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Deduction for restoring item held under claim of right.

If, during a tax year (year 2), a taxpayer is entitled to deduction exceeding $3,000 because the taxpayer restores to another person an item that was included in the taxpayer's gross income for a prior tax year (year 1), year 2's tax is the lesser of

--the tax for year 2, computed with this deduction (Sec. 1341(a)(4)); or

--the tax for year 2, computed without this deduction, but reduced by the decrease in year 1's tax that would result from excluding the item from year 1's gross income (Sec. 1341(a)(5)).

Regs. Sec. 1.1341-1(d)(2)(i) limits its the Sec. 1341(a)(5) exclusion to the amount previously included in gross income. However, there is no comparable regulatory (or statutory) limitation on the Sec. 1341(a)(4) deduction.

Nevertheless, in Skelly Oil Co., 394 US 678 (1969), the Supreme Court held that

the Code should not be interpreted to allow respondent "the practical equivalent of double deduction," ... absent a clear declaration of intent by Congress.... Accordingly, to avoid that result in this case, the deduction allowable in the year of repayment must be reduced by the percentage depletion allowance which respondent claimed and the Commissioner allowed in the years of receipt as a result of the inclusion of the later-refunded items in respondent's "gross income from the property" in those years. Any other approach would allow respondent a total of $1.27 1/2 in deductions for every $1 refunded to its customers. (Citations omitted.)

Example: T received a $10,000 oil royalty in 1991 and claimed a $1,500 depletion deduction. Thus, T's 1991 gross income was increased by $8,500. However, T refunds this $10,000 royalty in 1992 because it was established in 1992 that T did not have an unstricted right to that royalty.

In computing T's 1992 tax under Sec. 1341(a)(5), T can exlude only $8,500 from his 1991 income. On the other hand, in computing T's 1992 tax under Sec. 1341(a)(4), there is no specific statutory or regulatory prohibition against T claiming a $10,000 deduction. Nevertheless, under Skelly, T's 1992 Sec. 1341(a)(4) deduction also is limited to $8,500.
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Article Details
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Author:Dudzinsky, Robert J.
Publication:The Tax Adviser
Article Type:Brief Article
Date:May 1, 1992
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