Claim of Right Doctrine Doesn't Apply to Trustee's Voluntary Repurchase of Stock

(Parker Tax Publishing November 2021)

The Seventh Circuit held that the sole beneficiaries of a grantor trust were not entitled to a refund of taxes they paid on a sale of stock held by the trust under the claim of right doctrine as codified in Code Sec. 1341 after the trustee determined in the following year that the sale was prohibited by the trust agreement and used the sale proceeds to buy back the same stock. The court found that the taxpayers failed to establish that the trust did not have an unrestricted right to the income from the stock sale since the beneficiaries did not demand the restoration of the stock or otherwise communicate an intent to pursue any of their rights for the breach of the trust agreement. Heiting v. U.S., 2021 PTC 333 (7th Cir. 2021).

Background

In January 2004, Kenneth and Ardyce Heiting created a revocable trust which was administered by the trustee BMO Harris Bank. Because the Heitings could revoke the trust agreement at any time during their lifetime, the trust was considered a grantor trust for federal tax purposes. As a grantor trust, the trust itself filed no tax returns, and the Heitings reported the trust's gains and losses on their own returns.

Under the terms of the trust, the trustee had broad authority as to the trust assets in general, but that power was explicitly limited with respect to two particular categories. With respect to Bank of Montreal Quebec common stock and Fidelity National Information Services, Inc. common stock (collectively, the "restricted stock"), the trustee had "no discretionary power, control or authority to take any action(s) with regard to any shares ... including, but not limited to, actions to purchase, sell, exchange, retain or option the Stock." In contrast to the nearly limitless power as to other stocks, with respect to the restricted stock the trustee thus lacked the authority to take any actions, including any sale or purchase of that stock, absent the Heitings' express authorization.

Despite that restriction, the trustee in October 2015 sold the restricted stock held in the trust and incurred a taxable gain on the sale which totaled $5,643,067. The Heitings accordingly included that gain in their gross income on their 2015 personal tax return and paid taxes on it. The trustee subsequently realized that the sale of the restricted stock was prohibited by the trust agreement, and, in January 2016, the trustee purchased the same number of shares of that restricted stock with the sale proceeds from the earlier transaction.

Following the purchase of the restricted stock in 2016, the Heitings sought to invoke the claim of right doctrine as codified in Code Sec. 1341 to claim a deduction on their 2016 return for the amount included in income in 2015. Under the claim of right doctrine, a taxpayer must report income in the year in which it was received, even if the taxpayer could be required to return the income at a later time. However, the taxpayer would then be entitled to a deduction in the year of that repayment. To alleviate inequities in the application of the claim of right doctrine, Congress subsequently enacted Code Sec. 1341, which added, as an alternative to the deduction in the repayment year, the option of the taxpayers recomputing their taxes for the year of receipt of the income. In order to qualify for relief under Code Sec. 1341, taxpayers must show that (1) an item was included in gross income for a prior tax year because it appeared that the taxpayer had an unrestricted right to such item; (2) a deduction is allowable for the tax year because "it was established" after the close of the prior tax year that the taxpayer did not have an unrestricted right to the item; and (3) the amount of such deduction exceeds $3,000.

The IRS rejected the Heitings' claim for a refund after determining that under Code Sec. 1341(b)(2), such relief was inapplicable to the sale or other disposition of the stock in trade of the taxpayer. The Heitings then filed a complaint in a district court and the IRS filed a motion to dismiss, but it abandoned its reliance on the stock-in-trade provision to support the denial. The district court dismissed the Heitings' complaint after finding that they were entitled to relief under Code Sec. 1341 only if they were legally obligated to return the proceeds of the restricted stock sale, and their complaint alleged no such obligation.

The Heitings appealed to the Seventh Circuit. They contended that the issue was the tax obligations of the trust, not of themselves as individuals, so the proper focus was on whether the trust had an unrestricted right to the income in the initial and subsequent tax years. The trustee's sale and subsequent repurchase of the restricted stock, the Heitings argued, fell within the language of Code Sec. 1341(a) as a taxable transaction that was "reversed" in the year after the sale by a trustee that was legally obligated to do so. As authority for their assertion of the trustee's legal obligation, the Heitings pointed to a Wisconsin law which authorizes lawsuits against trustees and sets forth the remedies for a breach of trust.

Analysis

The Seventh Circuit agreed with the district court that the Heitings could not show they were legally obligated to restore the income from the 2015 stock sale. The court therefore affirmed the district court's dismissal of their complaint.

First, the Seventh Circuit rejected Heitings' characterization of the 2016 stock purchase as a "reversal" of the 2015 sale. The court reasoned that, given that the price of stock fluctuates over time, a sale of stock in one time period cannot be simply reversed by purchasing the stock back at a different time. But the court said that regardless of the characterization of the transactions, the insurmountable problem for the Heitings wasn't that the transactions were unequal in nature but that they could not show that the trust had a legal obligation to restore the items of income - the restricted stock - as is required under Code Sec. 1341(a)(2). The court found that in Batchelor-Robjohns v. U.S., 2015 PTC 179 (11th Cir. 2015) and other decisions, the language requiring that "it was established" that the taxpayer did not have an unrestricted right to the item has been interpreted as requiring a legal obligation to restore the item of income; a voluntary choice to repay is not enough. According to the court, an involuntary legal obligation to restore the item of income can be shown by a court judgment requiring the repayment, but a good faith settlement of a claim can also suffice.

The court found that in this case, the Heitings failed to allege that "it was established" that the trust did not have an unrestricted right to the item of income. Rather, the Heitings alleged only that the sale was contrary to the trust agreement, which in the court's view was at most a potential restriction originating at the time of the transaction in 2015. But the court emphasized that the Heitings, as the sole beneficiaries of the trust, never demanded the restoration of the stock or otherwise communicated an intent to pursue any of their rights for the breach of the trust agreement. The existence of a potential claim against the income was not, in the view of the court, enough to "establish" that the trust lacked an unrestricted right to the income. The court said that the violation of the terms of the trust agreement was a dormant restriction, dependent upon the future application of law, that was insufficient to indicate that a right to the item of income was not an unrestricted one.

The court also rejected the Heitings' reliance on the Wisconsin statute as establishing a legal obligation to reverse the sale. According to the court, the statute does not mandate as a remedy the action taken in this case - the repurchase of the stock, but rather provides a list of potential remedies for a breach of trust, including seeking damages from the trustee or suspending or removing the trustee. The court further noted that the terms of the trust agreement in fact prohibited the trustee's 2016 repurchase of the restricted stock just as it had prohibited the sale of that stock in 2015. Thus, the Wisconsin statute failed to establish that the trustee had a legal obligation to purchase the restricted stock in 2016. However, the court explained that the statutory authority was unhelpful for an even more fundamental reason, which was that the Heitings as beneficiaries never sought relief at all from the trustee nor did they allege an intent or even a threat to do so. The court said that the mere possibility that they could have done so, as authorized by the Wisconsin statute, was insufficient to establish that the trust lacked an unrestricted right to the proceeds of the sale of the restricted stock.

For a discussion of the claim of right doctrine, see Parker Tax ¶70,110.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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