Claim of Right Doctrine
The Claim of Right doctrine offers benefits to taxpayers who have included an amount in income in one tax year but have had to repay all or part of it in a later year.
Transactions Covered by the Doctrine
The doctrine can apply to most any type of transaction in which a taxpayer receives income, other than one involving sale of inventory. Thus, required repayments of wages, commissions, alimony, social security, capital gain income, etc., can all be covered by the claim of right provisions.
Deduction vs. Tax Credit in the Repayment Year
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Repayments of $3,000 or less – If the amount repaid is $3,000 or less, deduct it from the taxpayer’s income in the year the taxpayer repaid it. The repayment is generally deducted on the same form or schedule on which the income was previously reported. For example, if it was reported as self-employment income, deduct it as a business expense on Schedule C (Form 1040) or Schedule F (Form 1040). If reported as a capital gain, deduct it as a capital loss on Form 8949 (1040 Schedule D). If reported as wages, unemployment compensation, or other non-business income, it is a Schedule A Tier 2 miscellaneous itemized deduction. BUT - see next!
Years 2018-2025: Tier 2 miscellaneous itemized deductions (those subject to the 2% of AGI reduction) are suspended by the TCJA starting with 2018 and through 2025. Therefore, during this period taxpayers making repayments of $3,000 or less that aren’t related to a business or capital transaction are effectively prohibited from deducting these payments.
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Repayments over $3,000 (no change by TCJA) - If the amount repaid was more than $3,000, the taxpayer can deduct the repayment as explained above (except as a Tier 1 (no 2% of AGI reduction) miscellaneous deduction if itemizing deductions) OR as a tax credit based on the difference in tax with or without the repaid income in the year the income was originally reported. Make both computations and select the one that provides the greater benefit.
The Calculations for Repayments Over $3,000
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Computation - Repayment Year,
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Step I: Compute the tax for the year in the usual manner without considering the repayment.
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Step II: Deduct the repayment as a Tier 1 (not a Tier 2) itemized deduction and recompute the tax.
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Step III: Subtract the tax computed in Step II from tax computed in Step I; the difference is the potential tax savings using the current-year deduction.
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Computation - Year the income was originally reported - In this step, determine how much tax would have been saved if the repayment amount had never been included in income in the first place., To do this, recompute the tax for the year of income receipt without including the repaid amount., Subtract the result from the tax as originally reported., The difference is the amount of allowable tax credit potentially available in the repayment year.
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Compare the results of (A) and (B). Determine which results in the lesser tax in the repayment year, claiming the deduction or the credit. There is no government form with which to make the computation or claim the credit, but when claiming the credit, it should be claimed as part of credits and payments made on Schedule 3, Part II, line 13d for 2021 – Credit for repayment of amounts included in income from earlier years.
Example - Claim of Right Computation – Note: The 2022 tax tables were not available when this example was updated, so 2021 is used in the example. In 2021, James, a single taxpayer, was required to repay $5,000 he had reported as wages under claim of right in 2019. The following schedule compares his 2019 and 2021 tax liabilities, both with and without the repaid wages.
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| 2019: | With Wages | Without Wages |
| Taxable Income | $15,000 | $10,000 |
| Tax Liability | $1,609 | $1,009 |
| Tax Savings (Credit Method)..........$600 | ||
| 2021: | Without Deduction | With Deduction |
| Taxable Income | $49,950 | $44,950 |
| Tax Liability | $6,743 | $5,643 |
| Tax Savings (Deduction Method)......$1,100 |
James was in the 12% tax bracket in 2019, and the 22% bracket in 2021. Thus, the deduction method, based on '21 rates, exceeds the credit method based on '19 rates. He will pay less tax by claiming a Tier 1 miscellaneous deduction for the repaid wages on his '21 return; the following worksheet shows James' computation:
Original Reporting Year: 2019
Restoration Year: 2021
SECTION I - DEDUCTION METHOD - RESTORATION YEAR COMPUTATION (Complete only if itemizing.)
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Taxable income (w/o deduction) ............................................................. 49,950
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Claim of right deduction ........................................................................ <5,000>
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Taxable income (with deduction), ...........................................................44,950
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Tax based on the amount of line 1 ...........................................................,6,743
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Tax based on the amount of line 3 ........................................................<5,643>
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Tax savings this method (line 4 less line 5) .............................................1,100
SECTION II - TAX CREDIT METHOD - (Line 8 must exceed $3,000.)
7. Taxable income (as filed) ...................................................................... 15,000
8. Claim of right adjustment ..................................................................... <5,000>
9. Modified taxable income (if negative, treat as zero) ...........................10,000
10. Tax based on line 7 ............................................................................... 1,609
11. Tax based on line 9 .............................................................................. <1,009>
12. Tax savings this method (ln 10 less ln 11) ...............................................600
Line 12 is a refundable credit in the year of restoration if credit method is used
13. Best tax savings (larger of ln 6 or ln 12) ............................................... 1,100
METHOD USED: [ X ] Deduction Method [ ] Credit Method
Note: if a client is not itemizing, automatically use the credit method. But for 2018-2025, if repayment of nonbusiness or non-investment income is $3,000 or less, neither a deduction nor a credit is available.