IRS backs off on advance

Good lawyering got the IRS to back off the assessment of additional tax on receipt of an advance. Client entered into a three year service contract with Company to sell a new product. Company provided an advance of $100X to Client when he signed the contract. Under the contract, if Client reached his sales goals at the end of the three years, he would be paid compensation of $500X. If Client failed to reach his sales goals, he was obligated to return the advance of $100X.

Client took the position on his tax return that the $100X advance was not income until earned at the end of the third year because the advance might have to be returned if the sales targets were not met. During the audit, the IRS asserted that the $100X was income at the time the money was received under a “claim of right” theory.

The claim of right theory generally provides that funds received are includible in income unless the restriction of the use of funds is so substantial that they effectively deprive the taxpayer of the economic benefit of possessing the funds.[1] If the funds are actually repaid, the taxpayer would be entitled to a deduction.[2]

For example, in Winter v. Comr.[3], a taxpayer received a long-term contract to serve as bank chairman and CEO and in 2001 he was paid a $5 million bonus. The bonus was repayable in part if he quit or was fired for cause. In December 2002, the taxpayer was fired for cause and in 2003 the bank demanded repayment of almost $4 million of the bonus. The Tax Court citing the claim of right rule determined that the entire bonus was taxable in 2001 even though there was a possibility he'd have to return the money later.

Despite the adverse case law regarding the claim of right theory, the IRS ultimately conceded that the $100X advance paid to Client was not income until after the third year. The IRS was convinced to back off when presented with Ahadpour v. Comr.[4], which reached an opposite conclusion on the law. In Ahadpour, the taxpayer entered into an agreement to sell certain real estate. Pursuant to the agreement, the buyer paid the taxpayer a $700,000 advance on the purchase price. The closing was delayed due to zoning and related legal issues on the real estate. Three years later the parties agreed to cancel the contract and taxpayer returned money to the buyer. The IRS asserted that the $700,000 was income to the taxpayer under a theory of claim of right. The court ruled that the $700,000 was not income to the taxpayer because a money deposit received on execution of a sales contract is not income until the taxpayer acquires an unconditional right to retain the deposit.

The lesson here is that taxpayers can prevail over the IRS but tenacious legal representation is crucial to do so. Let a legal professional be your strong advocate when fighting the IRS or other tax controversies.