An individual who paid half of an amount previously included in income by her ex-spouse on a joint return was allowed a claim of right deduction under IRC §1341 for her payment in the case of Mihelick v. Commissioner, Case No. 17-14975, CA 11.
Claim of right issues are the sort of thing CPAs run into infrequently, but almost everyone seems to hit at least one or two during a career in tax. The claim of right rule, found at IRC §1341(a), provides the following:
(a) General rule If—
(1) an item was included in gross income for a prior taxable year (or years) because it appeared that the taxpayer had an unrestricted right to such item;
(2) a deduction is allowable for the taxable year because it was established after the close of such prior taxable year (or years) that the taxpayer did not have an unrestricted right to such item or to a portion of such item; and
(3) the amount of such deduction exceeds $3,000,
then the tax imposed by this chapter for the taxable year shall be the lesser of the following:
(4) the tax for the taxable year computed with such deduction; or
(5) an amount equal to—
(A) the tax for the taxable year computed without such deduction, minus
(B) the decrease in tax under this chapter (or the corresponding provisions of prior revenue laws) for the prior taxable year (or years) which would result solely from the exclusion of such item (or portion thereof) from gross income for such prior taxable year (or years).
For purposes of paragraph (5)(B), the corresponding provisions of the Internal Revenue Code of 1939 shall be chapter 1 of such code (other than subchapter E, relating to self-employment income) and subchapter E of chapter 2 of such code.
Ms. Mihelick had been married to Michael Bluso. She filed for divorce in 2004 and as that proceeded her soon to be ex-husband’s sister filed a suit against Ms. Mihelick’s soon to be ex-husband. The opinion describes the facts as follows:
From 1999 to 2004, the couple lived in Ohio and worked at Gotham Staple Company, a closely held Ohio corporation owned by Bluso’s family. Mihelick worked for the company, planning events, caring for and maintaining the homes of Bluso’s parents, and handling administrative tasks. Bluso was the chief executive officer of Gotham at the time, and he eventually became majority shareholder as well. Both Mihelick and Bluso earned income for their roles at Gotham, and the couple filed joint tax returns that included Bluso’s income during those years. The couple likewise paid taxes on the taxable income they earned from Gotham during that time.
In September 2004, Mihelick filed for divorce. While the divorce was pending, Pamela Barnes — one of Bluso’s sisters, who was a minority shareholder at Gotham — sued Bluso, Gotham, and others. Among other things, Barnes claimed that Bluso had breached his fiduciary duties by excessively compensating himself at Gotham’s expense.
Mihelick was not a party to the litigation, but Bluso wanted Mihelick to share any resulting liability from Barnes’s lawsuit. To Bluso, Mihelick had also reaped the benefits of his compensation, so she should share the burdens of his compensation as well.
At first, Mihelick opposed the idea of sharing liability for the Barnes litigation — she wanted the separation agreement to provide that she was “not liable for anything that Pam Barnes comes up with.” But when Bluso threatened to have a judge decide Mihelick’s responsibility, Mihelick relented and agreed to share liability for the Barnes lawsuit.
After some back and forth between the parties about how to divide the liability, they agreed to Article 5 of their separation agreement, which provided that any liability from the Barnes litigation would be considered a marital liability for which Bluso and Mihelick would be jointly and severally liable. Specifically, the section clarified that the liability “arose all or in part from the acquisition of marital assets,” and that since the marital assets had been equally divided, the liability “shall be deemed to be a marital liability,” too.
Eventually Mr. Bluso settled the dispute with his sister for $600,000, which he paid. He then sought reimbursement from Ms. Mihelik for half of those funds. While she initially resisted paying it, eventually, after her attorney told her it was required under the divorce agreement, she paid Mr. Bluso $300,000.
Mr. Bluso claimed a tax benefit on $300,000 of the payment under the claim of right doctrine of §1341, and the IRS granted him that relief. Mr. Bluso testified he did not claim the entire $600,000 he paid, as he did not feel it was right to do so, since Ms. Mihelick was liable for the other $300,000.
But when Ms. Mihelick attempted to get relief for her $300,000 payment under the same provision, the IRS balked at granting that relief. The question of whether she can get relief under §1341 depends on three factors, all of which the IRS claims are resolved against her:
The taxpayer must have appeared to have had an unrestricted right to the income (meaning the taxpayer reasonably believed she had such a right);
The taxpayer must show she actually did not have an unrestricted right to the income; and
The taxpayer must be eligible to deduct the payment under another provision of the IRC.
The IRS first argued that the taxpayers did not have appear to have an unrestricted right to the income since, the government argued, Mr. Bluso knowingly misappropriated money from the Company. The opinion noted that if an individual knowingly steals income, there would be no reasonable belief that the person had an unrestricted right to the income, thus failing the first test. But the opinion noted:
But here, the record lacks any proof that Bluso knowingly misappropriated income, since his settlement agreement with Barnes expressly disclaimed any wrongdoing. Since we must take the facts in the light most favorable to Mihelick, the government’s contention that Bluso did not believe he had an unrestricted right to his income necessarily fails.
The IRS also argued that Ms. Mihelick had no right to the income, since the salary was her husband’s salary. But the opinion first notes that’s what relevant is not if she had a right to the income, but whether she believed she had an unrestricted right to such income. The opinion notes that §1341 only applies when it turns out the taxpayer did not have such a right—so §1341 would never apply if the taxpayer had to actually have an unrestricted right to the cash. Rather, the taxpayer must simply reasonably believe she had such a right.
As well, the opinion, relying on Ohio property law, found that Ms. Mihelick did have a right to this income even though it was salary issued to her then husband. The opinion notes:
Although Ohio is not a community property state, it does treat income from labor — as opposed to passive income — as marital property, and “[e]ach spouse shall be considered to have contributed equally to the production and acquisition of marital property.” Ohio Rev. Code § 3105.171. Marital property is to be divided equally upon divorce, unless doing so would be inequitable. Id. So it appears that under Ohio law, Bluso’s income was marital property, and Mihelick presumptively had an equal right to it.
The panel also found that the second prong of the test was met—she did not actually have an unrestricted right to the funds. If a taxpayer merely gives the money back voluntary (that is, not under any compulsion), that would not meet the requirement to show she did not have an unrestricted right to funds.
The panel notes that the mere fact that the payment arose from a settlement rather then a final judgment does not make this into a voluntary payment of funds rather than a showing that the couple did not have an unrestricted right to the funds. Citing the Tax Court’s reasoning in Barrett v. Commissioner, 96 TC 713 (1991), the panel noted that a good faith, arm’s length settlement of a lawsuit will qualify to show the unrestricted right did not exist.
That is true both of the settlement with Mr. Bluso’s sister to pay back the full $600,000 and Ms. Mihelick’s agreement to reimburse Mr. Bluso for half of that payment.
The final test is whether Ms. Mihelick would have the right to a claim a deduction for the amount she paid under some provision of the IRC so she obtains the right to elect to use the credit under §1341 in lieu of that deduction. The panel found that the payment would qualify for a deduction under IRC §165(c)(1) on its own. IRC §165 provides in part:
(a) General rule
There shall be allowed as a deduction any loss sustained during the taxable year and not compensated for by insurance or otherwise.
(c) Limitation on losses of individuals In the case of an individual, the deduction under subsection (a) shall be limited to—
(1) losses incurred in a trade or business;
The panel found this situation like the situation the Tax Court addressed in the case of Butler v. Commissioner, 17 TC 675 (1951) where a corporate officer was sued for a claimed breach of fiduciary duty as an officer of the corporation and was granted a deduction for a payment made personally to settle the suit.
Applying that reasoning to the dispute that gave rise to Ms. Mihelick’s payment, the decision notes:
As CEO and majority shareholder, Bluso carried out the trade or business of serving as a fiduciary and employee of Gotham. Barnes's lawsuit alleged that Bluso breached his fiduciary duty by misappropriating funds from Gotham as he was acting as CEO. The two sides then settled the lawsuit. So the settlement payment was made “in settlement of a suit for breach of trust or mismanagement of funds by a fiduciary, where the threatened litigation is bona fide” and “arises . . . out of the business of the taxpayer.” Butler, 17 T.C. at 679. And, like the case in Butler, there is no public policy issue with allowing the deduction because Bluso may well be innocent, since his settlement disclaimed wrongdoing. Thus, as was the case with the settlement amount in Butler, the $600,000 settlement here was deductible as a loss incurred in Bluso's business as a fiduciary.
Since Mihelick was presumed to have contributed equally to the production and acquisition of the income from Gotham, she also was presumed to have contributed equally to the ensuing $600,000 liability. And the couple affirmed that presumption through their actions, as Mihelick did pay for her share of that liability. Because she paid for half the liability that she helped create, and because that liability was deductible under § 165(c)(1), Mihelick can take a deduction for her payment under § 165(c)(1).
The panel concludes that Ms. Mihelick has the right to claim the benefits of IRC §1341. Thus, she is allowed to either claim a deduction for the $300,000 paid as a miscellaneous itemized deduction on Schedule A for the year of repayment, or a credit against her tax for the year of repayment equal to the extra tax paid on the prior joint income tax return related to the $300,000 she paid to her ex-husband during the year. Which path she goes down depends on which path results in the lower tax for the year of repayment.