Section 1341 allows a deduction when a taxpayer had an apparent right to an amount over $3,000 included in gross income in a prior year but subsequently discovers it did not have an unrestricted right to that income. Uncertainty surrounding such questions as what kinds of claims qualify and how intrinsically they must be related to the income against which they are deducted, however, often make applying this relief problematic.
From 1940 to 1987, aluminum manufacturer Alcoa Inc.’s production process created waste byproducts that required it to spend large sums in 1993 for environmental cleanup. Under the annual accounting period rules, these expenditures would have been deductible in 1993. But since the corporate tax rate in 1993 was significantly lower than in 1940–1987, Alcoa used section 1341 to deduct the costs from its income in the prior period. The government’s rejection of Alcoa’s resulting refund claim of more than $12 million was upheld in 2005 by the U.S. District Court for Western Pennsylvania. The court based its ruling on a nearly identical case decided a short time earlier that year by the U.S. District Court for Eastern Virginia against Reynolds Metal Co. (Reynolds Metal Co. et al. v. U.S. , 96 AFTR2d 2005-6003). Alcoa appealed the Pennsylvania case to the Third Circuit.
The Third Circuit said in a Nov. 28, 2007, opinion that Alcoa’s retrospective deduction for its cleanup costs failed because the costs lacked a substantial nexus of circumstances, terms and conditions with the earlier income. The cleanup obligations did not arise from the earlier failure to spend the money but from new circumstances, terms and conditions—notably a 1980 legislative mandate. Moreover, it wasn’t clear who was exercising a competing claim to the money. Earlier cases, along with the plain meaning of “restoration” and “restitution” referred to in section 1341’s legislative history, require payment to a specific individual or business and not simply an expenditure that benefits many.
It was also unclear to the court what relation the 1993 costs bore to amounts Alcoa would have incurred for cleanup during the earlier period and how the costs might have been apportioned over those 47 years. Although a “significant question,” this point was relegated to a footnote; Alcoa’s construal of the statute’s key elements, “while artful, is not convincing,” the opinion said.
In a separate case, the Federal Circuit Court of Appeals rejected a claim by Pennzoil-Quaker State Co. (the successor to Quaker State Corp.) for a $4.4 million deduction claimed under section 1341. The amount was paid in 1995 as a settlement in a price-fixing lawsuit. The Federal Circuit overturned the 2004 decision of the Court of Federal Claims (94 AFTR2d 2004-6545), which had allowed the deduction. (See “ Tax Matters: Section 1341 Clarified," March 05, page 86.)
Quaker State claimed the payments as “other deductions” on its 1995 and 1996 tax returns, contending the settlement resulted in an overstatement of gross income of $4.4 million for the years 1981–1995. Similarly to the Third Circuit in Alcoa , the Federal Circuit said Pennzoil-Quaker State’s “settlement payments did not arise from the same circumstances” as the oil company’s past understatement of cost of goods sold. The court also ruled the claim was barred by the “inventory” exception of section 1341(b)(2), which disallows the deduction when the item was included in gross income because of the sale of inventory.
These decisions, if followed by other courts, reject the use of section 1341 for claims lacking a clear and contemporaneous connection to income or an identifiable claimant.
Alcoa Inc. v. U.S. , 100 AFTR2d 2007-6815
Pennzoil-Quaker State Co. v. U.S. , 101 AFTR2d 2008-415
Prepared by Edward J. Schnee, CPA, Ph.D., Hugh Culverhouse Professor of Accounting and director, MTA Program, Culverhouse School of Accountancy, University of Alabama, Tuscaloosa.