Van Cleave v. U.S.

• Decision Date: 05 October 1983
• Docket Number: No. 82-1162,82-1162
• Citation: 718 F.2d 193
• Parties: 83-2 USTC P 9620 Eugene Van CLEAVE and Carol Van Cleave, Plaintiffs-Appellants, v. UNITED STATES of America, Defendant-Appellee.
• Court: U.S. Court of Appeals — Sixth Circuit

Page 193

718 F.2d 193

83-2 USTC P 9620

Eugene Van CLEAVE and Carol Van Cleave, Plaintiffs-Appellants, v. UNITED STATES of America, Defendant-Appellee.

No. 82-1162.

United States Court of Appeals Sixth Circuit.

Argued May 24, 1983.

Decided Oct. 5, 1983.

Lawrence J. Ross (argued), Washington, D.C., David A. Guberman, Sherin and Lodgen, Boston, Mass., for plaintiffs-appellants.

Leonard R. Gilman, U.S. Atty., Detroit, Mich., Glenn Archer, Michael L. Paup, Richard W. Perkins, Libero Marinelli (argued), Dept. of Justice, Tax Div., Washington, D.C., for defendant-appellee.

Before ENGEL and KRUPANSKY, Circuit Judges and BROWN, Senior Circuit Judge.

BAILEY BROWN, Senior Circuit Judge.

This appeal involves a claim of favorable income tax treatment under 26 U.S.C. Sec. 1341 by a taxpayer who in a subsequent year paid back excessive compensation to the corporation which employed him. The taxpayer included this excessive compensation in his return for the year the compensation was received. The government concedes that taxpayer is entitled to a deduction in the subsequent year. Taxpayer contends, however, that he should be allowed, pursuant to Section 1341, more favorable tax treatment by in effect excluding the excessive compensation from his income in the year received, thereby reducing his tax liability for that year and receiving a credit against his tax liability for the subsequent year. The district court, after a bench trial, entered judgment for the government in taxpayer's refund action and taxpayer appealed. We reverse and hold that taxpayer is entitled to the benefit of Section 1341.

BACKGROUND

The taxpayer, Eugene Van Cleave, was president and majority stockholder of Van-Mark Corporation throughout the time in question. In 1969, the corporation adopted a by-law requiring corporate officers who received from the corporation income determined by the Internal Revenue Service (IRS) to be excessive--and so not deductible by the corporation as a business expense--to pay back the amount determined to be excessive to the corporation. In addition, Mr. Van Cleave entered into a separate agreement requiring him to reimburse the corporation for nondeductible compensation.

Mr. Van Cleave received $332,000 in salary and bonuses in 1974. During 1975, the IRS audited the corporation's return, determined that $57,500 of Mr. Van Cleave's salary was excessive, and disallowed that portion of his salary as a deduction to the corporation. In December, 1975, pursuant to the corporation's by-law and the agreement between Mr. Van Cleave and the corporation, Mr. Van Cleave repaid the nondeductible $57,500.

Mr. Van Cleave reported the full compensation on his calendar year 1974 income tax return. On his 1975 return, prepared with the repayment to the corporation in mind, he calculated his tax liability by using 26 U.S.C. Sec. 1341. The IRS audited the return, and allowed a deduction for 1975 but disallowed use of Section 1341, resulting in a tax deficiency of $5,987.34. Mr. Van Cleave paid this deficiency and brought this action for a refund.

This case turns on the interpretation of Section 1341 of the Internal Revenue Code. Section 1341 provides, in pertinent part:

(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).

See also Treasury Regulation Sec. 1.1341-1, which provides:

(a)(1) If, during the taxable year, the taxpayer is entitled under other provisions of chapter 1 of the Internal Revenue Code of 1954 to a deduction of more than $3,000 because of the restoration to another of an item which was included in the taxpayer's gross income for a prior taxable year (or years) under a claim of right, the tax imposed by chapter 1 of the Internal Revenue Code of 1954 shall be the tax provided in paragraph (b) of this section.

Section 1341 was enacted by Congress to mitigate the sometimes harsh result of the application of the "claim of right" doctrine. United States v. Skelly Oil Co., 394 U.S. 678, 681, 89 S.Ct. 1379, 1381, 22 L.Ed.2d 642 (1969); H.R.Rep. No. 1337, 83d Cong., 2d Sess., 86-87 reprinted in 1954 U.S.Code Cong. and Ad.News 4017, 4436; S.Rep. No. 1622, 83d Cong., 2d Sess., 118-19, reprinted in 1954 U.S.Code Cong. and Ad.News 4621, 5095. Under the claim of right doctrine, a taxpayer must pay tax on an item in the year in which he receives it under a claim of right even if it is later determined that his right to the item was not absolute and he is required to return it. The taxpayer, however, is allowed to deduct the amount of the item from his income in the year of repayment. This result was held to be required because income and deductions are determined on an annual basis. Skelly at 681, 89 S.Ct. at 1381. But, as pointed out by the Supreme Court in Skelly, it is possible for a taxpayer to benefit less from the deduction in the year of repayment than he would benefit if he had been able to deduct the amount repaid from his income in the year of receipt. Id. This result of the claim of right doctrine could occur when, as was the case with Mr. Van Cleave, the taxpayer had been in a higher tax bracket in the year of receipt than he was in the year of repayment.

Section 1341 allows the taxpayer to choose the more favorable alternative as follows:

If the taxpayer included an item in gross income in one taxable year, and in a subsequent taxable year he becomes entitled to a deduction because the item or a portion thereof is no longer subject to his unrestricted use, and the amount of the deduction is in excess of $3,000, the tax for the subsequent year is reduced by either the tax attributable to the deduction or the decrease in the tax for the prior year attributable to the removal of the item, whichever is greater. Under the rule of the Lewis case (340 U.S. 590, 71 S.Ct. 522, 95 L.Ed. 560 (1951)) [see infra ], the taxpayer is entitled to a deduction only in the year of repayment.

H.R.Rep. No. 1337, 83d Cong.2d Sess., 86-87, reprinted in 1954 U.S.Code Cong. and Ad.News 4017, 4436; S.Rep. No. 1622, 83d Cong.2d Sess., 118-19, reprinted in 1954 U.S.Code Cong. and Ad.News 4621, 5095.

I.

The district court held that Section 1341 treatment was not available to Mr. Van Cleave because it determined that his repayment was voluntary. The district court determined that it was voluntary because Mr. Van Cleave owned a substantial majority of the stock and in that sense controlled the corporation. On appeal, however, the government does not contend that Section 1341 is inapplicable because the repayment was voluntary and indeed does not contend that the repayment in fact was voluntary.

The district court also seemed to be persuaded by the argument that, if Mr. Van Cleave were allowed Section 1341 treatment under these circumstances, this would open the door to tax avoidance in that taxpayers who controlled corporations could "test the waters" in setting their compensation without risk of an adverse tax result. We believe, however, that such possibility of tax avoidance is not a proper consideration in applying this statute, and that the consideration is a legislative rather than a judicial consideration. Moreover, as Mr. Van Cleave suggests, the possibility of tax avoidance could be reduced by requiring the corporation and recipient of compensation to state in their returns that such compensation was paid subject to an obligation to reimburse in the event a deduction is disallowed to the corporation.

II.

The leading case on the claim of right tax doctrine is North American Oil Consolidated v. Burnet, 286 U.S. 417, 52 S.Ct. 613, 76 L.Ed. 1197 (1932). North American Oil involved a dispute over the year in which income, earned on property held by a receiver during a title dispute between the taxpayer and the government, was to be taxed. The possibilities were 1916, the year in which the income was earned; 1917, the year in which the district court ruled in favor of the taxpayer and the money was paid to the taxpayer; or 1922, the year the litigation was finally terminated in the taxpayer's favor. In an opinion by Justice Brandei...