Allowing a Double Bite but No Double Deduction

In Batchelor-Robjohns v. United States, the U.S. Court of Appeals for the Eleventh Circuit held that (1) res judicata doesn’t apply to a claim against a taxpayer if the claim arises from a transaction that was previously litigated, but addressed a different tax liability, and (2) disallowed an income tax credit under Internal Revenue Code Section 1341for items previously deducted on an estate tax return.[1] The taxpayer, George Batchelor, was the subject of multiple lawsuits after his death in 2002, and it was left to his estate to resolve them. One suit, in which the government sought payment of additional personal income tax from George, arose from the same underlying transaction as a prior government suit against George for his business's corporate income tax under a transferee liability theory. The Eleventh Circuit found that res judicata didn’t apply, allowing the government a second bite at the apple.  After the estate settled the other lawsuits, it deducted such payments from the gross estate when filing its federal estate tax return. The following year, the estate claimed a credit on its income tax return under IRC Section 1341, which provides an adjustment when a taxpayer must return items previously included in gross income.  The court held that the estate was prevented from taking this “double deduction” under IRC Section 642(g).

Allowing a Double Bite—Res Judicata    

In 1999, George sold all of the stock in his wholly-owned aviation business, International Air Leases, Inc. (IAL), to International Air Leases of P.R., Inc., for $502 million, $150 million of which was in the form of a promissory note secured by certain assets of IAL.  George had the option to buy back these assets, in which case the balance of the note would be adjusted. George exercised the option the same year as the sale and paid capital gains tax on $483 million of gain.  When IAL became bankrupt in early 2002, the government argued that the company’s insolvency was caused by an undervaluation of the assets subject to George’s option. As a result, the Internal Revenue Service sought to collect IAL’s corporate income tax from George himself under a transferee liability theory. The government’s suit was unsuccessful, as the government had failed to properly disclose its experts.

After George’s death, the government initiated a second suit against the estate, alleging that George hadn’t paid sufficient capital gains tax on the sale. The suit was related to the exact same valuation issue, but sought to collect George’s personal income tax liability, as opposed to the corporate tax liability. The estate contented that the government’s basis for assessing additional capital gains tax—namely, the undervaluation of the assets subject to George’s option—was tantamount to the government’s argument in the prior case against George, resulting in the new claims being precluded by res judicata.

The Eleventh Circuit, however, found that res judicata wouldn’t prevent the government from collecting in this case.  Generally, res judicata bars a claim if it arises from the same cause of action, involving the same rights and duties, as a prior case, if certain other factors are met.[2] The court noted that what constitutes the same cause of action has been interpreted broadly in some areas of law, but for taxation, which is primarily based on statute, the concept is interpreted very narrowly. Referring to Tax Court precedent, the Eleventh Circuit found that res judicata didn’t apply when claims are for different tax liabilities (here, the cases involved income tax liability under IRC Section 1 and a corporate tax liability under IRC Section 11), even though they may arise from the same transaction and facts.[3]

No Double Deduction—IRC Sections 1341 and 642(g)

The estate settled several other lawsuits brought by third parties for a total of $41 million in 2004 and deducted such payments on its federal estate tax return as claims against the estate.[4] The following year, the estate took an $8.3 million credit on its income tax return under Section 1341 and filed suit when the IRS rejected this amount.  In denying this credit through a technical reading of the IRC, the Eleventh Circuit created an inequitable result.

Section 1341 was enacted in 1954 to address the tax mismatch that can result when a taxpayer repays income previously received under a claim of right.[5]  The regulations define  “income included under a claim of right” as “an item included in gross income because it appeared from all facts available in the year of inclusion that the taxpayer had an unrestricted right to such item.”[6]  Prior to 1954, a taxpayer was obligated to report any income received under a claim of right in the year such income was received.  If it was later found that the taxpayer wasn’t entitled to such income, the only recourse was to deduct the amount the taxpayer was required to repay, in the year of repayment.  Because tax rates and brackets change year to year, Congress recognized that often “the deduction allowable in the later year does not compensate the taxpayer adequately for the tax paid in the earlier year.”[7]  Thus, Section 1341 was implemented to permit the taxpayer to take either a credit or a deduction—whichever results in less tax—in the year of repayment.[8]

To receive relief under Section 1341, the taxpayer must meet three requirements:

1. the taxpayer must have included an item in gross income in a prior taxable year (or years), because it appeared that the taxpayer had an unrestricted right to such item;
2. there must be a deduction allowable for the current taxable year, because it was established after the close of such prior year(s) that the taxpayer didn’t have an unrestricted right to such item (or a portion of it); and
3. such deduction must exceed $3,000.[9]

The court’s holding was based primarily on its reading of the second factor: whether a deduction was allowable in the current year.  Noting that Section 1341 doesn’t provide an independent grounds for a deduction, and rather, is predicated on the existence of an available deduction in the current year, the court assessed whether the estate was entitled to take an income tax deduction for the settlement payments it had previously deducted from the estate tax return.  The court relied on Section 642(g), which prohibits estates from taking a “double deduction” for items that can be properly deducted on a federal estate or income tax return.  Although the estate was only attempting to deduct a fraction of the settlement payments it had previously deducted, such fraction representing the tax associated with the repaid income, the court found that Section 642(g) disallowed the later income tax deduction.

Section 642(g) permits a double deduction for deductions in respect of decedents (IRD deductions).[10]  Items such as business expenses, interest and taxes, which have accrued at the date of death but haven’t yet been paid—aren’t properly deducted on the decedent’s final return, but may be taken as both an estate tax deduction and an estate income tax deduction, because the items would have reduced the decedent’s gross estate as well as his income had he been alive to pay them. IRC Section 691(b) lists six code provisions that qualify as IRD deductions,[11] and the estate attempted to qualify the settlement payments as a business expense under IRC Section 162, or alternatively, an ordinary and necessary expense for the production or collection of income under IRC Section 212. However, the court determined that the settlement payments ultimately arose from the sale, which was reported as capital gain and, therefore, should be reported as a capital loss instead of a Section 162 business expense or similar expense under Section 212.

The cases the court relied on for this proposition concerned taxpayers receiving a “tax windfall” from taking ordinary deductions on capital gain income.[12]  Here, however, the estate wouldn’t have received a windfall, because it wasn’t attempting to deduct the full $41 million a second time on its income tax return.  Rather, at issue was the $8.3 million credit, which was determined by recalculating the capital gains tax owed on the sale of the aviation business, less the settlement payments paid out by the estate.  The Treasury Regulations for Section 1341 explicitly state that the requirement for a current year deduction applies to deductions that are capital in nature.[13]  Thus, had George lived through the conclusion of the third-party lawsuits, he would have been able to receive relief under Section 1341 for any payments made pursuant to their outcomes.[14]

Technical Reading

Although the Eleventh Circuit’s reading of the IRC may be technically correct, the interaction between Sections 1341 and 642(g) creates a mismatch in income and estate tax liability.  The estate cited several cases in which similar  “double deductions” were permitted.[15]  These cases found that Section 1341 wasn’t controlled by Section 642(g) and relied on the intended purpose of Section 1341 and the relationship between a decedent and his estate.[16] When a taxpayer returns income received under a claim of right, his gross estate is accordingly reduced.  Section 1341 seeks to restore the taxpayer to the position he would have been in had he never received the money by refunding any income taxes paid on it.  To avoid a benefit to the taxpayer, the refunded amounts should, in turn, be included in the taxpayer's estate, as the IRS has accepted in the past with Section 1341,[17] such that neither the taxpayer nor the government is in a worse position.  Thus, the equitable result in Batchelor would be to permit the $8.3 million income tax credit and subject such amount to estate tax.

The Eleventh Circuit decision reflects a technical reading of the relevant IRC sections, outside of their typical contexts, resulting in inequitable result with a windfall to the government. The court relied heavily on Eleventh Circuit precedent, and courts in other jurisdictions may arrive at an opposite conclusion.  There’s therefore a fair amount of uncertainty regarding the application of Section 1341 in the estate context, and estates shouldn’t rely on their ability to receive a double deduction for amounts repaid under claim of right, at least until more favorable case law is released or until Congress addresses the issue.

Endnotes