Tax Court Upholds $7 Million Deduction Under Claim of Right Doctrine

(Parker Tax Publishing June 2025)

The Tax Court held that a mortgage loan originator that overreported more than $7 million in income on its tax returns for years 2007-2013 due to accounting errors was entitled to claim a deduction for 2014, the year the errors were discovered, because the income from 2007-13 was included in accordance with the claim of right doctrine. The court further held that, as an accrual basis taxpayer, the taxpayer was entitled to claim the deduction in 2014 because all events relating to the taxpayer's obligation to provide collateral as a substitute for the underreported mortgage receivables were met in that year. Norwich Commercial Group, Inc. v. Comm'r, T.C. Memo. 2025-43.

Background

Norwich Commercial Group, Inc. was a residential mortgage loan originator (originator). It engaged in warehouse lending transactions and maintained warehouse lines of credit (LOCs) with at least three banks: Liberty, Farmington, and People's United Bank. Norwich was not itself a bank.

A warehouse lending transaction is generally accomplished in several steps. First, the originator borrows funds from a warehouse lender by drawing on a warehouse LOC. Second, the originator provides the borrowed funds to a homebuyer (customer) in exchange for a secured promissory note (mortgage receivable). Third, the originator sells the mortgage receivable to a mortgage loan investor. Fourth, the originator deposits the proceeds from the mortgage receivable sale with the warehouse lender. Last, the warehouse lender subtracts amounts owed to it on the warehouse LOC from those proceeds and sweeps the remaining funds, representing the originator's mortgage fee income, into the originator's operating account (usually an account with the warehouse lender).

Norwich overreported more than $7 million in income on its 2007 through 2013 federal income tax returns. The overreported income was related to accounting and other errors in connection with Norwich's warehouse lending business supported by LOCs at Liberty and Farmington. The errors resulted in severe undercollateralization of the LOC at Liberty.

Norwich discovered the errors in 2014 and signed an agreement providing additional collateral and agreeing to reduce the LOC balance with Liberty by the amount of the mistaken undercollateralization of that LOC. Norwich then claimed a "claim of right doctrine adjustment" deduction of $7,580,507 on its 2014 tax return. In 2014, Norwich repaid Liberty $1.2 million and received an interest credit from Liberty of $599,112. It also paid Farmington $626,388. In 2015, Norwich repaid $5,476,577, representing the remaining balance due to Liberty under the agreement. The IRS disallowed the 2014 deduction and the 2015 net operating loss (NOL) carryover stemming from the claim of right doctrine. Norwich took its case to the Tax Court.

Claim of Right Doctrine

Income is generally taxable for the year in which the taxpayer receives it, unless the taxpayer's regular method of accounting requires recognition of the income for a different year. Code Sec. 451 provides that accrual method taxpayers (like Norwich) recognize taxable income when all events fixing the right to receive income have occurred and the amount can be determined with reasonable accuracy.

The claim of right doctrine is codified in Code Sec. 1341. The doctrine applies where a taxpayer includes an item in gross income for a prior year under a claim of right because it appeared that the taxpayer had an unrestricted right to such item, but the taxpayer discovers after the close of the tax year that it did not have an unrestricted right to such item. In such a case, the taxpayer may either claim a deduction from the current year's taxes or claim a credit for the amount its tax was increased in the prior year by including that item.

The IRS contended that the claim of right doctrine did not apply because the origin of the funds at issue was borrowing on an LOC, and the "loan" was repaid when the error was discovered. The IRS emphasized that the LOC was overextended and that Norwich had an obligation to repay when the LOC distributions were made; therefore, the repayments were simply repayment of loans. The IRS asserted that loans are not income and that loan repayments are not deductible. There was implicit consensual recognition between Liberty and Norwich, the IRS argued, that Norwich was obligated to pay back the erroneous advances.

The IRS cited Smarthealth, Inc. v. Comm'r, T.C. Memo. 2001-145, to support its contention. In Smarthealth, the Tax Court held that customer overpayments were not includible in a business' taxable income because there was an implicit recognition between the business and its customers that customers were entitled to a return of any overpayments they made. The business was aware of the overpayments as they were made, recorded customer credit balances as liabilities on its general ledger, and informed customers of their credit balances when customers called to place subsequent orders.

Analysis

The Tax Court held that Norwich's inclusion of "phantom income" from 2007-2013 was in accordance with the claim of right doctrine, thus entitling Norwich to a deduction for 2014, the year the errors were discovered and the collateralized obligation to reduce its LOC balance with Liberty was executed.

The court found that, because Liberty accidentally advanced more funds than it should have and failed to properly secure repayments from sales to investors; both Norwich and Liberty operated under the assumption that Norwich was holding more collateral (assets) than existed; and Norwich was entitled to disbursement of more mortgage fee income than it had earned. Liberty transferred funds in error from the clearing account to the operating account, which were then accounted for as Norwich's earned mortgage fee income. The court noted that under Reg. Sec. 1.1341-1(a)(2), "income included under a claim of right" is defined as "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 such item." The court observed that if the mortgage receivables had been correctly accounted for, the mortgage fee income disbursements would not have occurred.

Observation: The court found that, unlike the taxpayer in Smarthealth, Norwich was unaware until 2014 that the erroneous transfers were not actually income. This lack of awareness, the court noted, was due to incorrect statements provided by Liberty to Norwich and relied on by both parties in maintaining the LOC. The court said there was no implicit consensual recognition between Norwich and Liberty that the funds would later be repaid. Thus, the court held that there was no explicit or implicit recognition of an obligation to repay the erroneous transfers by either Norwich or Liberty until they were discovered in 2014.

Having determined deductibility, the court next addressed the year or years for which Norwich could claim deductions. The court observed that accrual basis taxpayers (like Norwich) may deduct expenses for the years in which they incur the expenses, regardless of the actual payment dates, and the all events test determines whether a business expense has been incurred. In the court's view, the most applicable timing provision was found in Code Sec. 461(h)(2)(B), which establishes that "if the liability of the taxpayer requires the taxpayer to provide property or services, economic performance occurs as the taxpayer provides such property or services." The court found that Norwich was required to immediately provide property by restoring collateral for the LOC and then to quickly pay down the LOC. Thus, the court found that economic performance occurred in 2014, when Norwich and Liberty signed an agreement giving Liberty a first lien on and security interest in all of Norwich's business assets.

For a discussion of the claim of right doctrine, see Parker Tax ¶70,110. For a discussion of the all-events test, see Parker Tax ¶241,705.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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