IRC section 1341 - a reversal.
In 1983 Cinergy Corp., a public utility, increased its rates due to financial difficulties. The higher rates were based on, among other things, current and deferred federal income taxes. In 1988 following an improvement in Cinergy's financial condition, the government ordered it to refund part of its prior rate collections, specifically the portion for deferred taxes. The deduction for the refund generated a lower savings than the tax the company paid on the original receipts. Cinergy attempted to calculate the tax using section 1341, and the IRS objected. The taxpayer paid the assessed tax and sued for a refund.
Result. For the IRS. Taxpayers may avail themselves of the special computation in section 1341 if they have met three conditions:
* The taxpayer included an item in income to which it appeared to have an unrestricted right.
* The IRS allowed a deduction in a subsequent year because the taxpayer did not have a right to the item.
* The deduction exceeds $3,000.
The government successfully argued Cinergy did not meet the first two requirements.
The IRS said the taxpayer did not meet the first requirement because it had an actual, not an apparent, right to the income it reported. To qualify for section 1341 a taxpayer must have only an apparent right to the income. Cinergy responded that in prior cases the courts had accepted an actual right as falling within the statute's requirements because the word "appears" does not just refer to an incorrect conclusion. An appeals court found prior cases had conflicting opinions and looked at the legislative history behind section 1341, Based on the review, the court concluded Congress did not intend for taxpayers with an actual right in income to use this provision. Congress had enacted it to help taxpayers that incorrectly reported income under the claim-of-right doctrine only to find out later they did not have a right to the income.
The IRS also argued Cinergy did not meet the second condition because the refund was based on subsequent events rather than on events connected to the original collection and reporting of the income. The court agreed there needed to be a direct nexus between the original reporting of income and its refund. In this case the taxpayer did not demonstrate a connection. The refund was the result of the company's improved financial condition rather than an item that existed when the rate increase was granted. Having failed two of the three requirements, Cinergy could not use section 1341.
This case reopens the question of whether a taxpayer that reports income based on an actual right to it may use section 1341. This most recent decision concludes actual income does not qualify, although several prior cases allowed it to. Although not at issue, the court's reasoning suggests it would side with prior courts and deny section 1341 treatment to any income a company received without a claim of right, such as illegally obtained income (for example, embezzled funds). The case also demonstrates the need for a taxpayer to prove a link between the collection of the income in question and its refund. Given the projected future decreases in tax rates, this limitation on the use of section 1341 will be detrimental for some taxpayers in years to come.
* Cinergy Corp. v. United States, U.S. Court of Federal Claims, March 2003.
For Richer, For Poorer--But Mostly Poorer
Married couples with joint filing status submit less than half of the country's tax returns (48%), yet pay 74% of all U.S. income taxes.
Sources: Tax Foundation, www.taxfoundation.org, 2003.
More Deductions, Higher Cost
Firms charged an average of $208 to prepare an itemized form 1040 in 2002 and about $102 for a nonitemized one. *
* Fees vary sharply by state and region.
Source: National Society of Accountants, www.nsacct.org, 2002.
Prepared by Edward J. Schnee, CPA, PhD, Hugh Culverhouse Professor of Accounting and director, MTA program, Culverhouse School of Accountancy, University of Alabama, "Tuscaloosa.