In Shakespeare, an English King blames the loss of an important battle on his lack of a horse: “A horse, a horse, my kingdom for a horse!”[1]
In real life (and especially, it seems, in tax law) it is more like to be the lack of a timely piece of paper that causes the taxpayer to lose.
In the course of administering a trust, it sometimes happens that mistakes are made that require correction. For example, distributions may be made that are not in accordance with the provisions of a trust: payments to the wrong beneficiaries, or in the wrong amounts or for the wrong purposes. A similar situation may arise when a trust instrument requires the trustee not to make any disposition of certain “legacy” assets, and the trustee erroneously sells them anyhow.
In such situations, the way to “undo” the transactions is for the parties to reverse the erroneous transaction by returning the distributions made in error. When the year of distribution is a closed tax year and the act of correction is made in a later year, it is important to make sure that the distribution that is returned is treated as a tax-deductible expense, thus offsetting the taxable receipt of the erroneous distribution in the prior tax year.
Fortunately, the tax law contains a provisions that seems custom-designed for such situations. Under the claim of right doctrine (as now codified in under Int. Rev. Code § 1341) a taxpayer that is under a legal duty to make a repayment is entitled to a deduction in the year of that repayment. See, e.g., U.S. v. Skelly Oil Co., 394 U.S. 678 (1969).
But a recent decision of the 7th Circuit Court of Appeals reminds us that there are technicalities that must be complied with if these provisions are to apply.
Heiting v. United States, 16 F.4th 242 (7th Cir., October 21, 2021) involved the erroneous sale of assets comprising part of the corpus of a grantor trust. Under the terms of the trust, the trustee had broad authority over the trust assets in general, but that power was limited with respect to two particular publicly-traded stocks over which the trustee had no power to take any actions “including, but not limited to, actions to purchase, sell, exchange, retain or option the Stock.” For reasons not made clear in the opinion, the trust erroneously sold the restricted assets in 2015, incurring over $5.6 million in taxable gain which passed through to the grantors as 2016 taxable income even though the sales proceeds were not distributed.
Early in 2016, the trustee realized its mistake and “reversed” the transaction by using the undistributed sales proceeds to repurchase the securities in question. The trust then sought to invoke §1341 to claim a deduction that would pass through to the grantors’ 2016 return. The IRS denied the deduction, arguing that the requirements in Code Sec. 1341 had not been met.
The dispute wound up before the 7th Circuit Court of Appeals, which sided with the IRS. The problem, the court said, was that the claim of right doctrine as codified in Sec. 1341 is applicable only where there is a legal obligation to return the erroneous distribution.
One clear example of a “legal obligation” would be a court judgment requiring the funds in question to be returned. Lacking that (the Seventh Circuit said), even a good faith settlement agreement acknowledging the legal obligation to restore the mistaken transaction would suffice.
But in Heiting, there was neither a judgment nor a settlement agreement. Indeed, there was no evidence that the grantors had never made any sort of demand for the trustee to restore the stock. That left the “legal obligation” as, at most, a potential claim — which, according to Heiting, is not the same as a legal obligation; and so the court held for the IRS.
Would a timely demand letter from a lawyer in the year of correction been enough to swing the decision in favor of the taxpayers? Perhaps … but there was no such letter. It seems likely that for the lack of a demand letter, this case was lost.
A letter, a letter, my kingdom for a demand letter!
It is not unusual for big cases to turn on such small matters. Please do not enter into any transaction with significant tax consequences without the help of a qualified tax professional. Our Tax Group at Gray Reed stands ready to help.
[1] Richard III, Act V.