Section 1341 Clarified

BY EDWARD J. SCHNEE

As a result of unforeseen circumstances, taxpayers may discover they must repay an amount previously collected and included in income. If the tax rates or other items have changed from those that existed in the year the income was reported, the current deduction for the repayment may not completely offset the taxes paid on the prior reported income.

In these cases, the taxpayer should consider whether IRC section 1341 provides relief.

Between 1981 and 1995 Quaker State bought crude oil from independent oil producers. In 1994 these independent producers, including Lazy Oil, brought suit claiming price-fixing against Quaker State and others. In 1995 Quaker State settled the suit for $4.4 million without admitting guilt. Quaker State took advantage of the relief provision contained in section 1341 to calculate the tax result of this payment. Under it a taxpayer may reduce its current year’s tax by the amount of the extra tax paid as a result of having included the item in income in the prior year. (This reduction is in lieu of claiming the payment as an expense.) The IRS objected to Quaker State’s use of section 1341, saying the taxpayer had not met the code requirements for doing so.

Result. For the taxpayer. In its decision the U.S. Court of Federal Claims referred to the following five requirements of section 1341 and then considered whether the taxpayer had met each one:

An item must have been included in income in a prior year.
The inclusion must have occurred because the taxpayer appeared to have an unrestricted right to the income.
A deduction was allowed in the current year.
It was established the taxpayer did not have an unrestricted right to the income.
The deduction exceeded $3,000.

Section 1341(b) denies relief when an included item is from the sale of inventory (inventory exception). The parties agreed that Quaker State had met the fifth requirement. But, they disputed whether the taxpayer had met the other four requirements and whether the inventory exception denied relief. The court discussed each of these requirements in turn.

The first dispute was whether Quaker State had included an item in income in a prior year. The IRS said an understatement of an expense (cost of goods sold) was not the inclusion of an item of income; Quaker State argued it was. The court agreed with the taxpayer, saying that, because Quaker State was a manufacturer, understating its cost of goods sold was the equivalent of including an item in income. Therefore the taxpayer met the first requirement. The second disagreement was whether Quaker State had an appearance of the right to income. The IRS argued Quaker State had an actual right to the income, not just an appearance of the right: The court rejected this position. After reviewing earlier cases and commentary, the court ruled that an actual right to income is within the phrase “apparent right to income.” (Prior courts had split on this.)

The requirement that the taxpayer be entitled to a deduction has two subtests. First, there must be a deduction as the result of the restoration of the income, and, second, the deduction must occur under a code section other than section 1341. The IRS argued there was no restoration of income. The court disagreed, saying restoration does not have to be to the party that made the payment, but only to someone who reported lower income in a prior year. Therefore, this condition was met. The court then stated the payment generated a deduction under section 162, fulfilling this requirement.

The last item considered was whether the payment was the result of Quaker State’s lack of an unrestricted right to keep the income. The court ruled, based on prior cases, the requirement was met because the taxpayer made the payment as a result of a legal obligation. The requirement excluded voluntary payments. A settlement even without an admission of guilt is an involuntary payment. Therefore this requirement was met.

The IRS’s last argument was that the payment fell within the inventory exception. The court concluded, based on prior cases and the regulations, this exception primarily applied to sales returns and allowances. Since the payment was neither, it was not excluded.

This case joins others in which the courts took a very broad view of section 1341. The outcome is due, in part, to the general rule that remedial provisions should be interpreted broadly and all doubts resolved in the taxpayer’s favor. If this trend continues, more companies should be eligible to use the relief provision contained in section 1341.

Pennzoil-Quaker State Co. v. United States, U.S. Court of Federal Claims, 2004 US Claims, Lexis 281.

Prepared by Edward J. Schnee, CPA, PhD, Hugh Culverhouse Professor of Accounting and director, MTA Program, Culverhouse School of Accountancy, University of Alabama, Tuscaloosa.

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