houston tax attorney claim of right

If you sell stock for a large gain in one year, can you later go back and get credit for the tax paid in the earlier year using the claim of right doctrine? Is the claim of right doctrine a mechanism for unwinding a stock sale? The court addresses this in Heiting v. United States, No. 3:19-cv-00224 (W.D. Wis. 2020).

Facts & Procedural History

The taxpayers created a revocable trust in 2004. A bank was named as the trustee.

As the trustee, the bank sold shares of publicly traded stock held by the trust. This was apparently prohibited by the terms of the trust.

The sale resulted in a taxable gain of $5,643,067.50 in 2015. In January of 2016, three months later, the trustee realized the sale was not authorized by the terms of the trust, so it repurchased the same publicly traded stocks using the trust monies.

The trust was taxed as a grantor trust, so the tax on this gain was reported and paid on the taxpayers’ individual income tax return for 2015.

On their 2016 tax return, the taxpayers claimed a deduction under I.R.C. § 1341 for the 2015 taxes they had paid on the gain from the stock sale. The IRS audited the their 2016 return and denied the deduction. Tax litigation ensued.

About the Claim of Right

The claim of right is a valid deduction or credit. It essentially allows a taxpayer to offset its current year income tax, for tax overpayments in a prior year.

This deduction or credit is needed given that our income tax system works on a tax year, by tax year basis. This tax year by tax year basis, plus the limit on the time to correct older years, can result in inequities. Thus, the need for the claim of right deduction or credit in the later year.

The claim of right applies if there is:

(1) an item was included in gross income for a prior taxable year (or years) because it appeared that the taxpayer had an unrestricted right to such item;

(2) a deduction is 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; and

(3) the amount of such deduction exceeds $3,000. . . .

Given these rules, does the claim of right apply to a revocable trust that sold and repurchased stocks?

Claim of Right to Correct a Stock Sale

The dispute focused on whether the taxpayers had an unrestricted right to the income in the prior year. Put another way, did the taxpayers have a right to the gain from the sale of the stock in the earlier year?

If the answer is yes, the claim of right would be a great way to correct a stock sale. This would be a great tax planning tool.

The taxpayers argued that they did not have a right to the gain in the earlier year, as the stocks should not have been sold under the terms of the trust. They reasoned that they should not be able to gain from an illegal transaction.

The IRS auditor argued that once the sale was made, the taxpayers had no obligation to repurchase the stock. Thus, they had a legal right to the gain in the earlier year.

The IRS also argued that the trustee did not have to follow the terms of a revocable trust under Wisconsin law. Wisconsin law allows the trustee to take direction from the trustees despite language to the contrary in the trust. Thus, the taxpayers had an unrestricted right to the income in the earlier year.e

The court agreed with the IRS. As a result, the taxpayers were to pay tax on the gain in the earlier year and did not get to deduct the taxes in the later year. Instead, they had tax basis in the new shares, which would offset the gain on the eventual sales of the new shares.

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