Eleventh Circuit Reverses District Court, Upholds Taxpayer's Sec. 1341 Refund Claim

(Parker Tax Publishing July 2019)

The Eleventh Circuit reversed a district court's judgment against a taxpayer and concluded that the taxpayer had a right to recover the taxes she paid on $300,000 of income, when she repaid that amount to her former husband as part of a $600,000 breach-of-fiduciary settlement he reached with his sister regarding a family owned business. The Eleventh Circuit held that the taxpayer met the requirements under Code Sec. 1341 and rejected the government's contention that the taxpayer was required to return the funds not to her ex-husband but to their "actual owner" in order to qualify for relief under Code Sec. 1341. Mihelick v. U.S., 2019 PTC 226 (11th Cir. 2019).

Background

From 1999 to 2004, Nora Mihelick and her then-husband, Michael Bluso, lived in Ohio and worked at Gotham Staple Company, a closely held corporation owned by Bluso's family. Mihelick worked for the company, planning events, caring for and maintaining the homes of Bluso's parents, and handling administrative tasks. Bluso was the CEO of Gotham and the majority shareholder. Both Mihelick and Bluso earned income for their roles at Gotham, and the couple filed joint tax returns that included Bluso's income during those years.

In 2004, Mihelick filed for divorce. While the divorce was pending, Pamela Barnesone of Bluso's sisters, who was a minority shareholder at Gothamsued Bluso, Gotham, and others. Barnes claimed that Bluso had breached his fiduciary duties by excessively compensating himself at Gotham's expense. Mihelick was not a party to the litigation, but Bluso wanted her to share any resulting liability from Barnes's lawsuit. To Bluso, Mihelick had also reaped the benefits of his compensation, so she should share the burdens of his compensation as well. Bluso and Mihelick eventually agreed that they would be jointly and severally liable for any liability from the Barnes litigation. Specifically, the agreement clarified that the liability arose from the acquisition of marital assets, and since the marital assets had been equally divided, the liability was deemed to be a marital liability.

Mihelick and Bluso finalized their divorce in 2005, but the Barnes litigation continued. In 2007, Bluso settled with Barnes for $600,000. Bluso paid Barnes the $600,000 and took a tax deduction for his half of the payment, $300,000. Bluso looked to Mihelick to cover her half of the $600,000 liability, but Mihelick resisted paying. Bluso withheld alimony and threatened to deprive her of more support. After contentious negotiations, during which Mihelick's lawyer told her she had an obligation to pay, Mihelick paid Bluso $300,000 in 2009.

On her 2009 tax return, Mihelick claimed a refund of the taxes she had previously paid on the $300,000. However, unlike what it had done with Bluso, the IRS denied Mihelick's claim for a refund because she had paid the money to Bluso instead of returning the money directly herself. Mihelick sought relief in a district court, but the district court agreed with the government and granted summary judgment against Mihelick. Mihelick appealed to the Eleventh Circuit.

Code Section 1341

Under Code Sec. 1341, a taxpayer is entitled to either a deduction from current year's taxes or a credit for the amount that tax was increased in a prior year as a result of including an item in income that the taxpayer later returned if the following four requirements are met: (1) the income was included in a prior year's gross income because it appeared the taxpayer had an unrestricted right to the income; (2) the taxpayer actually did not have an unrestricted right to the income; (3) the amount to which the taxpayer did not have an unrestricted right exceeded $3,000; and (4) that amount is deductible under another provision of the Code. The first requirement is met if the taxpayer sincerely believed he or she had an unrestricted right to the income. To satisfy the second requirement, the taxpayer must demonstrate that the income was involuntarily given away because of some obligation and the obligation had a substantive nexus to the original receipt of the income.

Observation: Congress enacted Code Sec. 1341 in response to the Supreme Court's decision in U.S. v. Lewis, 340 U.S, 590 (1951), in which a taxpayer who paid tax on a $22,000 bonus in 1944 learned two years later that the bonus was improperly computed and had to return $11,000 of the bonus. The taxpayer tried to recalculate his 1944 taxes, but the Supreme Court ruled that he could deduct $11,000 from his 1946 return only, not the 1944 tax return. Lewis was seen as unfair because, since factors like tax rates and income brackets may change from year to year, the taxpayer still may have unnecessarily paid taxes on income that he turned out not to have.

The government argued that Mihelick did not appear to have an unrestricted right to the income in question because she had no presumptive right to Bluso's income and, even if she did, Bluso could not have claimed an unrestricted right to the income because he knowingly misappropriated it from Gotham. The government also said that Mihelick was not obligated to return the $300,000. The government's position was that a taxpayer lacks an unrestricted right to an item of income (i.e., the second requirement of Code Sec. 1341) only if he or she returned the income to its "actual owner" and Mihelick did not meet this requirement because she returned the income to Bluso, not to Barnes.

Eleventh Circuit's Analysis

The Eleventh Circuit reversed the district court and remanded for it to reconsider whether there was any dispute that Mihelick met the requirements of Code Sec. 1341. The Eleventh Circuit explained that the first requirement of Code Sec. 1341 was met because Mihelick sincerely believed she had a right to Bluso's income, and the government's challenge to the correctness of that belief made no difference. With respect to the second requirement of Code Sec. 1341, the court rejected the government's argument that Bluso did not appear to have an unrestricted right to the income, reasoning that there was no proof that he knowingly misappropriated the funds and that his settlement agreement expressly disclaimed any wrongdoing. The Eleventh Circuit also found that Mihelick did not have an unrestricted right to the $300,000. The court said that Mihelick involuntarily gave up the income because she reasonably anticipated litigation, and payments to settle a lawsuit may constitute an involuntary obligation for purposes of Code Sec. 1341. The court also found that there was a substantive nexus between Mihelick's obligation to pay and the receipt of the original income because the income was presumptively for Mihelick and Bluso's shared marital estate and Barnes sued to recover it on grounds that it was allegedly wrongfully dispensed to the couple as income. The court rejected the government's contention that Mihelick had to have returned the income to its "actual owner." In the court's view, the government was arguing for a new requirement that lacked a basis in the statutory text and was inconsistent with the purpose of Code Sec. 1341.

Finally, the Eleventh Circuit determined that the fourth requirement of Code Sec. 1341 was met because Mihelick could deduct the $300,000 under Code Sec. 165(c)(1), which allows a corporate officer to deduct the amount to settle a bona fide suit alleging mismanagement of corporate affairs, if the allegations are directly connected with the taxpayer's business activity. The court explained that since Mihelick was presumed to have contributed equally to the production and acquisition of the income, she also was presumed to have contributed equally to the $600,000 liability. Because she paid for half the liability that she helped create, and because that liability was deductible under Code Sec. 165(c)(1), Mihelick could take a deduction for her payment under Code Sec. 165(c)(1), the court concluded.

For a discussion of relief under Code Sec. 1341, 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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