The concept of a “claim-of-right” can be confusing for both taxpayers and tax professionals. In the case of Yoklic v. Commissioner, TC Memo. 2017-143, a taxpayer did not include unemployment benefits received in 2012 in income because the state agency administering the benefits (Arizona’s Department of Economic Security (DES)) had determined he was not entitled to the benefits, and Mr. Yoklic repaid those benefits in 2013.
Mr. Yoklic applied for unemployment benefits in 2012 and received $3,360 in such benefits from April to August 2012. However, eventually DES determined he was not eligible for such benefits:
Thereafter, DES issued petitioner a determination letter dated August 9, 2012, followed by decision letters dated September 14 and October 25, 2012. These letters stated that petitioner was not entitled to the unemployment benefits received, resulting in an overpayment of unemployment benefits of $3,360 determined against him.3 The October 25, 2012, letter also informed petitioner that the last date to file a request for review was November 26, 2012. The only action petitioner took in response to this letter was to repay the benefits he had received, as evidenced by a copy of an endorsed check dated September 26, 2013, paid to the order of DES for $3,527.94.
Despite receiving a Form 1099G from DES for 2012, Mr. Yoklic did not report the $3,360 as income for 2012.
As the Court notes, the claim-of-right doctrine exists because of our annual method for reporting our tax liabilities. As the opinion notes:
A taxpayer receives income under a claim of right whenever he “acquires earnings, lawfully or unlawfully, without the consensual recognition, express or implied, of an obligation to repay and without restriction as to their disposition”. Id. (quoting James v. United States, 366 U.S. 213, 219 (1961)). Under the claim-of-right doctrine, laid out by the Supreme Court in N. Am. Oil Consol. v. Burnet, 286 U.S. 417, 424 (1932), “[i]f a taxpayer receives earnings under a claim of right * * *, he has received income which he is required to return, even though it may still be claimed that he is not entitled to retain the money, and even though he may still be adjudged liable to restore its equivalent.” Receipts subject to a taxpayer’s claim of right are includible for the year of receipt.
When income is received under a claim-of-right, the taxpayer reports it in the year received, despite the possibility (or in this case, certainty) that repayment may be demanded in a later year.
One exception to the claim of right doctrine is the doctrine of rescission. In a rescission, the transaction is fully reversed and treated as if it never happened. The opinion explains this doctrine as follows:
The doctrine of rescission represents an exception to the claim-of-right doctrine. See Blagaich v. Commissioner, at *13. Pursuant to this exception, income received under a claim of right need not be included in gross income if, in the year of receipt, the taxpayer (1) recognizes an existing and fixed obligation to repay the amount received and (2) makes provisions for repayment. See id. at *13-*14; see also Hope v. Commissioner, 55 T.C. 1020, 1030 (1971), aff’d, 471 F.2d 738 (3d Cir. 1973); Gaddy v. Commissioner, 38 T.C. 943, 949 (1962), aff’d in part, remanded in part, 344 F.2d 460 (5th Cir. 1965); Goldberg v. Commissioner, T.C. Memo. 1997-74, slip op. at 48, aff’d, 246 F.3d 674 (9th Cir. 2000).
But Mr. Yoklic failed to meet the requirements to invoke the doctrine of rescission to override the claim-of-right doctrine. As the Court notes:
On the basis of the record before us, we find that petitioner’s obligation to repay the unemployment compensation he received from DES in 2012 became fixed in that same year. However, petitioners do not contend, nor is there any evidence in the record indicating, that they made provisions for repayment also in that same year. Instead, the record clearly shows repayment to DES the following taxable year in September 2013. The doctrine of rescission thus does not save petitioners from respondent’s adjustment including in their gross income for 2012 the unemployment compensation that, in that year, petitioner received from DES.
Accordingly, pursuant to sections 85(a) and 451(a), we sustain respondent’s determination that for 2012 petitioners had $3,360 of unemployment compensation that was taxable income to them.
A reader may complain that this hardly seems fair—Mr. Yoklic is paying tax on funds he was not allowed to keep. Since the case only dealt with 2012, the Court did not address how this inequity is dealt with under the law.
Generally, a taxpayer restoring funds under a claim of right may take a deduction for the repayment in the year of repayment (2013 in this case). But if the amount repaid exceeds $3,000, the taxpayer may elect, in lieu of a deduction, to claim a credit for the amount his/her tax was increased in the year of inclusion, and then use that credit against the taxes for the year of repayment. This credit is found at IRC §1341.