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TAX ACCOUNTING DOCTRINES
§2.01 ANNUAL ACCOUNTING DOCTRINE
A taxpayer must compute his income on the basis of a taxable year.1 The term “taxable year”
means:
• The taxpayer's annual accounting period, if it is a calendar year or a fiscal year;
• The calendar year;
• The period for which a return is made, if the return is made for a period of less than 12 months;
or
• The filing of a return for a period of at least 12 months, in the case of a FSC or DISC.
The term “annual accounting period” means the annual period on the basis of which a
taxpayer regularly computes his income in keeping his books. 2 If a taxpayer does not keep books,
the Code provides an annual accounting period for him—the calendar year. 3
The annual accounting concept was given approval by the Supreme Court in Burnet v.
Sanford and Brooks Co. 4 The taxpayer in this case was a government contractor who contracted
to dredge the Delaware River from 1913 through 1916. In 1913, 1914, 1915, and 1916, the
government contractor’s books reflected a loss. In 1914, the contractor’s books reflected income.
However, the contractor did not include as income, on its tax return in any year, the amounts
received from the government. The Commissioner assessed a deficiency against the contractor, in
1920, the year in which the contractor recovered from the government the money it owed him.
The contractor argued to the Court that since it had no profits on the contract, it should not have to
pay any taxes. The contractor also contended that since the dredging produced an overall loss, it
should not have to report any income for tax purposes. The IRS, however, determined that the
contractor had income in 1920 and said that the contractor should determine its income on an
annual basis.
The issue thus framed for the Supreme Court to decide in this case was simply whether tax
accounting is to be handled on an annual basis or on a transactional basis. The Court noted that all
prior revenue acts, as well as the statute in effect at the time, referred to an annual accounting
period. The Court concluded that in 1920 the contractor should have determined whether it had
income under the statute and that prior losses had no effect on that year. In reaching its
conclusion, the Supreme Court reasoned:
It is the essence of any system of taxation that it should produce revenue
ascertainable and payable to the government at regular intervals and that only by
1 For a discussion of the entity’s tax year, see Chapter 3.
2 Section 441(c).
3 Section 441(g). This is so whether the taxpayer does not have an accounting period or the taxpayer does not keep
books.
4 9 AFTR 603, 282 US 359, 51 S Ct 150, 75 L Ed 383, 2 USTC P 636.
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Fundamentals of Tax Accounting
such a system is it practical to produce a regular flow of income and apply
methods of accounting assessment and collection capable of a practical
operation. 5 Moreover in order for the government to run it has to have a
predictable source of income and transactional taxation could not produce such
predictability. 6
The annual accounting doctrine can produce harsh results as it divides up transactions into
annual periods, some of which may produce income and some of which may produce losses.
Today, the Internal Revenue Code has a relief provision in Section 172 that allows for net
operating losses. Under this provision, a taxpayer can spread out losses over multiple tax periods.
Other Code provisions that reduce the harshness of the annual accounting doctrine include Section
1341, 7 which provides relief from the claim of right doctrine, and Section 111, 8 which provides
relief from the tax benefit doctrine.
§2.02 CLAIM OF RIGHT DOCTRINE
Under the claim of right doctrine, a taxpayer who receives income under a “claim of right,” i.e.,
free of restrictions, must include that income in gross income in the year of receipt. The claim of
right doctrine is based on the annual accounting period for reporting income. Income must be
determined at the close of the taxable year without regard to possible subsequent events.
The origin of the doctrine can be found in North American Oil Consolidated v. Burnet. 9 In
North American Oil, the taxpayer was a drilling company that was drilling for oil on land owned
by the United States. The government instituted a suit against the company to regain possession
and, in 1916, the government secured the appointment of a receiver to supervise the drilling
company’s operations and to hold its income from its drilling activity. The receiver collected the
income but did not make any payments to the company. In 1917, the district court dismissed the
government’s suit and the receiver paid the collected income to the drilling company. The money
paid to the company in 1917 represented the net profits it had earned from its drilling activities on
the property in 1916 during the receivership.
The net profits were entered on the company’s books as income, and were reported as
income on an amended return filed in 1918. In an audit of that return, the IRS determined that the
income was realized in 1917, not 1918. On appeal to the Supreme Court, the issue before the
Court was the year in which the net profits would be taxable as income. After holding that the
profits were not income to the taxpayer while the property was operated by the receiver, the Court
determined that the net profits were taxable as income in 1917, the year in which they were paid
to the taxpayer. This determination was grounded in the now famous quote by Justice Brandeis.
If a taxpayer receives earnings under a claim of right and without restriction as to
its disposition, he has received income which he is required to return, even though
5 9 AFTR at 606.
6 It is to be noted that Sanford and Brooks was decided before net operating losses came into the Code.
7 See §2.03, below.
8 See §2.05, below.
9 11 AFTR 16, 286 US 417, 52 S Ct 613, 76 L Ed 1197, 3 USTC P 943.
Brunetti
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it may still be claimed that he is not entitled to retain the money, and even though
he may still be adjudged liable to restore its equivalent. (Citations omitted.) If in
1922 the government had prevailed, and the company had been obliged to refund
the profits received in 1917, it would have been entitled to a deduction from the
profits of 1922, not from those of any earlier year. 10
The claim of right doctrine has been reaffirmed by the Supreme Court on several
occasions since North American Oil and has become a firmly established principle of federal
income taxation.
§2.02(a) Effect of Doctrine
The claim of right doctrine applies even when the taxpayer is not entitled to retain the
income and might be obligated to return it. Accordingly, the doctrine applies to income received
under a mistake of fact. Consider the following hypothetical, for example.
A taxpayer receives a bonus from his employer in 2007 that the employer later
asserts was incorrectly computed. In 2008, the taxpayer repays a portion of the
bonus. Under the claim of right doctrine, the taxpayer cannot amend his 2007
return to exclude from income the portion of the bonus he repaid in the later year.
The doctrine fixes the year in which the taxpayer received income even though the
taxpayer was not entitled to retain the money.
§2.02(b) Circumstances Where Doctrine Applies
Where the following circumstances exist, the claim of right doctrine applies
• Receipt of money or other property;
• Control by the taxpayer over the utilization or the disposition of money or property; and
• Assertion by the taxpayer of some claim of right or entitlement to receipt. 11
The claim of right doctrine does not apply to money or property received under circumstances
where the receipt is not income. The doctrine does not create income where no income exists. For
example, assume the following.
Sam obtains a $100,000.00 loan from a bank, secured, in part, on property
that he does not own. Although it is likely that Sam will be required to
return the money before the end of the loan term and that he has received
the money under a claim of right, he has not received income. Because loan
proceeds are not gross income, the claim of right doctrine does not apply to
Sam’s transaction.
§2.02(c) Uncertainty of Income Status or Amount
The claim of right doctrine does not apply to the receipt of money or property if, at the
time of receipt, it cannot be determined whether the money or property received constitutes
income. Consider, for example, the following.
10 11 AFTR at 18.
11 Actual receipt of the income may not be necessary if the principle of constructive receipt applies.
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Fundamentals of Tax Accounting
In 2007, Dan receives $10,000 from Matt as consideration for an
option to purchase property for $80,000.00. Dan’s adjusted basis in
the property is $85,000.00. The option expires in 2008. The
$10,000.00 will be ordinary income if the option is permitted to
expire without exercise, or will be non-taxed return of capital, if the
option is exercised. In 2007, it is impossible to determine whether
the $10,000.00 will be income because Matt’s decision will not be
known with certainty until 2008. The claim of right doctrine does
not apply with respect to the $10,000.00 received in 2007.
On the other hand, if the money to be received constitutes income but the total amount of income
to be received has not yet been determined, the claim of right doctrine is applicable. The
following hypothetical is illustrative.
Meg owns land that is condemned by the state. Her adjusted basis
in the land is $250,000.00. The parties cannot agree on the fair
market value of the land, but the state concedes that it is worth at
least $1 million. The parties agree to litigate the issue, because
Meg contends that the land is worth $1.5 million. In 2007, the state
pays Meg $750,000.00. Litigation is expected to be final in 2008.
Under the claim of right doctrine, Meg has $500,000.00 of gain
realized in 2007 even though she may have additional gain in
subsequent years.
§2.02(d) Restrictions on Disposition
The claim of right doctrine is inapplicable if there are restrictions on the taxpayer's
disposition of the funds, provided the restrictions arise out of the receipt of the funds and not as a
result of independently established restrictions, such as a garnishment of wages. These
restrictions may be imposed by law or by contractual arrangement. Examples of restrictions on the
disposition of income that render the claim of right doctrine inapplicable include:
• The deposit of funds in a joint bank account pending determination of proper apportionment
between the joint tenants,
• The segregation of prepaid legal fees into a restricted account pursuant to a state code of
professional responsibility, and
• Restrictions imposed by a state agency upon a regulated utility. 12
12 Cf. Monroe Abstract Corp. v. Commissioner, 41 B.T.A. 5, 9 (1940) (arrangement between taxpayer and company
insuring its title searches requiring taxpayer to deposit a portion of its income from title searches in a reserve account
against future losses was held not to prevent taxation of amounts placed in reserve). But cf. Preston v. Commissioner,
35 B.T.A. 312, 321 (1937), acq. (two attorneys received a check payable to the order of both for services rendered,
but could not agree upon their respective shares; funds held in account pending determination of such). See also
Collins v. Commissioner, 31 T.C.M. (CCH) 835 (1972) (funds deposited in restricted bank account pending outcome
of litigation).