Learn about the Claim of Right deduction

Learn about the Claim of Right deduction

Overview

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:
    • Weren’t 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 isn’t otherwise deductible in determining Massachusetts income.

Since Massachusetts already allows for certain deductions under

  • I.R.C. §§ 62 (relating to trade or business expenses) and
  • 404 (without regard to § 265),

the Claim of Right deduction might be taken only if amounts repaid weren’t otherwise deductible.

Federal Rules

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 isn’t yet fixed or
  • They may later be required to return it.

If taxpayers later repay amounts received under a Claim of Right because:

  • They didn’t, 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:
    • For example, I.R.C. §§ 162, 212, etc.

If the amount of the deduction exceeds $3,000:

  • Taxpayers may compute their tax liabilities for the year of repayments under I.R.C. § 1341 to relieve them from possible hardship due to the federal progressive rate structure.

There is No Recomputation of Federal Gross Income

Regardless of whether taxpayers simply take an available deduction

  • Under the Code, or
  • Compute taxes under I.R.C. § 1341,

there is no recomputation of federal gross income for the taxable year the item was received and included in federal gross income.

As a result, taxpayers aren’t 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.

Massachusetts Rules

Since Massachusetts gross income for a tax 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 didn’t, 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.

Massachusetts already allows for certain deductions under:

  • I.R.C. §§ 62 (relating to trade or business expenses) and
  • 404 (without regard to § 265), see G.L. c, 62, s. 2(d)(1).

The new claim of right deduction might be taken only if amounts repaid weren’t otherwise deductible under that subsection.

Prior Year Returns

Prior year returns aren’t being reopened. As a result, a 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 couldn’t reduce gross income in the year of repayment by the amount repaid.

Application of Claim of Right Doctrine Examples

  • Stock under a 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:
    • The taxpayer receives a distribution concerning 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.

Reporting Claim of Right on Your Tax Return

The amount allowed is entered on: 

  • Mass Form 1
  • 1-NR/PY, Schedule Y, Line 14.

Additional Information

Massachusetts References

Federal References

  • I.R.C. §§ 162, 212, 1341(a)(2)

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