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Date: 11-13-2021
Case Style:
Kenneth Heiting v. United States of America
Case Number: 20-1324
Judge: Ilana Kara Diamond Rovner
Court: United States Court of Appeals
For the Seventh Circuit
On appeal from The United States District Court for the
Western District of Wisconsin.
Plaintiff's Attorney: United States Attorney’s Office
Defendant's Attorney:
Description:
Chicago, IL- Tax lawyer represented defendant seeking an income tax refund of the taxes paid on an unauthorized sale of stock by a trust.
In January 2004, the Heitings created the Kenneth E. and
Ardyce A. Heiting Joint Revocable Trust. The trust was administered at all relevant times by the trustee BMO Harris
Bank. Because the Heitings could revoke the trust agreement
at any time during their lifetime, the trust is considered a
“grantor trust” for purposes of federal taxation. As a grantor
trust, the trust itself filed no tax returns, and the Heitings reported the trust’s gains and losses on their own returns. See
Schulz v. Comm’r of Internal Revenue, 686 F.2d 490, 495 (7th Cir.
1982) (noting that “[t]he main thrust of the grantor trust provisions is that the trust will be ignored and the grantor treated
as the appropriate taxpayer whenever the grantor has substantially unfettered powers of disposition.”)
Under the terms of the trust, the trustee had broad authority as to the trust assets in general, but that power was explicitly limited with respect to two particular categories. With respect to Bank of Montreal Quebec Common Stock (“BMO”)
and Fidelity National Information Services, Inc. Common
Stock (“FIS”) (collectively, the “restricted stock”), the trustee
had “no discretionary power, control or authority to take any
action(s) with regard to any shares … including, but not limited to, actions to purchase, sell, exchange, retain or option the
Stock.” Amendment and Restatement of the Joint Trust
Agreement, Articles IX and X, App. at A-21. In contrast to the
nearly limitless power as to other stocks, with respect to the
restricted stock the trustee thus lacked the authority to take
any actions, including any sale or purchase of that stock, absent the Heitings’ express authorization.
Despite that restriction, the trustee in October 2015 sold
the restricted stock held in the trust and incurred a taxable
gain on the sale which totaled $5,643,067.50. The Heitings
No. 20-1324 3
accordingly included that gain in their gross income on their
2015 personal tax return, and paid taxes on it. The trustee subsequently realized that the sale of the stock was prohibited by
the trust agreement, and in January 2016 the trustee purchased the same number of shares of that restricted stock with
the sale proceeds from the earlier transaction.
Following the purchase of the restricted stock in 2016, the
Heitings sought to invoke the claim of right doctrine as
codified in 26 U.S.C. § 1341 to claim a deduction on their 2016
return. Under the claim of right doctrine, a taxpayer must
report income in the year in which it was received, even if the
taxpayer could be required to return the income at a later time
but would then be entitled to a deduction in the year of that
repayment. United States v. Skelly Oil Co., 394 U.S. 678, 680
(1969). To alleviate inequities in the application of that
doctrine, Congress subsequently enacted 26 U.S.C. § 1341,
which added, as an alternative to the deduction in the
repayment year, the option of the taxpayers recomputing
their taxes for the year of receipt of the income. Id. at 681–82.
In order to qualify for relief under § 1341(a), taxpayers
must plead that: “(1) an item was included in gross income
for a prior taxable year (or years) because it appeared that the
taxpayer had an unrestricted right to such item; (2) a deduction is allowable for the taxable year because it was established after the close of such prior taxable year (or years) that
the taxpayer did not have an unrestricted right to such item
or to a portion of such item; and (3) the amount of such deduction exceeds $3,000.” 26 U.S.C. § 1341(a)(1)–(3). If those are
established, then the tax imposed for the taxable year is the
lesser of “the tax for the taxable year computed with such deduction,” or “the tax for the taxable year computed without
4 No. 20-1324
such deduction, minus … the decrease in tax … for the prior
taxable year (or years) which would result solely from the exclusion of such item (or portion thereof) from gross income
for such prior taxable year (or years).” 26 U.S.C. §1341(a)(4)–
(5).
In initially rejecting the Heitings’ claim for a tax refund,
the IRS relied on an exception in the statute, maintaining that
under § 1341(b)(2) such relief was inapplicable to “the sale or
other disposition of the Stock in trade of the taxpayer.” Before
the district court, however, the government did not argue that
the denial of relief was supportable on that reasoning,
abandoning any reliance on the stock-in-trade provision to
support the denial. Nor does it argue such a basis for denial
here. Accordingly, that rationale is not before us.
In granting the government’s motion to dismiss, the district court held that the Heitings were entitled to a credit on
the taxes under § 1341 only if they were legally obligated to
return the proceeds of the restricted stock sale, and that the
complaint alleged no such obligation. We consider de novo a
district court’s grant of a motion to dismiss, accepting all wellpleaded facts as true and taking all reasonable inferences in
the plaintiff’s favor. White v. United Airlines, Inc., 987 F.3d 616,
620 (7th Cir. 2021). We can affirm on any ground adequately
raised in the district court that is supported by the record. Id.
On appeal, the government concedes that the Heitings can
establish the first requirement under § 1341(a), in that they
alleged the receipt of an item of income in 2015—the $5.6
million gain received on the sale of the restricted shares—
which was taxable directly to the Heitings as taxpayers
because the revocable trust is disregarded for tax purposes.
The government asserts that the second element of § 1341(a)
No. 20-1324 5
was not met, however, and that the district court properly
granted the motion to dismiss on that basis. First, as it did in
the district court, the government argues that the Heitings
failed to adequately allege that, after the close of tax year 2015,
they did not have an unrestricted right to the income from the
sale of the restricted stock held in their trust, and were under
a legal obligation to restore that income to its actual owner, as
is required under § 1341(a)(2). The government asserts that
the trustee simply bought some stock in 2016 in an attempt to
reverse the effect of the earlier, 2015, transaction, but the
taxpayers’ right to the income from the earlier transaction was
never in question. Finally, the government argues that the
Heitings did not, and could not, plead that their “restoration”
of income was a deductible expense to them, as required
under § 1341.
The Heitings contend that because the issue is the tax
obligations of the trust, not of themselves as individuals, the
proper focus must be on whether the trust had an unrestricted
right to the income in the initial and subsequent tax years.
Accordingly, they challenge the argument of the government
that there was no legal obligation to restore the item of income
because the Heitings, the taxpayers here, had the ability to
approve of the sale of the restricted stock and therefore
authorize the sale and the retention of the proceeds after-thefact. See Wis. Stat. § 701.0808(1) (stating that “[w]hile a trust
is revocable, the trustee may follow a direction of the settlor
that is contrary to the terms of the trust.”) They argue that the
district court, in determining that the requirements of §
1341(a)(2) were not met, improperly relied on the nature of
the trust under which the Heitings themselves could approve
of the sale of the restricted stock after the fact thus eliminating
6 No. 20-1324
any restriction on the income or any legal obligation to restore
the income.
As the sole beneficiaries, the Heitings had an unrestricted
right to the funds, because they had the absolute authority to
choose to accept the funds and authorize the trust’s actions.
But the Heitings maintain that the proper focus is on the
trust’s actions, and whether the trust retained an unrestricted
right to the funds, arguing that they merely stepped into the
shoes of the trust in including the trust income on their taxes.
We need not address that issue, however, because even considering only whether the trust itself had an unrestricted right
to the funds, the Heitings cannot succeed. With that focus on
the obligations of the trust rather than the Heitings, we turn
to the Heitings’ challenge to the dismissal.
The Heitings argue that the trustee’s sale and subsequent
repurchase of the restricted stock falls within the language of
§ 1341(a) as a taxable transaction that was “reversed” in the
year after the sale by a trustee that was legally obligated to do
so. As an initial matter, the characterization of the purchase
as a “reversal” of the original sale implies that the second
transaction was a retraction of the first, undoing it cleanly and
putting the parties to the transaction in the same place as before it, but as the government points out the different timing
of the two transactions renders that characterization inaccurate. The government asks us to take judicial notice of the
publicly reported stock prices on the New York Stock Exchange, which would indicate that BMO shares that the trust
sold for $59.27 in 2015, were repurchased for a lower price,
between $50.18 and $52.46, on January 13, 2016, and the FIS
shares that the trust sold for $72.24 per share in 2015, were
repurchased at a lower price of between $58.93 and $60.70 on
No. 20-1324 7
January 13, 2016. We need not take judicial notice of the actual
numbers to conclude that a sale of stock in one time period
cannot be simply “reversed” by purchasing the stock back at
a different time, because the fluctuation in prices will often
result in a greater loss or gain over that time. But regardless
of the characterization of the transactions, the insurmountable
problem for the Heitings is not that the transactions were unequal in nature, but that the complaint does not adequately
allege that the trust had a legal obligation to restore the items
of income—the restricted stock—as is required under
§ 1341(a)(2).
Under § 1341(a)(2), the Heitings had to show that the
repayment in the later year occurred because “it was
established after the close of such prior taxable year (or years)
that the taxpayer did not have an unrestricted right to such
item or to a portion of such item.” See Alcoa, Inc. v. United
States, 509 F.3d 173, 177 (3d Cir. 2007) (“The taxpayer bears
the burden of proving his eligibility for section 1341
treatment.”). The language requiring that “it was established”
that the taxpayer did not have an unrestricted right to the item
has been interpreted as requiring a legal obligation to restore
the item of income; a voluntary choice to repay is not enough.
Batchelor-Robjohns v. United States, 788 F.3d 1280, 1293–94
(11th Cir. 2015) (“[t]he taxpayer's return of the income must
not be the result of the taxpayer's purely voluntary choice;
rather, it must be ‘established,’ for example, by a court, that
the taxpayer did not have an unrestricted right to the income.
… [P]ayments made to settle a lawsuit may satisfy this
requirement.”); Cal-Farm Ins. Co. v. United States, 647 F. Supp.
1083, 1092 (E.D. Cal. 1986), aff’d 820 F.2d 1227 (9th Cir. 1987)
(noting that the statute requires a legal obligation to restore
the funds and that “voluntary repayments are outside the
8 No. 20-1324
scope of section 1341”). To meet that requirement, taxpayers
must demonstrate that they “involuntarily gave away the
relevant income because of some obligation, and the
obligation had a substantive nexus to the original receipt of
the income.” Mihelick v. United States, 927 F.3d 1138, 1146 (11th
Cir. 2019). That involuntary legal obligation to restore the
item of income can be shown by a court judgment requiring
the repayment, but a good-faith settlement of a claim can also
suffice. Id.; Cal-Farm Ins. Co., 647 F. Supp. at 1092.
We have no allegation here that “it was established” that
the trust did not have an unrestricted right to the item of
income in this case. The Heitings have alleged only that the
trustee’s sale of the restricted stock was contrary to the trust
agreement. At most, that alleges a potential restriction, which
originated at the time of the transaction in 2015. But the
Heitings make no allegations that they, as the sole
beneficiaries of the trust, demanded the restoration of the
stock or otherwise communicated an intent to pursue any of
their rights for the breach of the trust agreement. The
existence of a potential claim against the income is not enough
to “establish” that the trust lacked an unrestricted right to the
income.
In fact, the case relied upon by the Heitings in this case,
First Nat. Bank of Chicago v. United States, 551 F. Supp. 157
(N.D. Ill. 1982), makes clear that distinction, and weighs
against the Heitings’ position. In First National, an action was
brought by the trustees of two trusts for a refund of taxes paid
in 1972 and 1973. The taxes were paid on the proceeds of the
sale of certain stock in 1972 and 1973, and the propriety of the
sale by the trusts was challenged by a trust beneficiary. Id. at
158. The trust beneficiary filed a lawsuit as to that challenge
No. 20-1324 9
in 1974, and a court ultimately ordered the sale rescinded. Id.
The question before the First National court was whether the
taxpayer’s right to the items of income was not actually “unrestricted” in 1972 and 1973 given that the sale was limited by
the trust agreement and the challenge raised to the sale by one
of the trust’s beneficiaries.
The First National court held that “[t]he fact that a trust
beneficiary disputed the sale only represented a ‘potential restriction’ which is not a ‘restriction on use’” within the meaning of the claim of right doctrine. Id. at 159. For that holding,
the First National court cited Healy v. Commissioner of Internal
Revenue, 345 U.S. 278, 284 (1953), which held that under the
claim of right analysis, “a potential or dormant restriction …
which depends upon the future application of rules of law to
present facts, is not a ‘restriction on use.’” Accordingly, the
First National court held that the plaintiff possessed an unrestricted right to the income for the years 1972 and 1973, even
though the trustee challenged the sale and the trustees were
bound by the fiduciary obligation to the beneficiary. The trustee was entitled to a deduction in the year of repayment once
it was established that the taxpayer did not have an unrestricted right by the beneficiaries’ pursuit of a lawsuit and
judgment.
The First National court made clear, therefore, that an
initial objection by a beneficiary to the sale, or the limitations
of the trust agreement itself, were not in themselves sufficient
to demonstrate that the taxpayer did not have an unrestricted
right to the item of income. That is essentially what we have
here. Unlike First National, there is no such order requiring the
re-purchase of the stock, and no requirement that the funds
be returned to another. In fact, the Heitings do not even allege
10 No. 20-1324
a challenge by the beneficiaries to the sale—and as the
beneficiaries, they would be in a position to identify any
challenge. Instead, they merely argue that the sale of the
restricted stock was in violation of the terms of the trust
agreement. That is precisely the type of potential or dormant
restriction, dependent on the future application of law to fact,
that is insufficient to indicate that a right to the item of income
was not an unrestricted one. See also Inductotherm Indus., Inc.
v. United States, 351 F.3d 120, 124 (3d Cir. 2003) (holding that
even though the government could prosecute a corporation
for the failure to comply with an Executive Order placing
restrictions on certain funds, the government had the
discretion not to pursue that violation, and the Executive
Order was therefore merely a potential or dormant restriction
which depended on the future application of law to facts and
not a disposition restriction under the second prong of §
1341).
Finally, the only authority relied upon by the Heitings as
establishing a legal obligation to reverse the sale does not
support that interpretation. The Heitings point to Wisconsin
statutory law allowing lawsuits against trustees and setting
forth the remedies for a breach of trust. See Wis. Stat. §§
701.0201, 701.1001. That authority does not help the Heitings.
First, the statute does not even mandate as a remedy the
action taken by the trustee in this case—the repurchase of the
stock. The Wisconsin statute cited by the Heitings provides a
list of potential remedies for a breach of trust including,
among others: compelling a trustee to redress a breach of trust
by paying money, restoring property, or other means;
ordering a trustee to account; suspending or removing the
trustee; reducing the compensation or denying the
compensation to the trustee; and voiding an act of a trustee,
No. 20-1324 11
or tracing trust property and ordering recovery of the
property or its proceeds (although this option is unavailable
in the case of a good faith purchaser). See Wis. Stat. §
701.1001(2)(a)–(j). Given the range of potential remedies,
including merely seeking damages from the trustee or
suspending or removing the trustee, the statutory authority
certainly does not establish an obligation for the trustee to
repurchase the stock. In contrast, the terms of the trust
agreement specifically prohibited the purchase of the restricted
stock in 2016, just as it had prohibited the sale of that stock in
2015. Therefore, the legal authority relied upon by the
Heitings fails to establish that the trustees had a legal
obligation to purchase the restricted stock in 2016 but does
establish—by the terms of the trust agreement—a prohibition
on that action.
Moreover, the statutory authority is unhelpful for an even
more fundamental reason, which is that the beneficiaries
never sought any relief at all from the trustee, nor did they
allege an intent or even a threat to do so. As we discussed
earlier, although the Heitings were the beneficiaries of the
trust with the authority to approve or disapprove of the
actions of the trustee, the complaint contains no allegation
that they ever challenged the purchase of the restricted stock
or made any demand of the trustee with respect to that sale of
the restricted stock. At most, then, the reference to the
Wisconsin statutory rights alleges that the Heitings could
have pursued a legal remedy if they in fact were displeased
with the trustee’s actions in breach of the trust. That mere
possibility is, as we have shown, insufficient to “establish”
that the trust lacked an unrestricted right to the proceeds of
the sale of the restricted stock. Accordingly, the district court
properly determined that the requirements of § 1341(a)(2)
12 No. 20-1324
were not met and we need not consider the government’s
alternative argument that the Heitings did not, and could not,
plead that their “restoration” of income was a deductible
expense to them, as required under § 1341.
Outcome: The decision of the district court is AFFIRMED
Plaintiff's Experts:
Defendant's Experts:
Comments: