IRS denies claim of right doctrine to avoid arbitrage on shared loss agreement

The IRS has claimed in a heavily redacted field attorney advice (FAA 20231601F) that there is no specific authority to apply the claim of right doctrine and avoid an unfavorable rate arbitrage result in a situation involving Federal Financial Assistance (FFA) and contractual repayments under a shared-loss agreement between a taxpayer and FDIC.

The taxpayer addressed by the FAA entered a purchase and assumption agreement with the FDIC in connection with acquiring the assets of a failing bank. The agreement provided a shared-loss agreement for the reimbursement of loss sharing on certain acquired loans, under which the FDIC made payments to the taxpayer each month based on a certificate of losses claimed. Upon termination of the agreements, the losses did not reach the expected level, so the taxpayer was obligated to pay a percentage of the excess to the FDIC as a true-up.

Section 597 and the regulations thereunder generally provide rules for treating the FFA payments and true-up. The amount the taxpayer receives from the FDIC is income in accordance with the taxpayer’s method of accounting, and if the taxpayer has loss repayment, it first reduces the FFA income in the current year, with any excess reducing the balance in its deferred FFA account. Any excess over those two amounts is then deducted. The taxpayer included the FFA amounts in income when the corporate rate was 35% but paid the true-up and was entitled to offsetting reductions or deductions when the corporate income tax rate had dropped to 21%.

Section 1341 provides a claim of right doctrine that ensures a taxpayer's position is not worse (except for the time value of money) after a change in tax rate than it would have been in if the taxpayer had not included the item or portion thereof in gross income in the earlier year. The IRS discussed the three prongs of the claim of right doctrine under Section 1341(a): 

• An item was included in a taxpayer’s gross income during a prior taxable year because it appeared that the taxpayer had an unrestricted right to that item
• A deduction is allowable for the current taxable year because it was established after the close of the prior taxable year that the taxpayer did not have an unrestricted right to that item
• The amount of the deduction is greater than $3,000 

The IRS devotes a significant portion of the analysis discussing the first prong and whether it requires only an appearance of a right or whether it requires an actual right to an item (in which there are differing results between the Tax Court, certain Appeals Courts, and the Court of Federal Claims). The IRS reiterated that its position is that Section 1341 applies only if an item was included in a taxpayer’s gross income because it appeared that the taxpayer had an unrestricted right to that item. It is unclear whether the IRS ultimately decides whether FFA and repayments meet the first prong or not, as that part of the discussion has been redacted. The unredacted portion states that the IRS found no authority specifically applying Section 1341 to a situation involving FFA and contractual repayments pursuant to a shared-loss agreement.

Because significant portions of the field advice are redacted, it is unclear why the IRS believes that there is no support that Section 1341 does not apply to such contractual repayments arising from the FFA.