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1341 claim of right and 162(f)(2) deduction

Technical topics regarding tax preparation.
21-Apr-2014 9:28am
Company probably violated some state rules generally similar to a Fed Trade Commission violation and is considering a settlement with the state that would involve “restitution” via a payment to the state. The amount paid to the state will be based to a large extent on the income the company received from the sales that the state believes violated their consumer laws. The income was reported in 2016 and the payment to the state will occur in 2019.

Tax issues:

162(f)(2) was added by TCJA, and it says that (f)(1), which disallows fines and penalties, does not apply to payments constituting restitution. But is this payment restitution if it is paid to the state, not the consumers? If it’s not, then it may not be deductible and therefore fails this requirement of 1341: "(a)(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;"

162(f)(2)(A)(ii) requires that the settlement documents identify the payment as “restitution”, which they expect to happen, but the law goes on to say "The identification under clause (ii) alone shall not be sufficient to make the establishment required under clause (i)." So no matter how well written the settlement documents are, there is more that is required.

1341’s claim of right rules will be very helpful if they apply. It did appear to the company that it had an unrestricted right to the income in 2016. But some court cases (pre-TCJA if that matters) have held that 1341 requires that a “nexus” of sorts is required between the receipt of the income in the earlier year and the “establishment” in the later year that the company did not have an unrestricted right to the income. Do we run afoul of this court-created nexus rule?

Alcoa is one of the relevant cases. . It discusses in detail what the court felt was the nexus required. For example, "There is no substantive nexus that can be recognized for our purposes between the waste disposal expenses Alcoa did not incur in 1940 to 1987 and its clean-up expenses in 1993.” Alcoa also cites Cinergy and Arrowsmith. So does the required nexus exist here?

Then there are the Nacchio cases, which are a mixed bag of problem and support for our goals. ... 2016.1.PDF (Federal Circuit case in 2016) and ... ed-states/ (Claims Court case in 2014). The “restitution” provision was not yet in the law, but the Appeals Court held that the settlement of an insider trading profit disgorgement was in the nature of a penalty and therefore not a 162 deduction and therefore also not eligible for 1341 treatment. This may be a concern in our facts. On the other hand, the cases do not mention the nexus requirement, either because the courts felt they did not even need to address it because they got to the result by the penalty route, or (more hopefully), because they did not agree with it.

All input welcome, even though most of us have likely not had much experience in this group of issues.

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