If a taxpayer receives money that she believes is properly hers, she has income under the Internal Revenue Code and the funds received will be subject to tax. If she learns in a subsequent year that she was not entitled to the money and repays it, then she would have a deduction in that tax year. But if the taxpayer’s tax bracket is different in the year of repayment, the deduction may not be equal to the excessive tax previously paid.
To address this problem, Congress enacted section 1341 of the Code, which provides the taxpayer with an additional option: She may calculate her tax in the year of repayment by deducting the excessive tax paid in the year the income was received. I.R.C. § 1341(a)(5); see United States v. Skelly Oil Co., 394 U.S. 678, 682 (1969). Last week, the First Circuit decided an unusual claim of right issue, ruling that funds obtained through fraud did not fall within the claim of right doctrine, even if a tax refund was sought by a receiver. Robb Evans & Assocs. v. United States, N0. 15-2540, 2017 U.S. App. LEXIS 3888 (1st Cir. 2017).
Robb Evans came in the aftermath of a consumer fraud: The plaintiff in the case was a receiver appointed to recover funds under judgments rendered in class actions against a network of companies that engaged in consumer fraud in the credit counseling market. 2017 U.S. App. LEXIS 3888 at *3-*5. The receiver was pursuing a tax refund claim of the malefactors for the benefit of the injured consumers, and it argued that claim of right relief was available under section 1341. Id. at *5-*6. After the district court granted partial relief to the receiver, both sides appealed.
In addressing the applicability of section 1341, the First Circuit focused squarely on the question whether the taxpayers had received the funds under a claim of right, as the other requirements were acknowledged to be met. Id. at *12. The court noted that the prior judgments establishing liability had conclusively established that the taxpayers had obtained the funds from the consumers by fraud. Id. at *13-*14. That determination was problematic, since “it cannot be said to appear to an embezzler or fraudster that he has an unrestricted right to his ill-gotten gains.” Id. at *15. Given the prior determination that the taxpayers had obtained the funds through fraud, the First Circuit concluded that collateral estoppel precluded the receiver from demonstrating that the funds were received under a claim of right. Id. at *16.
Alternatively, the receiver asserted an equitable argument that Congress did not intend to impute the taxpayers’ fraud to a receiver. This was unavailing; in the court’s view, nothing in the language and legislative history of section 1341 supported the receiver’s effort to avoid the requirement that funds be subject to a claim of right to qualify for relief. Id. at *19-*21. While section 1341 was enacted to address a perceived inequity, in the First Circuit’s view, that did not mean the statute “may be interpreted to address every inequity attributable to the tax code.” Id. at *20.
While sympathy for the victims of the fraud is in order, the First Circuit’s decision is sound. The receiver was standing in the taxpayers’ shoes to pursue the refunds, and there is no reason why a receiver should be able to recoup a tax refund where the taxpayer himself could not.