In Mihelick v. United States, the Court of Appeals for the Eleventh Circuit (Eleventh Circuit) reversed a US district court's grant of summary judgment in favor of the government, finding that a wife who paid her half of a settlement liability met the requirements for IRC Section 1341 relief.¹ The Eleventh Circuit also remanded the case to the district court to determine whether any factual issues needed to be resolved regarding the IRC Section 1341 requirements, and advised the district court to find in favor of the taxpayer if there were none.

Background

Nora Mihelick and her ex-husband, Michael Bluso, worked at Gotham Staple from 1999 to 2004. Gotham Staple was a closely held Ohio corporation owned by Bluso's family. Mihelick and Bluso filed joint tax returns and paid the taxes on the income they earned at Gotham Staple.

Mihelick and Bluso filed for divorce in 2004. While the divorce was pending, Bluso's sister sued Bluso, Gotham, and others, claiming that Bluso breached his fiduciary duties by overcompensating himself. Although Mihelick was not a party named in the suit, she agreed in their marital separation agreement to be held jointly and severally liable in the result of the suit.

The divorce was final in 2005, and Bluso settled the lawsuit with his sister in 2007 for $600,000. Bluso claimed a tax deduction for $300,000, and Mihelick paid him $300,000 in 2009 for her half of the $600,000 settlement. Mihelick then filed a refund claim for the $300,000 she paid to Bluso, but the IRS denied her claim. Mihelick sued the government, but the district court agreed with the government and granted summary judgment against her. She appealed that decision.

Holding

A taxpayer must satisfy the following four requirements to obtain IRC Section 1341 relief:

1. The taxpayer must have included an item of income in a prior year's income because "it appeared that the taxpayer has an unrestricted right to such item."
2. The taxpayer must have learned later that he or she did not have an unrestricted right to the income.
3. The amount to which the taxpayer did not have an unrestricted right must exceed $3,000.
4. The amount must be deductible under another provision of the Code.

If these requirements are met, the taxpayer can choose to deduct the income amount from the current year's taxes or claim a credit for the amount the tax would decrease if the repayment amount were excluded from income in the prior year.

Because the amount in this case exceeded $3,000, the Eleventh Circuit addressed the remaining requirements to determine whether Mihelick qualified for IRC Section 1341 relief. The district court had held that Mihelick could not show that the amount was deductible.

Mihelick appeared to have an unrestricted right to the income in the year of inclusion

Rejecting the government's argument that Mihelick did not appear to have an unrestricted right to the income, the Eleventh Circuit found that there was enough evidence to prove Mihelick believed she had an unrestricted right to Bluso's income from 1999 to 2004. In determining whether the appearance requirement is satisfied, the court stated, the key question is framed and considered from the taxpayer's subjective viewpoint, even if that belief is not completely reasonable. The Eleventh Circuit pointed to the separation agreement, which stated that Bluso and Mihelick had an equal right to the family income and would be "equally responsible for any liability arising from Bluso's compensation." Additionally, the court observed that Ohio law treats income from labor as marital property and each spouse is "'considered to have contributed equally to the production and acquisition of marital property.' Ohio Rev. Code [Section] 3105.171." Also, Ohio requires "[m]arital property to be divided equally upon divorce, unless doing so would be inequitable." Therefore, the court concluded that Bluso's income was marital property to which Mihelick had an equal right.

Although Mihelick and Bluso did not enter into divorce proceedings until September 2004, the court also found that Mihelick was not precluded from relying on Ohio Rev. Code Section 3105.171's presumption that she contributed equally to the production and acquisition of marital property, which in this case was Bluso's income from 1999 to 2004.

Later determined that Mihelick did not have an unrestricted right to the income

To determine whether she did not have an unrestricted right to the income, Mihelick had to show that: (1) an obligation made her involuntarily give away the income, and (2) "the obligation had a substantive nexus to the original receipt of the income." The Eleventh Circuit found that Mihelick met both requirements because she involuntarily gave away the $300,000 to which she thought she had an unrestricted right, and a settlement payment can be an involuntary obligation for IRC Section 1341 purposes. In addition, the court observed that "Mihelick reasonably anticipated litigation and settled in good faith in the shadow of litigation," making her $300,000 payment involuntary for IRC Section 1341 purposes.

The Eleventh Circuit also ruled that Mihelick's payment had substantive nexus to the receipt of the original income. The court noted that the $300,000 of income was presumptively from the shared marital estate, and she paid that amount in settlement of the lawsuit after agreeing to split the $600,000 liability resulting from the lawsuit. Accordingly, Mihelick's payment stemmed from the original receipt of the income.

Mihelick can deduct the $300,000 payment under another Code section

The Eleventh Circuit held that Mihelick could deduct her payment under IRC Section 165(c)(1), which permits an individual to claim a deduction for uncompensated "losses incurred in a trade or business" during the tax year. Citing Butler v. Comm'r, 17 T.C. 675 (1951), the court found that the "settlement payment was made 'in settlement of a suit for breach of trust or mismanagement of funds by a fiduciary, where the threatened litigation is bona fide' and 'arises … out of the business of the taxpayer.'" The court also noted that there is no public policy reason for disallowing the deduction because Bluso could be innocent and disclaimed wrongdoing in the settlement agreement. Therefore, the $600,000 payment was deductible because it was a loss incurred in Bluso's business as a fiduciary.

Additionally, the Eleventh Circuit found that Mihelick was presumed to have contributed equally to the $600,000 liability just as she was presumed to have contributed equally to the production and acquisition of the income from Gotham. Because the liability was deductible under IRC Section 165(c)(1), she may claim a deduction for her half of the payment.

Reversed and remanded in favor of taxpayer

The Eleventh Circuit reversed the district court's grant of summary judgment in favor of the government and remanded the case to the district court for it to determine whether any factual issues needed to be resolved for each prong of IRC Section 1341. If fact issues existed, then the case should proceed to trial. If no factual issues existed, the Eleventh Circuit directed the district court to enter judgment for Mihelick.

Implications

This is an important post-TCJA case as it shows that courts may read IRC Section 1341 expansively in a manner that is consistent with its remedial and equitable intent. The court interpreted the appearance and substantial nexus questions broadly, which was favorable to the taxpayer. Especially favorable was the court's discussion that the existence of a good faith right to the income should be considered from the taxpayer's perspective, even if that belief is not completely reasonable.

Given the decrease in corporate income tax rates (e.g., 35% to 21%), companies should analyze and evaluate any potential repayments to see if they are eligible for IRC Section 1341 relief. The potential for a 14 percentage point savings is worth taking a hard look at any and all refunds or repayments in the first year or two following such a dramatic rate decrease.

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ENDNOTE

¹ If its requirements are satisfied, IRC Section 1341 effectively enables a taxpayer to deduct a payment at the same tax rate it was included in taxable income in an earlier year, even if tax rates have decreased.