The Claim of Right Doctrine and Illegally Obtained Funds

The Claim of Right Doctrine and Cousin Jethro

After your Uncle Bill’s unfortunate forklift incident, mentioned here and here, you were surprised to hear that Bill’s idiot boy Jethro got a job at the tannery, especially in light of his somewhat checkered past and run-ins with the law. The more you learn about Jethro’s new job, however, the more it makes sense. Unbeknownst to you, the tanneries of New England are run by a group of families referred to as the “Suede Hand.” You learned about this mafioso-esque group after Jethro showed up to the family reunion in November, which you were somehow swindled into attending, in a brand-new cherry-red Corvette Z06.

Claim of Right DoctrineDespite yourself, you asked Uncle Bill how Jethro’s job at the tannery enabled him to purchase an $85,000 sports car. Bill chuckled, as he is wont to do when there is illegality afoot, and he said simply that the Suede Hand took care of its own. Having ventured down the rabbit hole this far, you asked him for a bit more explanation.

Though you regretted your choice immediately—as, in your family, ignorance is truly bliss—Bill went on to explain the long and storied history of the five families of the Suede Hand, their origins as simple fur trappers, your great-great-great-great grandmother Irma’s marriage into the family (albeit to the black sheep of the family, Bijoux), and the current state of the families’ affairs.

The long and short of Bill’s explanation, which lasted well beyond the clambake and into the hoedown, was that Jethro was being compensated through under the table kickbacks—though Bill called them “loyalty payments.” Though you felt a migraine coming on, you humored Bill when he asked you how the “loyalty payments” should be reported on Jethro’s income tax return. Looking somewhat queerly at Bill’s question, he explained that he had just listened to a biography on Al Capone, and he didn’t want Jethro to get sent back to prison for failing to report any income, ill-gotten or otherwise.

You buried your face in the hands that you knew would be soon typing letters to the IRS on Jethro’s behalf, and you told Bill that he was right to think that Jethro had to report the income, and that you felt uncomfortable providing him any further advice, lest you become involved in any means with the Suede Hand. As Bill began to explain that you were already a member by blood, and that blood was thicker than the income tax code (a mixed metaphor which you did not appreciate), you walked away and asked Aunt Ethel where she kept the aspirin and moonshine.

Claim of Right Payback
They always do…

Not six months later, you received a call from Uncle Bill explaining that Jethro had been asked by some less-than-polite Federal officers to “repay” the “loyalty payments” to the government. You explained to Bill that this “repayment” was actually forfeiture of the kickbacks, and Bill asked you to not quibble with terminology. Because Jethro had reported all of the income on his tax return the year before, and he had been required to repay (forfeit) the funds in the current year, Bill wanted to know whether Jethro could deduct the payments (forfeitures) on his return for the current year under the “claim of right” doctrine.

Your shoulders tense, your heartbeat quickens, and you feel the inchoate signs of a pending migraine. You tell Bill that you will have to look into it, which shuts him up for a minute. You hang up the phone, to 800mg of ibuprofen, rinse it down with cold black coffee, and open up your legal search engine to research whether the claim of right doctrine, arising under IRC § 1341, applies to the restoration of illegally obtained funds.

The Claim of Right Doctrine

According to the IRS, IRC § 1341 governs the computation of income tax if: (i) an amount of income was included in a taxpayer’s gross income in a prior year(s) because it appeared that the taxpayer had an unrestricted right to such item; and (ii) a deduction exceeding $3,000 is allowable in the current taxable year because, after the close of such prior taxable year, it is established that the taxpayer did not have an unrestricted right to all or a portion of such item of income.[1]

The Supreme Court explained the claim of right doctrine in the 1932 decision of North Am. Oil Consol. v. Burnet.[2]

If a taxpayer receives earnings under a claim of right and without restriction as to its disposition, he has received income which he is required to report on his 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.

The Supreme Court explained that, if the taxpayer had been required to restore the equivalent of the money, he would have been entitled to a deduction for the year of the restoration.[3]

To obtain relief under IRC § 1341, a taxpayer must satisfy four requirements.[4]

First, an item of income must have been included in a prior year’s gross income “because it appeared that the taxpayer had an unrestricted right to such item.”[5]

Second, the taxpayer must have later learned that he actually “did not have an unrestricted right” to that income.[6]

Third, the amount the taxpayer did not have an unrestricted right to must have exceeded $3,000.

Fourth, the amount must be deductible under another provision of the tax code.[7]

If the taxpayer can demonstrate these elements, then he has a choice between two options: “he can deduct the item from the current year’s taxes, or he can claim a tax credit for the amount his tax was increased in the prior year by including that item.”[8]

Application of Claim of Right Doctrine to “Illegally Obtained Funds”

The Tax Court has plainly held that IRC § 1341 does not “apply to the restoration of illegally obtained funds.”[9] Although a deduction may be allowable under IRC § 165 with respect to the repayment of illegally received funds as restitution, the provisions of IRC § 1341 will not be applicable in the computation of his income tax liability with respect to such repayment.[10]

No “Unrestricted Right” under IRC § 1341 for Illegal Activity

Why does the claim of right doctrine not apply to illegally obtained funds? The answer is actually pretty straightforward—a taxpayer must have the right to “earnings” in the first place for the doctrine to apply.

Claim of Right KickbackA number of courts have held that a taxpayer is generally not entitled to IRC § 1341 treatment “upon repayment of illegal kickbacks.”[11] The Middle District of Florida noted that the “unrestricted right” language contained in IRC § 1341 “must be read to exclude from its coverage all those who receive earnings knowing themselves to have no legal right thereto.”[12] Similarly, if a taxpayer embezzles, say $90,000, from his employer, even though he dutifully reported and paid taxes on the embezzled money as “miscellaneous income,” and “refunded” the entire amount three years later, the taxpayer will not be entitled to relief under IRC § 1341.[13]

The Supreme Court has held that gain “constitutes taxable income when its recipient has such control over it that, as a practical matter, he derives readily realizable economic value from it.”[14] Even though kickbacks (or other illegally obtained funds) are indeed income, the taxpayer does not hold such income under a “claim of right” because the taxpayer does not have “an unrestricted right to such item.”[15] Simply put, “[w]hen a taxpayer knowingly obtains funds as the result of fraudulent action, it simply cannot appear from the facts known to him at the time that he has a legitimate, unrestricted claim to the money.”[16]

Perhaps the Federal Circuit stated it best when it remarked that if a taxpayer commits an intentional wrong, he must be “prepared for the eventuality of being discovered and being held liable for repayment” in the form of restitution, disgorgement, civil or criminal penalties, or the like.[17]

Plea Agreement & Restitution Not “Same Circumstances” of Income Inclusion

Claim of Right AllegedlyImagine the following scenario, a doctor allegedly submits false claims to his insurance provider, and the insurance company, accordingly, overpays the amount of its reimbursement to the taxpayer.[18] The doctor is ultimately “discovered,” and pursuant to a plea agreement the taxpayer reimbursed the insurance company and, thereafter, claimed a deduction under IRC § 1341.

The Sixth Circuit was having none of this and held that the “obligation to pay the money must arise from the same circumstances, terms and conditions of the transaction whereby the amount was included in income.” Thus, the court held that the money paid based on the plea agreement and the income he had received from his fraudulent reporting (and had, to his credit, included in income) that he had included as income did not result from the same circumstances.[19]

In another Sixth Circuit case, a taxpayer was obligated to pay $1,036,000 as judgment in a suit brought by the FTC to recover certain penalties.[20] The taxpayer argued that this amount arose from his original receipt of salary and dividend payments in an earlier tax year, which was true…but the taxpayer was not, technically “entitled” to such salary and dividends. The Sixth Circuit held that the amount of the penalty bore no relationship to the previous income, and, as such, the claim of right doctrine had no applicability.

Jethro’s Claim of Right Argument

As should be obvious by now, the “claim of right” doctrine will decidedly not help Jethro.

Because the doctrine requires Jethro to receive the income “under a claim of right and without restriction as to its disposition,” and to include the amount in his gross income for the year in which it was received, when it was later “determined” that Jethro must repay the kickbacks, Jethro is entitled to a deduction only where provided by statute (either IRC § 1341 or otherwise).[21] A “claim of right,” however, does not serve to convert the ill-begotten gains, even though reported in full on Jethro’s return, into income to which Jethro had an unrestricted right.[22]

Deductions Still May Be Available in Year of Repayments

Notwithstanding the fact that the IRC §1341 relief is not available, courts have acknowledged that a ne’er-do-well taxpayer may, nonetheless, be entitled to a loss deduction under IRC § 165 the year he repaid the embezzled funds.[23] In another instance, a taxpayer was entitled to deduction under IRC § 1211 against capital gains in the year in which he paid restitution under a plea agreement.[24] Indeed, some courts have even gone so far as to hold that “taxpayers who repay embezzled funds are ordinarily entitled to a deduction in the year in which the funds are repaid” if the restitution is primarily a remedial measure to compensate another party, not “a fine or similar penalty.”[25]

Carrybacks, However, Likely Not Available

It should be noted, however, that taxpayers “generally have been prohibited from carrying back losses arising from repayments of [ill-gotten] funds.”[26] For instance, the courts have held that since embezzlement is not, strictly speaking, a “trade or business,” repayments of embezzled funds are deductible only under IRC § 165(c)(2) as losses incurred in a transaction for profit, rather than under IRC § 165(c)(1), as trade or business losses.

Claim of Right YearUnder IRC § 165(c)(2), an individual taxpayer may claim a loss “incurred in any transaction entered into for profit, though not connected with a trade or business.” Because the IRS has held from time immemorial that illegal income is nonetheless taxable income, a loss related to an endeavor to obtain such ill-begotten income is, technically, a “transaction entered into for profit,” and a loss under IRC § 165(c)(2) may, indeed, be available to the taxpayer.[27]

You imagine that Jethro would argue that although he was not in a “trade or business” of receiving kickbacks, such kickbacks were intended to be a “source of working capital” for a trade or business of tanning hides. This, he would argue, would require the classification of the repayment as a “business loss,” which should be taken into account in full for net operating loss purposes, because it was “inextricably intertwined” with his alleged securities business.[28]

Unfortunately for Jethro, the Tax Court has previously held that an analogous argument was wholly without merit.[29] Consequently, because IRC § 165(c)(2) deductions are not included in net operating losses to the extent provided by IRC § 172(d)(4), they may not be carried back by a taxpayer.[30]

The Ill-Fated Phone Call

You prophylactically take a handful of ibuprofen tablets and wait for twenty minutes until they kick in to call Uncle Bill. To your surprise, Aunt Ethel answers. Before you can ask her to have Bill call you back, she begins to question you about Jethro’s “claim of right” argument. As you’ve mentioned before, Ethel has what can only be described as a jailhouse legal degree with a concentration in tax. Thus, Ethel’s questions are uncomfortable, probing, and discouragingly on point.

Claim of Right HeadacheYou explain that, although Jethro will not be able to make a “claim of right” argument, surprisingly, he will likely be able to make an argument under IRC § 165(c)(2) that he is entitled to take a personal loss on the “repayment” of the kickbacks from the Suede Hand. Ethel grunts in some sort of redneck approbation, and you hang up as soon the opportunity presents itself…before another one of Bill and Ethel’s idiot boys that something to implicate the Internal Revenue Code and your services.


  1. Rev. Rul. 2004-29
  2. 286 U.S. 417, 424 (1932).
  3. Id.; see also Barrett v. Commissioner, 96 T.C. 713, 716 (1991); United States v. Skelly Oil Co., 394 U.S. 678, 681 (1969).
  4. Mihelick v. United States, 927 F.3d 1138, 1143 (11th Cir. 2019).
  5. IRC § 1341(a)(1).
  6. See IRC § 1341(a)(2).
  7. Fla. Progress Corp. & Subsidiaries v. Commissioner, 348 F.3d 954, 959 (11th Cir. 2003).
  8. Id. at 957.
  9. O’Hagan v. Commissioner, T.C. Memo. 1995-409; Yerkie v. Commissioner, 67 T.C. 388, 390 (1976).
  10. Rev. Rul. 65-254.
  11. Perez v. U.S., 553 F.Supp. 558, 560-61 (M.D. Fla. 1982); see also Zadoff v. United States, 638 F.Supp 1240, 1243 (S.D. N.Y. 1985).
  12. Id.
  13. See McKinney v. United States, 574 F.2d 1240, 1241 (5th Cir. 1978).
  14. Rutkin v. United States, 343 U.S. 130, 136 (1952).
  15. Perez, 553 F.Supp. at 1243 (citing Treas. Reg. § 1.1341-1(a)(1); Treas. Reg. § 1.1341-1(a)(2)).
  16. Culley v. United States, 222 F.3d 1331, 1335 (Fed. Cir. 2000); see also Parks v. United States, 945 F.Supp. 865, 866–67 (W.D.Pa.1996) (denying taxpayers’ motion for summary judgment because there would be no unrestricted right to proceeds of sale of business if allegations of fraud were proven at trial); Zadoff v. United States, 638 F.Supp. 1240, 1243 (S.D.N.Y.1986) (no unrestricted right to illegal kickbacks and salary received while acting in a manner disloyal to employer); Wang v. Commissioner, T.C. Memo 1998-389 (no unrestricted right to profits from sale of insider information in violation of securities laws); Yerkie, 67 T.C. at 392 (no unrestricted right to embezzled funds).
  17. Culley, 222 F.3d at 1336.
  18. Kraft v. United States, 991 F.2d 292, 298-99 (6th Cir. 1993).
  19. Id.
  20. Bailey v. Commissioner, 756 F.2d 44 (6th Cir. 1985); see also Dominion Resources Inc., v. United States, 219 F.3d 359 (4th Cir. 2000) (same).
  21. Culley, 222 F.3d at 1336.
  22. Id.; see also Yerkie, 67 T.C. 388, 392 (1976) (holding that “[t]he inclusion of embezzled funds as gross income and the concomitant right to a deduction upon repayment neither categorizes embezzled proceeds as income rightfully received nor bestows upon these funds the characteristics of income received under a claim of right”).
  23. McKinney, 574 F.2d at 1231 (noting that the “Government does not dispute the taxpayer’s entitlement to a deduction for the year [the funds were paid back]”); see also Wood v. United States, 863 F.2d 417, 420 (5th Cir. 1989).
  24. Culley, 222 F.3d at 1336.
  25. Stephens v. Commissioner, 905 F.2d 667, 671 (2d Cir. 1990).
  26. Mannette v. Commissioner, 69 T.C. 990, 992–93 (1978).
  27. Fox v. Commissioner, 61 T.C. 704, 713-14 (1974).
  28. Id.
  29. Id. At 993.
  30. Id.; see also Yerkie, 67 T.C. at 393 (holding that “[i]t can hardly be said that embezzlement is an activity or function of employment or is a result which arises from one’s rights and obligations as an employee. To the contrary, employers have every right to expect adherence to standards of integrity and honor from the people they hire. We reject the concept that embezzlement and the repayment of embezzled funds constitute an aspect of the trade or business of a salaried employee”); Hankins v. United States, 403 F. Supp. 257 (N.D. Miss.); Rev. Rul. 65-254.
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