- General Rules
- Federal Rules
- Massachusetts Rules
- Where to Report on Original Tax Return; What to Enclose
- Massachusetts and Federal References
For tax years beginning on or after January 1, 2005, taxpayers who have paid Massachusetts personal income taxes in a prior year on income attributed to them under a "claim of right" may deduct such amounts of that income from their gross income if it is later determined that they:
- were not in fact entitled to the income, and
- have repaid the amounts in question.
The deduction is allowed in the year of repayment, provided:
- the amount was previously included in Massachusetts taxable income; and
- the repayment is not otherwise deductible in determining Massachusetts income. Because Massachusetts already allows for certain deductions under IRC §§ 62 (relating to trade or business expenses) and 404 (without regard to § 265), the claim of right deduction may be taken only if amounts repaid were not otherwise deductible.
Under the federal "Claim of Right" Doctrine, taxpayers receiving income under a claim of right and without restrictions on its use or disposition are taxed on that income in the year of receipt even though the right to retain the income is not yet fixed or they may later be required to return it.
If taxpayers later repay amounts received under a Claim of Right because they did not in fact have a right to it, they may be entitled to a deduction federally in the year of repayment for the amount repaid that was included in the earlier year's gross income. The deduction is allowed only if taxpayers are otherwise entitled to a deduction under some other provision of the Code, e.g. IRC §§ 162, 212, etc.
If the amount of the deduction exceeds $3,000, taxpayers may compute their tax liabilities for the year of repayments pursuant to IRC § 1341 to relieve them from possible hardship due to the federal progressive rate structure.
There is No Re-computation of Federal Gross Income:
Regardless of whether taxpayers simply take an available deduction under the Code, or compute taxes under IRC § 1341, there is no re-computation of federal gross income for the taxable year the item was received and included in federal gross income. As a result, taxpayers are not entitled to adjust their Federal 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.
Since Massachusetts gross income for a taxable year is federal gross income for the same period with modifications not relevant here, any amount included in taxpayers' federal gross income for the taxable year under a claim of right must also be included in their Massachusetts gross income for the same taxable year.
If taxpayers later repay amounts received under a Claim of Right because they did not in fact have a right to it, they may 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.
Prior Year Returns:
Prior year returns are not being reopened. As a result, taxpayer may not adjust their 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, taxpayers often could not reduce gross income in the year of repayment by the amount repaid.
Application of Claim Of Right Doctrine Examples
- Stock under claim of ownership: gains from sales of stock under a claim of ownership are included in gross income regardless of whether the taxpayer actually owns it. Pollock v. CIR, 45 TMC 12 (1985);
- Employment Contracts: amounts in settlement of employment contracts are included in gross income 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: taxpayer receives a distribution with respect to the 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;
- Repayment of unemployment compensation and supplemental unemployment benefits in a subsequent year.
Examples of Claim of Right:
Example #1: In 2006, taxpayer receives $5,000 in wages to which he appears to have an unrestricted right. Taxpayer includes the $5,000 in both federal and Massachusetts gross income and pays taxes on such income for the 2006 tax year. In 2008, taxpayer is notified that the $5,000 was based on an erroneous hourly wage figure, was paid in error and must be repaid in full. Since taxpayer pays back the $5,000 in tax year 2008, he is entitled to deduct such amount from his Massachusetts gross income pursuant to the claim of right deduction, as the repayment would not otherwise be deductible under G.L. c. 62, § 2(d)(1).
Example #2: In 2005, an art gallery owner receives $15,000 from the sale of a statue. Taxpayer includes $15,000 in both federal and Massachusetts gross income and pays taxes on such income for the 2005 tax year. In 2008, the statue is shown to be a fake, and is returned by the client for a full refund of $15,000. Since taxpayer pays back the $15,000 in tax year 2008, he is entitled to deduct such amount from his Massachusetts gross income 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.
Note: In either case above, even if the taxpayer had no liability in the year the income was originally claimed (No tax status), the taxpayer could still claim the deduction.
Where to Report on Original Tax Return; What to Enclose:
The amount allowed is entered on either Mass Form 1 or 1-NR/PY, Schedule Y, Line 14.
- M.G.L. c. 62, ss. 2(d)(1); 3(B)(a)(14) as amended by Acts 2005, c. 163, s. 5
- TIR 06-4: Deduction for Income upon which Taxes Have Been Paid under a Claim of Right
- IRC §§ 162, 212, 1341(a)(2)