops that they were not in fact entitled to the income, and have repaid the amounts in question. See new G.L. c. 62, § 3(B)(a)(14).  The deduction is allowed in the year of repayment, provided that the repayment is not otherwise deductible in determining Massachusetts income taxable under G.L. c. 62.

II.  Discussion

Under the federal “claim of right” doctrine, a taxpayer receiving income under a claim of right and without restrictions on its use or disposition is taxed on that income in the year of receipt, even though the right to retain the income is not yet fixed or the taxpayer may later be required to return it.[1]  See, e.g., United States v. Skelly Oil Co., 394 U.S. 678, 680‑81 (1969); Healy v. Commissioner of Internal Revenue, 345 U.S. 278, 281‑82 (1952); North American Oil Consolidated v. Commissioner of Internal Revenue, 286 U.S. 417, 424 (1932).  Since Massachusetts gross income for a taxable year is federal gross income for the same period with modifications not relevant here, G.L. c. 62, § 2, it follows that any amount included in a taxpayer’s federal gross income for the taxable year under a claim of right must also be included in the taxpayer's Massachusetts gross income for the same taxable year.

If a taxpayer later repays an amount received under a claim of right (because the taxpayer did not in fact have a right to it) the taxpayer may, for federal tax purposes, be entitled to a deduction under the Code in the year of repayment for the amount repaid that was included in the earlier year's gross income.  The deduction is allowed, however, only if the taxpayer is otherwise entitled to a deduction under some other provision of the Code, e.g., IRC §§ 162, 212, etc.  See, e.g., Cal-Farm Ins. Co. v. United States, 647 F. Supp. 1083, 1092 (E. D. Cal. 1985).  If the amount of the deduction exceeds $3,000, the taxpayer is allowed to compute his tax liability for the year of repayment pursuant to IRC § 1341 to relieve the taxpayer from possible hardship due to the federal progressive rate structure.[2]

Regardless of whether the taxpayer simply takes an available deduction under the Code, or computes taxes under § IRC1341, there is no re-computation of federal gross income for the taxable year the item was received and included in federal gross income. "[T]he earlier returns are not being reopened."  United States v. Skelly Oil Co., at 685.  See  Healy v. Commissioner of Internal Revenue, at 284‑85; North American Oil Consolidated, at 424.  As a result, a taxpayer is not entitled to adjust his or her Massachusetts gross income for an earlier year based on a subsequent repayment of amounts held under a claim of right by filing an amended return for that year.  Moreover, since the number of available Massachusetts income tax deductions is limited, and there was previously no specific deduction for amounts included under a claim of right, a taxpayer often could not reduce gross income in the year of repayment by the amount repaid.

This situation has been changed by Acts 2005, chapter 163, § 5, amending G.L. c. 62, § 3(B)(a), which now allows a deduction for:

(14) The amount as is described in section 1341(a)(2) of the Code, to the extent, if any, that that amount (i) was previously included in Massachusetts taxable income and (ii) is not otherwise deductible under section 2(d)(1) of this chapter.

IRC § 1341(a)(2) in turn references deductions 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.”   Such “items” refer to amounts that, as described in IRC § 1341(a)(1), were “included in gross income for a prior taxable year (or years) because it appeared that the taxpayer had an unrestricted right to such item,” i.e., income previously attributed to the taxpayer under a claim of right.  As a result, a taxpayer who has paid tax on income attributed to the taxpayer in a prior tax year because of such a claim may now deduct the amount of that income from his Massachusetts gross income in the year of repayment.  Because Massachusetts already allows for certain deductions under IRC §§ 62 (relating to trade or business expenses) and 404 (without regard to § 265), see G.L. c, 62, § 2(d)(1), the new claim of right deduction may be taken only if amounts repaid were not otherwise deductible under that subsection.

III.  Examples

(1) Taxpayer A receives income of $5,000 from employment in 2003 to which he appears to have an unrestricted right; the amount is included in federal and Massachusetts gross income upon which A pays taxes for the 2003 tax year.  In 2005, A finds that payment of the $5,000 was based on an erroneous hourly wage figure, was therefore paid in error and must be repaid.  A does so in tax year 2005. A is entitled to deduct $5,000 from his Massachusetts gross income pursuant to the claim of right deduction on his 2005 state income tax return, as the repayment would not otherwise be deductible under G.L. c. 62, § 2(d)(1).

(2) B, the owner of an art gallery, sells a statue to a client in 2000 for $15,000; the amount is included in federal and Massachusetts gross income upon which B pays taxes for the 2000 tax year.  The statue is later shown to be a fake, and is returned by the client for a refund, paid in 2005.  B is allowed to deduct $15,000 from his Massachusetts gross income in 2005 under G.L. c. 62, § 2(d)(1), as the refund is related to his trade or business.  No further claim of right deduction is allowed.

 

/s/Alan LeBovidge
Alan LeBovidge
Commissioner of Revenue

 

AL:MTF:lr

April 12, 2006

TIR 06-4



[1]  Some examples of areas in which the claim of right doctrine may be applied are:

  • Stock under claim of ownership:  gains from sales of stock under a claim of ownership must be included, regardless of whether the taxpayer actually owned it.  Pollock v. CIR, 45 TMC 12 (1985);
  • Employment Contracts.  Amounts in settlement of employment contracts must be included notwithstanding the prospect of eventual repayment to the employer of an amount equivalent to or greater than the amount received.   Satz v. CIR, 25 TCM 1578 (1975);
  • Dividends.  Where a taxpayer receives a dividend that must be repaid in a later year (e.g., because it impaired corporate capital), the dividend must be included in the year of receipt.  Duffy v. CIR, 2 TC 569 (1943).
  • Corporate Notes.  Where a taxpayer receives a distribution with respect to holding of notes, the income must be included regardless of whether it could be challenged by senior creditors.  Nordberg v. CIR, 79 TC 655 (1982)
  • Mistake in Validity of Claim.  The claim of right doctrine applies where a taxpayer merely mistakes the validity of his claim.  United States v. Lewis, 430 U.S. 590 (1951).
  • Advanced Insurance Commissions. Security Associates Agency v. CIR, TC Memo 1987-317.

This list is illustrative only. 

[2] An equivalent provision is unnecessary in Massachusetts, as a progressive income tax structure is forbidden by Article 44 of the Massachusetts Constitution.  See Mass. Const. Amend. Art. 44.