Should a Taxpayer be Liable for Tax on Income She Didn’t Receive?

Not even the IRS could go after someone for income they didn’t receive, right? Well, wrong. And when the taxpayer filed a lawsuit to reverse the result, she lost. She appealed to the Eleventh Circuit where the Court had a slightly different view of taxes than the government.

The story begins when her ex-husband is subject of a lawsuit (they were married at the time). It became clear the lawsuit would last longer than the marriage, and the couple agreed that they’d be equally liable for the judgment (if any). The couple divorced; later, the ex-husband settled the lawsuit for $600,000. He paid that to the plaintiff; he also filed a claim on his tax return for the $300,000 he paid. The IRS had no problem with that.

Per the divorce agreement, she reimbursed him $300,000. She also took a deduction under Section 1341 of the Internal Revenue Code. The IRS said no you don’t. She asked for relief in court. The district court granted summary judgment to the IRS. She appealed.

The Appellate Court looked at what’s necessary for relief: To obtain relief under § 1341, a taxpayer must satisfy four requirements.

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.” § 1341 (a)(1). Second, the taxpayer must have later learned that she actually “did not have an unrestricted right” to that income. See § 1341(a)(2). Third and fourth, the amount the taxpayer did not have an unrestricted right to must have exceeded $3,000 and be deductible under another provision of the tax code. Fla. Progress, 348 F.3d at 957, 959. If the taxpayer can demonstrate these elements, then she has a choice between two options: “[s]he can deduct the item from the current year’s taxes, or [s]he can claim a tax credit for the amount [her] tax was increased in the prior year by including that item.”

The government disputed whether the taxpayer had an unrestricted right to the income. The lawsuit claimed that there was misappropriation of funds. “But here, the record lacks any proof that [the ex-husband] knowingly misappropriated income, since his settlement agreement with [B] expressly disclaimed any wrongdoing.” The government also claimed that she had no presumptive right to the ex-husband’s income. “First, even if the government’s assertion were correct, it makes no difference to the § 1341 analysis. What matters is whether [she] sincerely believed she had a right to [his] income, not the correctness of her belief.”

The next part of Section 1341 is for the taxpayer to establish that “after the close of a taxable year, ‘the taxpayer did not have an unrestricted right’ to some amount she initially reported as taxable income. To make this showing, the taxpayer must demonstrate that she involuntarily gave away the relevant income because of some obligation, and the obligation had a substantive nexus to the original receipt of the income.” The government said that she voluntarily gave away the income. The Court disagreed.

[Her] situation is materially indistinguishable. As with Barrett, her obligation to pay arose not from a final judgment, but from an agreement she entered in good-faith to avoid litigation. And it would be equally as “ludicrous”—as it was in Barrett to say that Barrett voluntarily paid his $54,000—to conclude that [she] voluntarily paid $300,000 of her income without regard to any legal obligation.

Indeed, she initially opposed paying [her ex-husband] for any liability arising from the…lawsuit. Only after [the plaintiff in the lawsuit] threatened her with litigation did she agree to be bound to do so and enter into Article 5 of her separation agreement…

[She] also paid an attorney to advise her of her rights, and that attorney told her that she had an “obligation” to pay [the plaintiff]. Under these circumstances—and particularly in light of the desirability of fostering settlements without litigation—[she] did not need to wait to be sued before settling and paying for her payment to be considered involuntary. Because the record reflects [she] reasonably anticipated litigation and settled in good faith in the shadow of litigation, her $300,000 payment was involuntary for purposes of § 1341.

The Court also noted that the obligation to pay must relate to the original receipt of income, and that she clearly established that.

There’s one more element that must be met:

Finally, to qualify for § 1341 relief, Mihelick must show that her $300,000 payment is deductible under another provision of the tax code. Fla. Progress, 348 F.3d at 958-59. Mihelick can meet this element, as she can deduct her payment under 26 U.S.C. § 165(c)(1), which allows deductions for an individual’s uncompensated “losses incurred in a trade or business” during the taxable year.

Given that the ex-husband was the CEO and majority shareholder, and that the lawsuit alleged that he breached his fiduciary duty while acting as CEO, the lawsuit related to the income and can be deducted.

The Court began the decision as follows:

Inscribed above the main entrance of the Internal Revenue Service office in Washington, D.C., is a quotation from Supreme Court Justice Oliver Wendell Holmes Jr.: “Taxes are what we pay for a civilized society.”…An admirable outlook, yet even Justice Holmes would likely agree that it is uncivilized to impose taxes on citizens for income they did not ultimately receive. But that is precisely the result the government asks us to uphold today. [citation omitted]

The Court rightly chastised the IRS and US government for being uncivilized.

Case: Mihelick v. United States

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