Mihelick, (CA 11 6/18/2019) 123 AFTR 2d ¶2019-791
The Court of Appeals for the Eleventh Circuit has reversed a district court decision and held that a payment a divorcee made to her ex-husband pursuant to their divorce agreement was a deductible loss under Code Sec. 165(c)(2) and, therefore, qualified for treatment under the claim of right doctrine under Code Sec. 1341.
Background. Losses sustained during the tax year and not compensated for by insurance or otherwise may be deductible. (Code Sec. 165) Generally, an individual’s uncompensated losses incurred in a trade or business during the tax year (Code Sec. 165(c)(1) and losses incurred in any transaction entered into for profit are deductible. (Code Sec. 165(c)(2))
Code Sec. 1341 confers certain tax benefits if the taxpayer establishes that: (1) an item was included in gross income for a prior tax year (or years) because it appeared that the taxpayer had an unrestricted right to such item; (2) after the close of such prior tax year (or years) the taxpayer discovers she did not have an unrestricted right to such item or to a portion of such item; (3) the amount the taxpayer did not have unrestricted right to exceeded $3,000; and (4) the item was deductible under a provision in the Code other than Code Sec. 1341.
If a taxpayer can establish these elements, she can either: (1) deduct the item from the current year’s tax return; or (2) claim a tax credit for the amount her tax increased in the prior year by including that item. (Reg §1.1341-1(b))
To show that she did not have an unrestricted right to the income included in the prior year, the taxpayer must demonstrate that: (1) she involuntarily gave away the relevant income because of some obligation; and (2) the obligation had a substantive nexus to the original receipt of the income. (Batchelor-Robjohns, (CA 11 2015) 115 AFTR 2d 2015-2060)
Facts. Ms. Mihelick was married for many years to Mr. Bluso. Mr. Bluso was the CEO and majority shareholder of Gotham, a privately held corporation from which he drew a salary of approximately $1 million per year. While they were married, the couple filed joint returns.
After they were divorced, Mihelick and Bluso learned they had to return $600,000 of the income they had received from Gotham. This meant that the couple had paid taxes on $600,000 they didn’t get to keep. Since Mihelick and Bluso had both benefited from the income at issue, they agreed to split the liability evenly. So Bluso returned the full $600,000, and Mihelick reimbursed him $300,000 for her share. Bluso then deducted the $300,000 he returned using the claim of right doctrine under Code Sec. 1341. However, when Mihelick tried to do the same thing, the IRS denied her request.
District court’s decision. In Mihelick, (DC FL 2017) 120 AFTR 2d 2017-6146, the district court determined that Code Sec. 165(c)(2) did not apply and, therefore, the taxpayer was not entitled to a deduction for the $300,000 she reimbursed her husband. The district court held that Mihelick was attempting to deduct a repayment of Bluso’s excessive compensation from Gotham. However, Bluso’s excessive compensation was neither a loss nor a transaction entered into for profit under Code Sec 165 and, therefore, didn’t qualify for deduction under Code Sec. 1341.
Payment was deductible loss. The Appeals Court disagreed with the district court’s decision and held that Mihelick’s payment to her ex-husband was a deductible loss under Code Sec. 165 and, therefore, was eligible for treatment under the claim of right doctrine in Code Sec. 1341.
The Appeals Court rejected the IRS’s argument that Mihelick could not meet the Code Sec. 1341 tests because she did not have an unrestricted right to her ex-husband’s income and her payment to her ex-husband was not deductible under Code Sec. 165. The Appeals Court said that, under Code Sec. 1341, what mattered was that Mihelick sincerely believed she had a right to Bluso’s income, not the correctness of her belief.
According to the Appeals Court, there was enough evidence to show that Mihelick genuinely believed she had an unrestricted right to Bluso’s income. For example, their divorce agreement reflected the couple’s belief that each spouse had an equal right to the family income and both would be equally responsible for any liability arising from Bluso’s compensation.
Moreover, Mihelick had reason to believe that she had a presumptive right to Bluso’s income under state (Ohio) law, which provides that each spouse is considered to have contributed equally to the production of income and acquisition of marital property. (Ohio Rev Code §3105.171)
Further, the Appeals Court found that Mihelick involuntarily repaid the $300,000. Mihelick’s obligation to pay the $300,000 arose from her divorce agreement and, after she refused to pay, her attorney told her she had a legal obligation to reimburse Bluso for her half of the $600,000. Mihelick did not need to wait to be sued by her ex-husband for her payment to be considered involuntary. Therefore, Mihelick’s $300,000 payment to her ex-husband was involuntary for purposes of Code Sec. 1341.
Also, there was substantive nexus between Mihelick’s obligation to pay and her receipt of the original income. The income was originally part of Mihelick and Bluso’s marital estate, and she agreed to split the liability in her divorce agreement. Thus, Mihelick’s payment ultimately stemmed from her and Bluso’s original receipt of the income at issue.
Finally, the total $600,000 was deductible as a loss incurred in Bluso’s business as a CEO under Code Sec. 165(c)(1). In fact, Bluso deducted his share of the $600,000 payment under Code Sec. 1341 without a problem.
Since Mihelick contributed equally to the production and acquisition of the income, she also contributed equally to the $600,000 liability. Since she paid for half of the liability she helped to create, Mihelick was entitled to a deduction for her payment under Code Sec. 165(c)(1).
References: For losses incurred in a transaction entered into for profit, see FTC 2d/FIN ¶M-1510; United States Tax Reporter ¶1654. For claim of right doctrine, see FTC 2d/FIN ¶J-8001; United States Tax Reporter ¶614.003.