Norwich v. Comm’r: Private Credit Firm Prevails in Tax Dispute to Reverse Over-Reported Income

I. Facts of the Case
Between 2007 and 2014, the taxpayer, a domestic C corporation, was in the business of extending residential mortgage loans in the Northeast U.S. The taxpayer did not use significant amounts of its own capital in this business. Instead, it maintained a warehouse line of credit (LOC) with a third-party bank. When it was ready to close a loan, it made a draw on the LOC. After the loan was closed, it sought a buyer for the loan (presumably aggregating its originations until they reached a sizable portfolio). When the loan was sold, the sale proceeds were used to repay the lender. Amounts left in the bank account after the lender was repaid were swept by the taxpayer as its profit from the transactions. All cash sweeps required the lender’s permission.

Not surprisingly to anyone participating in the private lending market, the LOC contained significant covenants and restrictions. Foremost among these restrictions was a requirement that the taxpayer maintain sufficient collateral at all times to repay the amount outstanding to the bank.

The accountant for the taxpayer determined its income for federal income tax purposes by reference to the cash sweeps from the bank account. Specifically, the accountant treated the amounts withdrawn from the bank account as mortgage fee income. After all, all withdrawals were blessed by the bank and, once released, the taxpayer appeared to have an unrestricted right to keep the cash.

Somewhat surprisingly, between 2007 and 2014, the lending bank made numerous mistakes in the taxpayer’s favor with respect to the operation of the LOC and bank account. These mistakes included duplicate advances, failed paydowns and inaccurate paydowns. These mistakes were only discovered in 2014 when banking regulators required the taxpayer to implement a new system for tracking the LOC. The new system discovered that the LOC was short by approximately $7.3 million. As stated above, since the taxpayer’s accountant was using bank account withdrawals to determine the taxpayer’s income, the taxpayer had picked up these erroneous withdrawals as taxable income.

The taxpayer immediately notified the bank as to what the new system had discovered. The bank, not believing that it could have over-advanced more than $7 million, took months to respond to the taxpayer. Once, however, the situation became clear, the bank required the taxpayer to post additional collateral. The taxpayer repaid the mistaken advances in 2014 and 2015. As stated above, the taxpayer deducted the reimbursement in full on its 2014 tax return. It disclosed the deduction as the repayment of amounts received under a “claim of right,” that is, the payment reversed amounts previously included in income but that subsequent events determined that it had no rights to receive.

From your author’s humble perspective, it is hard to believe that there is anything further to say about these facts. It all seems fair, and justice was done. But the IRS had a different view. Citing to the LOC documents, the agency asserted that the over-advances to the taxpayer were additional loans in the years the advances were made and the taxpayer was at fault for reporting these amounts as income. It held fast that the taxpayer should have amended its prior returns before the statute of limitations expired, even though it did not know that it received more than it should have and clearly acted in good faith.

II. The Claim of Right Doctrine
None of the court, the IRS and certainly not the taxpayer, disputed that if the claim of right doctrine applied, it would have permitted a deduction in a taxable year later than the year in which the amounts were originally paid to the taxpayer. The Tax Court discussed Consolidated Oil v. Burnet,[3] the seminal claim of right case, for the proposition that the repayment of income received in one year “without restriction,” but subsequently determined to have been improperly received, is deductible in the year of repayment. As we’ll see below, the court correctly interpreted the law.

Treasury Regulation § 1.1341-1(a)(2) defines “income included under a claim of right” to mean an item included in gross income because it appeared from all the facts available in the year of inclusion that the taxpayer had an unrestricted right to the income. In early Revenue Rulings, the IRS ruled that if the taxpayer's right to the income is absolute but is undermined by facts arising in a year subsequent to the year the income was received, the taxpayer does not satisfy the appearance of an unrestricted right test.[4] Stated differently, the IRS interpreted the “appearance” requirement to be that the taxpayer must appear to have unrestricted right for the funds in the year received, as opposed to have absolute right for the funds. Even under this standard, the taxpayer in Norwich, supra, should have prevailed on its claim.

In Prince v. U.S., 610 F.2d 350 (1980), the Fifth Circuit reversed a District Court decision that the estate of a taxpayer was not entitled to a claim of right adjustment. A state court had ruled that the decedent, a trust beneficiary, had received trust funds, and paid federal income tax on them, that should have gone to the trustee as part of its fee. The state court required the decedent’s estate to return these funds to the trustee. The government’s position in that case was that Section 1341 of the U.S. Tax Code (the “Code”) (the statute into which certain aspects of the claim of right doctrine have been embedded) was not available to the taxpayer’s estate because the taxpayer had an unrestricted right to the income in the year of receipt, not just the appearance of a right.[5] In rejecting the government’s argument, the court said:

The Alabama judgment established, whether expressly or by implication, that the deductions from the trust income for the ten year fee had been miscalculated. As a result, [decedent] had received more income from the trust than she was entitled to receive. This income had to be returned. The requirements of Section 1341 were thus clearly satisfied. [Decedent] appeared to have an unrestricted right to the income when she received it; it was established in a taxable year after she received it that she did not have such a right.

Nevertheless, in Dominion Resources, Inc. v. U.S.,[6] a more recent case, the Fourth Circuit rejected the distinction between the so-called “absolute right” and the “appearance of a right” to receive income for purposes of this test. The court held that for purposes of Code § 1341, the use of the term “appears” does not mean that the taxpayer’s belief has to be proven to be false. As the Fourth Circuit explained:

All that §1341(a)(1) requires is that ‘an item be included in gross income for a prior taxable year (or years) because it appeared that the taxpayer had an unrestricted right to such item.’ Things very often ‘appear’ to be what they ‘actually’ are. As a matter of plain meaning, the word ‘appeared’ generally does not, as the IRS urges, imply only false appearance, and generally does not exclude an appearance that happens to be true. [emphasis in original]

On the other hand, Code § 1341 does not apply if a taxpayer had no right whatsoever to income in the taxable year it is included in the taxpayer’s gross income and had no reason to believe it had such a right. For example, although the proceeds of embezzlement constitute gross income in the year of embezzlement, the embezzler holds such funds without any entitlement and therefore a restoration of the embezzled amounts in future years does not come within the general legislative purpose of Code § 1341.[7] In McKinney v. U.S., 574 F.2d 1240 (5^th Cir. 1978) cert. denied, 439 U.S. 1072 (1979), a taxpayer embezzled from his employer, repaid the money in a later year, and sought to deduct the repayment under Code §1341. In holding against the taxpayer, the court noted that when the item was embezzled funds, it could not appear to the taxpayer that he had any right to the funds, much less an unrestricted right to them.[8]

A restriction on a taxpayer’s right to receive income not arising until a subsequent year does not affect the availability of the claim of right doctrine. In Eugene Van Cleave v. U.S, the taxpayer was president and majority stockholder of a company. The corporation adopted a by-law which required corporate officers who received excessive compensation as determined by the IRS to pay back that excessive amount. Some of the taxpayer’s 1974 salary was determined by the IRS to be excessive. He paid back that amount in 1975, and calculated his tax liability using Code § 1341, claiming a deduction for 1975 for the amount included in income in 1974. The Sixth Circuit allowed the deductions, explaining that Code § 1341 applies where it appeared that the taxpayer had an unrestricted right to an item of income, but it was later determined that he did not have an unrestricted right. The Appeals Court rejected the government’s argument that it did not appear that the taxpayer had an unrestricted right to the 1974 salary. The fact that the ultimate right to the compensation was not determined until the occurrence of a subsequent event, the court observed, did not mean that the taxpayer did not have, in the statutory sense, an unrestricted right when he received it.

As can readily be seen through the lens of the authorities discussed above, the taxpayer in Norwich, supra, received the erroneous funds under a claim of right. The LOC lender permitted releases of cash from the bank account based upon its mistaken belief that such releases belonged to the taxpayer. In fact, it was so sure of this result that it took over four months after being notified by the taxpayer that releases from the bank account were problematic for the bank to address the problem. The IRS’s position that bank account releases were loans under the terms of the LOC agreement were simply not supported by the facts. When this case is viewed with “20-20” hindsight, it is difficult to see why the IRS would have fought this issue through litigation, which clearly cost valuable resources for the government and significant expense to the taxpayer.

III. What Is Really Interesting Here
Once the court discerned that the claim of right doctrine should apply to the taxpayer’s reimbursement of the erroneously released funds, the issue became whether the taxpayer should claim a deduction in full in 2014 or split the deduction between 2014 and 2015, based on its actual reimbursement of the mistakenly advanced funds. Intuitively, one would think that the deduction should have been available to the taxpayer in 2014 and 2015 in proportion to its reimbursements. The court however, employed an unexpected approach to this issue.

The court approached the question as to the proper year of the deduction by asking whether the mandate in Code § 461(h)(2)(B), which limits an accrual basis taxpayer’s ability to claim deductions until economic performance has occurred, prevented the taxpayer from deducting the full reimbursement in 2014. (As discussed above, the actual reimbursement was made in 2014 and 2015.) The court found that economic performance was not the repayment of the over-advances. Instead, the court found that economic performance was the satisfaction of the collateral requirements under the LOC agreement. Since the taxpayer topped up the collateral in 2014, the court permitted it to claim the entire deduction in such year, notwithstanding the fact that the full repayment did not occur until 2015. This result is counterintuitive—one would have thought that economic performance was the repayment itself.

IV. Take Aways
The private credit market continues to face challenges related to the fact that serving underserved borrowers is inherently labor-intensive. It is reasonable to expect that there will continue to be reconciliation challenges similar to those faced by the taxpayer in Norwich, supra. This decision offers hope that taxpayers will have a clear path forward to addressing the federal income tax considerations applicable to a market that, by its very nature, will continue to present various tax accounting discontinuities.

^{[1] TC Mem. 2025-43 (May 12, 2025)}

^{[2] All figures used in text are approximate.}

^{[3]286 US 417 (1932)}

^{[4] As the IRS observed in Rev. Rul. 68-153, 1968-1 C.B. 371 “[t]he term ‘appeared’ as used in section 1341(a)(1) and Treas. Reg. section 1.1341-1(a)(2) refers to a semblance of an unrestricted right in the year received as distinguished from an unchallengeable right (which is more than an “apparent” right) and from absolutely no right at all (which is less than an apparent right).”}

^{[5] Id. at 352.}

^{[6] Dominion Resources, Inc. v. U.S., 219 F.3d. 359, 364 (4th Cir. 2000).}

^{[7] See e.g., Rev. Rul. 68-153, 1968-1, C.B. 371; Rev. Rul. 65-254, 1965-1 C.B. 50.}

^{[8] Id. at 1243. Similarly, in Parks v. United States, 96-2 U.S.T.C. paragraph 50,645 (W.D. Pa. 1996), the court stated that “[I]f the taxpayer commits fraud to obtain income, this court would not accept that such conduct can create the appearance of an unrestricted right to an item of income.” Id. at 86,287.}