Taxpayer allowed a deduction under claim of right

A divorced spouse could deduct her indirect repayment of an amount previously included in her and her former husband's jointly reported income.
By Charles J. Reichert, CPA

The Eleventh Circuit held that a taxpayer could deduct the reimbursement to her ex-spouse for her share of his repayment of an amount previously included as income on their joint tax return during their marriage, reversing the decision of a district court. According to the court, the taxpayer satisfied the requirements of Sec. 1341 even though she had not directly repaid the amount.

Facts: From 1999 to 2004, Nora Mihelick and her then-husband, Michael Bluso, worked for Gotham Staple Co., based in Ohio and owned by the Bluso family, with Bluso as CEO and the majority shareholder. They reported compensation from Gotham on their joint tax returns for those years. In 2004, Mihelick filed for divorce, but while the divorce was pending, Pamela Barnes, Bluso's sister and a minority shareholder of Gotham, sued Bluso, Gotham, and others, claiming that Bluso had paid himself excessive compensation.

The couple's divorce became final in 2005. It stipulated that the former spouses would be jointly and severally liable for damages, costs, and other expenses arising from Barnes's claim and incurred by Bluso, although Mihelick was not a party to the lawsuit. In 2007 the Barnes lawsuit was settled. Under the terms of the settlement, Bluso paid Barnes $600,000 but disclaimed any wrongdoing. He took a tax deduction of $300,000 because he was seeking reimbursement from Mihelick for the remaining $300,000, her share of the settlement payment. In 2009, after Mihelick's lawyer advised her that she had an obligation to reimburse Bluso, she paid him $300,000 and similarly sought a refund reflecting a deduction of that amount under Secs. 1341 and 165 on her 2009 return.

The IRS disallowed Mihelick the refund and deduction. She filed suit for a refund in district court, but it granted summary judgment in favor of the IRS, holding that no other Code section would allow a deduction to Mihelick for all or part of the repaid amount, a requirement of Sec. 1341. The district court also held there was no substantial nexus between Mihelick's right to the income when she received it and her obligation to return it (Mihelick, No. 2:16-cv-741-FtM-38MRM (M.D. Fla. 10/11/17)). Mihelick appealed the decision to the Eleventh Circuit.

Issues: Sec. 1341 allows a taxpayer to take a deduction or a credit if he or she repays an amount exceeding $3,000 that the taxpayer had reported as income in a prior tax year because he or she appeared to have had an unrestricted right to the item, but it is determined in a later tax year that the taxpayer did not actually have that unrestricted right. The repayment must also be deductible under some other Code provision. Taxpayers who know that they have improperly acquired income cannot have an unrestricted right to it. In the later tax year, to show that there was no unrestricted right to the income, the taxpayer must demonstrate that the reported amount was involuntarily given away because of some obligation and the obligation had a substantive nexus to the original receipt of the income. In Barrett, 96 T.C. 713 (1991), the Tax Court held that the settlement of a lawsuit made in good faith and at arm's length is an involuntary payment of an obligation for purposes of Sec. 1341.

The IRS argued that Mihelick did not have an unrestricted right to the $600,000 because it was Bluso's income, and even if she had a right to any of it, Bluso could not have believed he had a right to it because he knowingly misappropriated the funds. The government also argued that Mihelick voluntarily paid the $300,000 and that she could not satisfy the substantive-nexus requirement because the income from Gotham had nothing to do with her.

Holding: The appeals court held that Mihelick could deduct the $300,000 repayment, rejecting all of the government's arguments. According to the court, the evidence indicated that Bluso believed he had a right to the income because he conceded no wrongdoing in the settlement agreement related to alleged misappropriation of funds. The court also stated Sec. 1341 required only that Mihelick sincerely believe that she had an unrestricted right to the reported income, not whether that belief was correct, and since Ohio law treats income from labor as marital property where each spouse is considered to have contributed equally, her belief was sincere.

The court, citing Barrett, held that her payment was involuntary for purposes of Sec. 1341 because she made a settlement payment to avoid litigation. It also held there was a substantive nexus between the repayment and the previously reported income because "Mihelick's payment ultimately stemmed from the original receipt of the income at issue."

Lastly, the court held that her $300,000 payment was deductible under Sec. 165(c)(1) as an uncompensated loss from a trade or business because Bluso's $600,000 payment was due to his trade or business as a fiduciary of Gotham. Therefore, because Mihelick was presumed under Ohio law to have contributed equally to producing that income, "she also was presumed to have contributed equally to the ensuing $600,000 liability," according to the court.

  • Mihelick, No. 17-14975 (11th Cir. 6/18/19)

By Charles J. Reichert, CPA, instructor of accounting, University of Minnesota—Duluth.

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