United States Tax Court

United States Tax Court

T.C. Memo. 2025-43

NORWICH COMMERCIAL GROUP, INC.,

Petitioner

v.

COMMISSIONER OF INTERNAL REVENUE,

Respondent

__________

Docket Nos. 3639-19, 8104-19.

Filed May 12, 2025.

__________

P overreported more than $7 million in income on its

2007 through 2013 federal income tax returns. The

overreported income is related to accounting and other

errors in connection with P’s warehouse lending business

supported by lines of credit (LOC) at banks L and F. The

errors resulted in severe undercollateralization of the LOC

at bank L.

In 2014 P discovered the errors and signed an

agreement providing additional collateral and agreeing to

reduce the LOC balance with L by the amount of the

mistaken undercollateralization of that LOC. P then

claimed

a

“CLAIM

OF

RIGHT

DOCTRINE

ADJUSTMENT” deduction of $7,580,507 on its 2014

return. In 2014 P repaid L $1.2 million and received an

interest credit from L of $599,112. It also paid F $626,388.

In 2015 P repaid $5,476,577, representing the remaining

balance due L under the agreement. R disallowed the 2014

deduction and the 2015 NOL carryover stemming from the

claim of right doctrine but allowed the related income

adjustments for open years, some of which are before the

Court.

Held: P’s inclusion of phantom income from 2007–13

was in accordance with the claim of right doctrine entitling

Served 05/12/25

2

[*2]

P to a deduction for 2014, the year the errors were

discovered and the collateralized obligation to reduce its

LOC balance with L was executed.

Held, further, R’s reduction of P’s income for 2012 is

upheld only in the amount of $383,728 to correct for

accounting errors related to an LOC with F.

Held, further, the NOL carryforwards to 2014 and

2015 must be adjusted in accordance with the outcome of

this Opinion.

—————

James N. Mastracchio, Susan E. Seabrook, Karl Kurzatkowski, and Paul

N. Iannone, for petitioner.

William Derick, Athena K. Caiazzo, Stephen C. Best, and Nina P. Ching,

for respondent in docket No. 3639-19.

William Derick, Athena K. Caiazzo, and Nina P. Ching, for respondent

in docket No. 8104-19.

MEMORANDUM FINDINGS OF FACT AND OPINION

COPELAND, Judge: The Commissioner of Internal Revenue

(Commissioner) issued a Notice of Deficiency for tax years 2012 and

2014 to Petitioner, Norwich Commercial Group, Inc. (Norwich),

determining deficiencies of $71,125 and $107,958, respectively. 1 The

Commissioner later issued a Notice of Deficiency for tax year 2015 to

Norwich determining a deficiency of $1,269,106. The deficiencies are

largely attributable to a $7,580,507 deduction claimed by Norwich on its

2014 Form 1120, U.S. Corporation Income Tax Return, described as a

“CLAIM OF RIGHT DOCTRINE ADJUSTMENT.”

Norwich timely filed Petitions with this Court for

redetermination of the deficiencies determined by the Commissioner for

2012, 2014, and 2015 (years at issue), and we consolidated the cases.

After concessions, our decision turns on whether Norwich is allowed a

deduction during the years at issue for (1) the overreporting of assets

1 All dollar amounts are rounded to the nearest dollar.

3

[*3] and income in 2007–13 stemming from transactions with Liberty

Bank (Liberty) and (2) overreporting of income for 2012 stemming from

transactions with Farmington Bank (Farmington), because such income

had been overreported from 2007–13 under the claim of right doctrine.

FINDINGS OF FACT

Some of the facts have been stipulated and are so found. The First

and Second Stipulations of Facts and the accompanying Exhibits are

incorporated by this reference. Norwich maintained its principal place

of business in Avon, Connecticut, when it filed its Petitions.

Phillip DeFronzo, a mortgage broker, incorporated Norwich in

1989 under the laws of Connecticut. Mr. DeFronzo held a majority of

Norwich’s common stock at all relevant times.

Norwich is a

C corporation.

I.

Warehouse Lending

During 2007–15 Norwich 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).

II.

Liberty Warehouse LOC

Liberty was Norwich’s primary warehouse lender. Norwich and

Liberty entered into a Line of Credit and Security Agreement

(Agreement) on August 15, 2007. The Agreement stated that Norwich

could borrow up to $5 million on the LOC it held with Liberty. All LOC

4

[*4] funds were to be used exclusively for originating first and second

mortgage loans secured by residential real estate in Connecticut.

Norwich was then to sell the mortgage receivables to institutional

investors or mortgage banking entities satisfactory to Liberty. Over the

course of several subsequent Omnibus Loan Document Modification

Agreements, Norwich’s LOC was increased to $30 million, and its

permissible uses were expanded to include loans secured by real estate

in several additional states, including Massachusetts, Vermont, New

Hampshire, Maine, Florida, Tennessee, and Rhode Island. (We

sometimes refer to the Line of Credit and Security Agreement and the

Omnibus Loan Document Modification Agreements collectively as the

“Agreements.”)

In addition to the LOC, Norwich maintained separate clearing

and operating bank accounts at Liberty. Norwich used the clearing

account in virtually every step of its mortgage loan origination business.

Funds obtained from the Liberty LOC were deposited by Liberty into

the clearing account. Pursuant to the Agreements, Liberty was not to

transfer LOC funds to the clearing account unless Norwich satisfied

certain prerequisites. Norwich was to provide Liberty with a list of

mortgage loan investors to whom Norwich would sell the mortgages,

ensure the mortgage loans were underwritten in compliance with

Federal National Mortgage Association standards, furnish the

underwriting findings to Liberty, and designate one of Norwich’s

attorneys to hold the mortgage receivables as Liberty’s agent before they

were sold. Both the mortgage loan investors and the attorney had to be

preapproved by Liberty. Advances on the LOC were evidenced by

collateral, specifically mortgage receivables in which Norwich granted

Liberty a corollary and continuing security interest. LOC advances

were never to exceed the principal amount of the mortgage receivables,

lest the LOC become undercollateralized. Whenever Norwich drew on

the LOC, it did so to facilitate a specific customer’s purchase of a specific

house. Only Liberty had the authority to wire LOC funds into or out of

the clearing account.

As described, after a closing on a home purchase, Norwich

received a collateralized promissory note from the customer that

Norwich would subsequently sell to an investor. Norwich (or the

investor directly) then deposited the proceeds from the sale of the

mortgage receivable into the clearing account and then Norwich

informed Liberty of the deposit. Pursuant to the Agreements, Liberty

was to take from the proceeds the amount it was due according to the

relevant terms of the Agreements. Funds remaining in the clearing

5

[*5] account after Liberty took what it was owed were periodically swept

at Norwich’s request from the clearing account into the operating

account. 2 While it lacked control of funds in the clearing account,

Norwich had full discretionary control over funds in the operating

account. Similar procedures were followed with the other warehouse

lenders.

III.

Accounting for the Liberty LOC

Norwich hired Certified Public Accountant (CPA) William Schulz,

of Schulz & Urbanski, P.C., sometime in the early 1990s. Mr. Schulz

served as Norwich’s CPA until 2013. He prepared Norwich’s adjusting

journal entries, financial statements (which he subsequently audited),

and federal income tax returns for years 2007–13. Norwich is a

calendar-year accrual basis taxpayer.

Mr. Schulz used statements provided by Liberty (including LOC,

bank, and collateralized loan statements) to determine the amount of

mortgage fee income Norwich received each year and Norwich’s

mortgage receivable balance. Norwich earned the mortgage fee income

upon completion of each warehouse lending transaction. Mr. Schulz had

a high level of confidence in the Liberty statements. Unknown to Mr.

Schulz, Liberty provided Norwich with some inaccurate statements that

he relied upon during the years at issue. When Mr. Schulz conducted

Norwich’s audits, he began with the unadjusted yearend balances

reported in Norwich’s accounting software.

It was Mr. Schulz’

responsibility to record any necessary adjusting journal entries to

Norwich’s financial records. One of the accounts he adjusted annually

was a revenue account entitled “mortgage fee income.” Norwich relied

on Mr. Schulz to correctly reconcile and account for mortgage fee income

at the end of each year.

Mr. Schulz began his annual adjusting journal entries by debiting

cash and crediting mortgage fee income for all deposits to the clearing

2 The record contains multiple LOC paydown request emails sent by Norwich

to Liberty. Most of the emails state: “Pleas [sic] Pay-down our warehouse loan by the

aggregate funding amounts listed below and deposit the remaining balance to our

Liberty Bank operating account.” The parties stipulated that Norwich made the

transfers between accounts; however, the record further supports that such transfers

were only made with Liberty’s knowledge and approval. As is relevant here, Liberty

periodically failed to act on Norwich’s LOC paydown requests or transferred either less

or more than instructed in payment of the LOC, many times less.

6

[*6] account. 3 He knew that not all the deposits constituted mortgage

fee income, but he used the mortgage fee income account as a reconciling

account. He next credited the cash account and debited mortgage fee

income for moneys transferred back to Liberty in repayment of the LOC.

He then relied on Liberty’s LOC and collateralized loan statements for

additional adjustments to mortgage fee income to account for

outstanding mortgage receivables that had yet to be sold to investors. 4

He made these adjustments with the intention that the mortgage fee

income account would accurately reflect mortgage fee income for the

year, and Norwich’s assets would be correctly stated. The problem with

his approach was that duplicate advances and failed and inaccurate

paydowns by Liberty on the LOC were not detected, resulting in

overstated (and for one year understated) mortgage fee income for 2007–

13. The mortgage receivable asset accounts securing the LOCs were

likewise affected by these errors. Liberty’s advance and paydown errors

are discussed in greater detail below. The following table depicts

Norwich’s accounting as reported on each year’s tax return:

Year

Mortgage Receivables

Warehouse LOC Payable

2007

$2,082,164

$2,068,645

2008

9,482,356

9,258,316

2009

11,571,765

11,359,540

2010

18,577,162

18,681,692

2011

18,075,903

17,580,697

2012

18,288,524

19,394,158

2013

21,222,777

21,222,624

Mr. Schulz issued an unqualified opinion that Norwich’s financial

statements fairly presented the financial position of Norwich for every

year from 2007 to 2013. Each year after preparing Norwich’s audited

financial statements, Mr. Schulz prepared Norwich’s Form 1120. The

amounts reported as mortgage fee income on Norwich’s 2007–13 audited

3 Debits and credits are how business activity is recorded in a double-entry

accounting system. See Debit, Black’s Law Dictionary (12th ed. 2024) (“[I]n

bookkeeping, [a debit is] an entry made on the left side of a ledger or account, noting

an increase in assets or a decrease in liabilities.”); id., Credit (“[A credit is] an

accounting entry reflecting an addition to revenue or net worth . . . .”).

4 Mr. Schultz correspondingly recorded the unsold mortgage receivables as

assets on Norwich’s tax returns and audited financial statements (although, over the

years, he variously labeled them “Mortgage receivables,” “Mortgages receivable,”

“Secured mortgages,” “Mortgage Notes Receivable,” “Mortgage loans held for sale,” or

“Mortgage notes held for resale”).

7

[*7] financial statements were identical to the amounts reported as

mortgage fee income on Norwich’s tax returns for those years. 5 Mr.

Schulz believed that mortgage fee income was correctly reported on

Norwich’s 2007–13 financial statements and tax returns.

IV.

Discovery and Remediation of Liberty LOC Variances

In response to a Joint Consent Order issued July 1, 2014, among

Norwich, the Connecticut Department of Banking, and the

Massachusetts Division of Banks, 6 Norwich began implementing new

loan origination software. On August 7, 2014, Norwich signed an

engagement letter with the consulting firm TeraVerde Management

Advisors (TVM). TVM was originally tasked with assisting Norwich’s

transition to the new software. While assisting with the transition,

TVM was unable to reconcile some accounts because of inexplicable

differences. TVM initiated a thorough review of each step in Norwich’s

loan origination process and discovered that Norwich did not have

sufficient collateral assets (i.e. mortgage receivables held for sale) to

cover the funds then advanced and outstanding on the Liberty LOC.

Upon this discovery, Norwich directed TVM to investigate the LOC and

the collateral variances.

On November 6, 2014, Liberty produced a statement indicating

that the LOC balance was $20,102,799. This is the amount Norwich still

owed Liberty and was consistent with the Norwich’s books and records.

TVM then assembled a detailed schedule of collateral held by Norwich

that totaled $12,733,690, significantly less than the mortgage

receivables asset recorded on Norwich’s books and records. The LOC

therefore appeared to be “out of trust” (meaning advances on the LOC

lacked supporting collateral) by approximately $7,369,000. TVM

5 This is true with for all years at issue except 2009. Norwich’s 2009 return

erroneously reported the amount of mortgage fee income from its financial statements

on the insurance premium revenue line item and vice versa. This mistake is contained

in the detail to Form 1120, Line 1a–Gross receipts or sales, and therefore does not

affect the aggregate gross receipts reported on the return.

6 The Joint Consent Order was implemented in order to protect borrowers; it

required Norwich to “establish, implement, and maintain procedures to ensure that

[Norwich] is capable of compiling and generating an accurate and complete loan list

upon request” and to “retain[] complete loan files, including without limitation,

documentation reflecting each loan application’s outcome.” The Order further required

Norwich to “ensure that no duplicate discharge/release recording fees are collected

from Massachusetts or Connecticut borrowers.” Norwich was not required to restate

its financial statements or file amended state or federal tax returns as a result of the

Joint Consent Order.

8

[*8] considered the undercollateralization highly unusual for two

reasons. First, the LOC had been “out of trust” for an extended period,

from 2007 to 2014. Second, as of 2014 the LOC was “out of trust” by 25%

or more of the total amount advanced. TVM concluded that the

undercollateralization stemmed from errors made by Liberty and that

“weak internal controls within [Norwich’s] Accounting/Finance

Department” prevented Norwich from detecting the errors.

TVM advised Norwich to contact Liberty to discuss the

undercollateralization. Norwich contacted Liberty in mid-November

2014 and informed them that the LOC was significantly

undercollateralized. Liberty did not initially believe Norwich was

correct or that the situation was urgent. It took Norwich’s chief financial

officer several attempts to schedule a meeting with Liberty staff.

Representatives from Liberty and Norwich eventually met to

discuss the issue. Liberty’s representatives were shocked and deeply

concerned upon learning that the LOC was “out of trust.” On November

21, 2014, Liberty and Norwich entered into an agreement wherein both

parties acknowledged that the LOC then had an unsecured “[o]veradvance amount of approximately $7,300,000.00.” Norwich agreed to

provide Liberty additional collateral and to reduce the LOC to match the

existing mortgage receivables held as security for the LOC. The

additional collateral consisted of “a first lien on and security interest in”

all of Norwich’s business assets 7 including its mortgage servicing rights

and goodwill, first mortgage liens on five delineated properties, and a

second position mortgage on a second property. Norwich and Liberty

also began working together to ascertain the origin and precise amount

of the undercollateralization. Liberty hired its own outside firm, Sobel

& Co. (Sobel), to verify the undercollateralization amount. Meanwhile,

TVM reviewed every warehouse lending transaction from the inception

of the LOC in 2007 through early 2015. Determining the origin and

amount of the undercollateralization was no simple task for either party

due to multiple transactions associated with each advance. In fact it

took Sobel four months to complete its separate verification work.

Liberty, Sobel, Norwich, and TVM collaborated with one another during

this time.

7 The business assets excluded mortgage loans pledged to Farmington and to

People’s United Bank.

9

[*9] Together they determined that the net variances between the

LOC and Norwich’s collateral totaled $7,275,689 for 2007–14. The

variances agreed to for each year were as follows:

Year

Liberty LOC Collateral

Variances

2007

$707

2008

(4,216)

2009

174,825

2010

1,329,028

2011

2,878,939

2012

443,395

2013

2,131,439

2014

321,572

Total

$7,275,689

The variances were primarily caused by three types of errors: duplicate

advances, failed paydowns, and inaccurate paydowns. Duplicate

advances occurred when, after Norwich requested an advance on the

LOC, Liberty advanced the requested funds and then made a second,

unrequested advance in exactly the same amount to Norwich. Failed

and inaccurate paydowns began with Norwich’s notifying Liberty that

collateral (a mortgage receivable) for an advance had been transferred

to an investor in exchange for cash that had been deposited into the

clearing account. Liberty was then instructed to transfer the cash out

from the clearing account to pay down the LOC; but Liberty either failed

to do so (failed paydown) or took an amount different from what Norwich

had instructed (inaccurate paydown).

The errors resulted in amounts advanced on the Liberty LOC

without collateral to support them, and in over-reported mortgage

receivable assets and income, all of which violated the terms of the

Agreements. Also contrary to requirements of the parties’ Agreements,

the unsecured advances were swept from the clearing account into

Norwich’s operating account. Both Norwich and Liberty believed

amounts swept into Norwich’s operating account were Norwich’s

revenues from completed warehouse lending transactions.

TVM also identified two errors in the Farmington warehouse

lending transactions during its review of the Liberty LOC. Proceeds

from the sale of mortgage receivables related to Farmington’s LOC had

been erroneously deposited into the Liberty clearing account. Both

10

[*10] deposit errors occurred in 2012. Those deposits were $383,728

related to a transaction identified as the Bur*** mortgage loan

(Farmington B mortgage loan) and $242,660 related to a transaction

identified as the Czy*** mortgage loan (Farmington C mortgage loan).

The parties agree that the Farmington C mortgage loan deposit into the

clearing account at Liberty did not result in over-reported mortgage fee

income. Norwich repaid the amounts related to the Farmington B and C

mortgage loan deposit errors in 2014.

On March 23, 2015, Liberty and Norwich amended their

November 21, 2014, agreement, in which they had memorialized their

initial understanding of the undercollateralization. They agreed to a net

amount due of $6,676,577 as of November 6, 2014. They arrived at this

sum by reducing the total unsecured amount of $7,275,689 by a

$599,112 interest credit, which they agreed upon because of excess

interest on the LOC Norwich had paid Liberty as a result of the

erroneously advanced funds. Norwich reported the $599,112 interest

credit as “other income” on its 2014 Form 1120 to correct interest

expense deductions claimed for prior years. Norwich began paying down

the LOC balance as early as November 24, 2014. Norwich paid Liberty

$1.2 million in 2014 and $5,476,577 in 2015, with the final payment

made on October 15, 2015. Some of the funds used by Norwich to pay

Liberty came from the sale of its profitable Mortgage Servicing Rights

business. Norwich also paid Farmington $626,388 in 2014.

V.

Norwich’s Tax Returns and Notices of Deficiency

The following table reflects the parties’ stipulations:

Year

Overstatement

(Understatement)

2007

$707

2008

(4,216)

2009

174,826

2010

1,329,029

2011

2,271,971

2012

1,434,091

2013

2,131,439

Total

$7,337,847

11

[*11] The parties thereby agree that Norwich overstated (and for one

year understated) mortgage fee income on its 2007–13 income tax

returns in the amounts delineated in the above table.

The total is computed by subtracting the 2014 LOC collateral

variances from the total 2007–14 Liberty LOC collateral variances

($7,275,689 − $321,572 = $6,954,117), 8 then adding the $383,728

Farmington B mortgage loan ($6,954,117 + $383,728 = $7,337,845). 9 On

its original 2014 return Norwich also added to the total the $242,660

Farmington C mortgage loan to calculate the $7,580,507 deduction it

claimed. Norwich concedes that addition was incorrect. On its return

Norwich described the deduction as a “CLAIM OF RIGHT DOCTRINE

ADJUSTMENT.” The record contains very little information about the

Farmington B and C mortgage loans other than that they were

accidentally deposited into Norwich’s clearing account at Liberty in 2012

and repaid in 2014.

The Commissioner issued a Notice of Deficiency to Norwich for its

2012 and 2014 tax years, adjusting each of Norwich’s 2012–14 tax

returns and determining deficiencies of $71,125 for 2012 and $107,958

for 2014. The Commissioner disallowed Norwich’s 2014 claim of right

doctrine deduction in its entirety. For 2012 the Commissioner decreased

Norwich’s taxable income to account for the erroneous advances

included in mortgage fee income and increased Norwich’s section 179 10

deduction for depreciation expenses. Norwich completed and attached

to its 2014 return a Corporation Application for Tentative Refund of

$629,471 that Norwich later received. The tentative refund arose from

Norwich’s 2014 net operating loss (NOL) carryback to its 2012 tax year.

The $71,125 deficiency is due to the refund’s exceeding Norwich’s

allowed reductions to income for 2012.

The Commissioner likewise decreased Norwich’s 2013 taxable

income by an amount equal to the 2013 stipulated overstatement. In

addition the Commissioner disallowed the entirety of Norwich’s 2013

8 Not to be confused with the $6,676,577 net over-advance amount agreed to

by Liberty and Norwich, which is the sum of the 2007–14 LOC variances, $7,275,689,

less the $599,112 interest credit.

9 There remains a $2 discrepancy that is due to rounding.

10 Unless otherwise indicated, statutory references are to the Internal Revenue

Code, Title 26 U.S.C. (I.R.C. or Code), in effect at all relevant times, regulation

references are to the Code of Federal Regulations, Title 26 (Treas. Reg.), in effect at all

relevant times, and Rule references are to the Tax Court Rules of Practice and

Procedure.

12

[*12] NYU tuition expense deduction and a portion of its NYC rent

expense deduction. These adjustments increased the loss reported for

2013 by $2,087,697. That loss carries forward and affects the NOL

adjustment made by the Commissioner in determining the 2014

deficiency.

In addition to the Commissioner’s disallowance of the $7,580,507

claim of right deduction for 2014, the Commissioner made additional

2014 adjustments that are either uncontested by Norwich, stipulated by

the parties, or related to NOL carryforwards and carrybacks that hinge

on the outcome of the 2014 claim of right deduction. The aggregate

adjustments resulted in an ordinary loss of $65,841 and an alternative

minimum tax (AMT) due of $107,958 for 2014.

The Commissioner issued a Notice of Deficiency for Norwich’s

2015 tax year determining a $1,269,106 deficiency. The deficiency is

due to the decreased NOL carryover from 2014 applied to 2015 and a

reduction to the section 179 depreciation deduction but offset by an

increased AMT NOL carryover.

After concessions, 11 the issues for decision are (1) whether

Norwich is entitled to deductions for amounts paid to Liberty and

Farmington in 2014 and Liberty in 2015 to rectify prior income

inclusions under the claim of right doctrine or whether those payments

were simply repayments of loans and (2) if Norwich is entitled to

deductions (i.e., the payments were not repayments of loans), for what

year such deductions should be claimed. Our determinations also

potentially affect the adjustments for the 2012 tax year and the

carryover loss from 2013 into 2014.

OPINION

I.

Introduction

Norwich argues that it properly claimed a $7,337,847 deduction

for 2014 for amounts previously received and reported as income for tax

years 2007 through 2013 under the claim of right doctrine. Norwich

11 The Commissioner and Norwich have stipulated that Norwich is entitled to

deductions of $12,966 and $13,467 for “NYU tuition” for 2013 and 2014, respectively.

In addition, the parties have stipulated that Norwich is not entitled to deduct “NYC

rent expense” for 2013 but is entitled to deduct $8,326 for “NYC rent expense” for 2014.

As indicated, see supra p. 10, Norwich concedes that the $242,660 Farmington C

mortgage loan should not be included in calculating its overstatement of mortgage fee

income.

13

[*13] argues that because 2014 was the year in which it discovered it

did not have an unrestricted right to the income it received in earlier

years, 2014 was the proper year for the deduction. In the alternative

Norwich suggests that deductions are allowable for the years of

repayment, those being 2014 and 2015. The Commissioner argues that

the overreporting of income for tax years 2007–13 was a result of

Norwich’s uncollateralized receipt of funds from Liberty and

Farmington through the LOCs that were required to be repaid.

Consequently, the moneys Liberty and Farmington failed to secure as

repayments were continuing loans such that the claim of right doctrine

does not apply. The Commissioner posits that the proper remedy is

amending the prior year returns to the extent not barred by the statute

of limitations. In the alternative the Commissioner argues that Norwich

is not entitled to a deduction beyond the amount of economic

performance, meaning the amounts repaid in the years repaid. The

years at issue before the Court include 2012, 2014, and 2015. 12

The claim of right doctrine is central to the disposition of this

issue. If the claim of right doctrine applies, the amounts reported as

mortgage fee income should have been included in Norwich’s 2007–13

taxable income and would be deductible when required to be repaid. If

the amounts were instead loans, they should not have been included in

the prior years’ income and are not deductible when repaid. If the

payments were loans, the claim of right doctrine would not apply to

remedy the prior improper inclusion of loan amounts in income.

II.

Burden of Proof

The Commissioner’s determinations in a Notice of Deficiency are

generally presumed correct, and the taxpayer bears the burden of

proving otherwise. Rule 142(a); INDOPCO, Inc. v. Commissioner, 503

U.S. 79, 84 (1992); Welch v. Helvering, 290 U.S. 111, 115 (1933). Under

certain circumstances the burden of proof shifts from the taxpayer to the

Commissioner. See I.R.C. § 7491(a). Norwich does not contend that it

has met the requirements for shifting the burden of proof, and the record

12 Norwich’s Petition in Docket No. 3639-19 did not assign error to (1) the

increased 2014 installment sale gain, (2) the disallowed 2014 recourse reserve

deduction related to that installment sale, or (3) the disallowed business expense

related to a captive entity. Norwich is thus deemed to have conceded the correctness

of those adjustments. See Rule 34(b)(1)(G); Funk v. Commissioner, 123 T.C. 213, 218

(2004).

14

[*14] does not indicate otherwise. Thus, the burden of proof for all

factual issues remains with Norwich.

III.

Claim of Right Doctrine

“[G]ross income means all income from whatever source derived,”

including “[g]ross income derived from business.” I.R.C. § 61(a)(2);

Commissioner v. Glenshaw Glass Co., 348 U.S. 426, 429 (1955). 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. See I.R.C. §§ 446, 451(a). 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. See I.R.C. § 451(b).

The claim of right doctrine provides an interesting twist to

determining when the receipt of funds constitutes taxable income and

what happens when the income inclusion is later determined to be in

error. The doctrine was first announced by the Supreme Court in North

American Oil Consolidated v. Burnet, 286 U.S. 417 (1932). In that

opinion the Supreme Court addressed the proper year for a company to

include in income earnings the ownership of which was uncertain

because of ongoing litigation. Id. at 420–22. The Supreme Court

articulated the doctrine as follows:

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 [include on his] return, even

though 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.

Id. at 424. As a corollary, the Supreme Court went on to say that if in a

later year “the company had been obliged to refund the profits received

in [a prior year], it would have been entitled to a deduction from the

profits of [the year of repayment], not from those of any earlier year.”

Id. In other words, if income that is received under claim of right and

without restriction in one year is required to be repaid, it is deductible

for the year of repayment and not by amending the return for the year

of receipt.

The Supreme Court further clarified the doctrine, noting that

“[t]here is a claim of right when funds are received and treated by a

taxpayer as belonging to him. The fact that subsequently the claim is

15

[*15] found to be invalid by a court does not change the fact that the

claim did exist. A mistaken claim is nonetheless a claim . . . .” Healy v.

Commissioner, 345 U.S. 278, 282 (1953). Thus, a mistake of fact about

whether funds received are taxable income does not prevent the

application of the claim of right doctrine. “Should it later appear that

the taxpayer was not entitled to keep the money, . . . he would be entitled

to a deduction in the year of repayment; the taxes due for the year of

receipt would not be affected.” United States v. Skelly Oil Co., 394 U.S.

678, 680–81 (1969).

Moreover, the receipt of funds must be “without the consensual

recognition, express or implied, of an obligation to repay.” James v.

United States, 366 U.S. 213, 219–20 (1961). Accordingly, a taxpayer has

a claim of right to funds if the taxpayer (1) receives the funds,

(2) controls the use and disposition of the funds, (3) asserts entitlement

to the funds, treating them as its own, and (4) lacks consensual

recognition of an obligation to repay the funds. Id.; see also Vandenbosch

v. Commissioner, T.C. Memo. 2016-29, at *13.

Importantly, after the caselaw under North American Oil

Consolidated and its progeny developed, Congress stepped in to remedy

a perceived inequity in the claim of right doctrine. Congress became

concerned that tax rate changes from year to year could harm taxpayers

who previously included items in income under the claim of right

doctrine and had to claim their deduction for a later year in which tax

rates were lower. Congress enacted section 1341 in response. See

Internal Revenue Code of 1954, ch. 736, § 1341, 68A Stat. 3, 348; see also

Dominion Res., Inc. v. United States, 219 F.3d 359, 363 (4th Cir. 2000)

(“To relieve ‘inequit[y][]’ [in tax rate changes,] Congress enacted § 1341,

which permits taxpayers [who were not adequately compensated from a

deduction allowable in a later year] ‘to recompute their taxes for the year

of receipt’ if they choose to do so. In sum, § 1341 is designed to put the

taxpayer in essentially the same position he would have been in had he

never received the returned income.” (first alteration in original)

(quoting Skelly Oil Co., 394 U.S. at 682)).

Section 1341 applies if (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,” I.R.C. § 1341(a)(1), i.e., the

taxpayer “must have included the item in income under a claim of right,”

Alcoa, Inc. v. United States, 509 F.3d 173, 177 (3d Cir. 2007)), (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

16

[*16] not have an unrestricted right to such item or to a portion of such

item,” I.R.C. § 1341(a)(2), and (3) “the amount of such deduction exceeds

$3,000,” I.R.C. § 1341(a)(3). “If these requirements are met, the

taxpayer has two choices: he can deduct the item from the current year’s

taxes, or he can claim a tax credit for the amount his tax was increased

in the prior year by including that item.” Fla. Progress Corp. & Subs. v.

Commissioner, 348 F.3d 954, 957 (11th Cir. 2003), aff’g per curiam 114

T.C. 587 (2000).

This provision, as explained by Skelly Oil Co., 394 U.S. at 682,

makes “clear that Congress did not intend to tamper with the underlying

claim-of-right doctrine; it only provided an alternative for certain cases

in which the new approach favored the taxpayer.” Here, Norwich

recognized the choice available under section 1341 but did not elect an

alternate computation of taxes for the year of deduction because it

acknowledged that the 2007–13 tax rates were not different from those

of 2014.

Interestingly, both the claim of right doctrine and the possibility

of subsequent but related deduction(s) must be considered here. For tax

year 2012, which is likewise before us, Norwich overreported mortgage

fee income by $1,434,091, which the Commissioner allowed as a

downward adjustment to mortgage fee income in his Notice of Deficiency

for 2012. 13 If the claim of right applies, that adjustment would be

reversed. For 2014 the Commissioner disallowed the entire $7,580,507

deduction claimed by Norwich, represented by payments of $1.2 million

in 2014 less the $321,572 advanced and repaid in 2014, and payments

of $5,476,577 in 2015 to Liberty, payments of $626,388 to Farmington

in 2014, and a $599,112 interest credit. 14 Both parties agree that

$242,660 of the Farmington payment was never included in income.

Also for 2014 the Commissioner increased the NOL carryover from 2013.

The increase is affected by the Commissioner’s $2,131,439 downward

adjustment to mortgage fee income for 2013.

Thus, in these cases, we must first consider whether the items

were subject to the claim of right doctrine and were therefore income

instead of loans for 2007–13. If we determine that the claim of right

doctrine should have applied, we must determine if and when the

13 The Commissioner’s adjustment in the Notice of Deficiency was $1,676,752

because he originally allowed an adjustment for $242,660 related to the Farmington C

mortgage loan which, as we have discussed, Norwich now concedes was not included

in income for 2012.

14 As noted supra note 9, there remains a $2 rounding discrepancy.

17

[*17] deductions are allowed, all for 2014 or when cash payments were

made for 2014 and 2015. The parties do not dispute that Norwich

received funds from Liberty and Farmington in 2007–13, and neither

party has asserted that the repayment was not required. Instead, the

parties’ dispute centers on the character of the payments (repayment of

loans versus deduction) and the timing of the deduction, if allowed.

Essentially this is a dispute as to the fourth and final requirement set

forth above in James, 366 U.S. at 219, see supra p. 15: whether at the

time of receipt there was a consensual recognition of an obligation to

repay the funds.

A.

Liberty’s Transfers of Funds: Mortgage Fee Income or

Loans?

1.

The Parties’ Legal Positions

Norwich argues that the issues in these cases stem from Liberty’s

allowing transfers from the clearing account to Norwich’s operating

account that should not have occurred. Norwich suggests that both

parties believed and understood that such transfers represented earned

mortgage fee income and, as a result, Norwich overreported such

income.

The Commissioner argues that the origin of the funds was

borrowing on an LOC, and that the “loan” was repaid when the error

was discovered. The Commissioner emphasizes that the LOC was

overextended and that Norwich had an obligation to repay when the

LOC distributions were made; therefore, he contends that the

repayments were simply repayment of loans. The Commissioner

correctly asserts that loans are not income and that loan repayments

are not deductible. See Commissioner v. Tufts, 461 U.S. 300, 307 (1983).

The Commissioner contends that there was implicit consensual

recognition between Liberty and Norwich that Norwich was obligated to

pay back the erroneous advances. See James, 366 U.S. at 219. He cites

Smarthealth, Inc. v. Commissioner, T.C. Memo. 2001-145, 81 T.C.M.

(CCH) 1777, to support his contention. In Smarthealth, 81 T.CM. (CCH)

at 1781, we 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

18

[*18] balances when customers called to place subsequent orders. Id.

at 1779.

2.

Analysis

What makes these cases particularly complicated is that Norwich

was in the business of facilitating loans. In order to earn mortgage fee

income, Norwich relied on borrowing from its LOCs. Thus, the

Commissioner focuses on the origin of the funds rather than the origin

of the transaction that caused Norwich to receive funds as income. It is

that income that all now agree Norwich was not actually entitled to

receive. Thus, we must step back and look at the full picture of what

occurred. The lending transactions were legitimate transactions and

there is no doubt that the Liberty LOC draws deposited into Norwich’s

clearing account were required to be repaid. The key to these cases is

that because Liberty accidentally advanced more funds than it should

have and failed to properly secure repayments from sales to investors;

both parties (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. See Treas. Reg. § 1.1341-1(a)(2) (defining

“‘income included under a claim of right’ [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”). If

the mortgage receivables had been correctly accounted for, the mortgage

fee income disbursements would not have occurred.

Important here is that Norwich incorrectly overreported its assets

and its income and correctly reported its “Warehouse LOC Payable.” To

illustrate, the following table depicts mortgage receivables assets versus

LOC liabilities related to LOC lending by Liberty as reported by

Norwich on its tax returns. Similar amounts were reported on

Norwich’s financial statements, but the amounts due Liberty were not

separately stated as with the tax returns.

19

[*19]

Year

Mortgage Receivables

Warehouse LOC Payable

2007

$2,082,164

$2,068,645

2008

9,482,356

9,258,316

2009

11,571,765

11,359,540

2010

18,577,162

18,681,692

2011

18,075,903

17,580,697

2012

18,288,524

19,394,158

2013

21,222,777

21,222,624

2014

12,733,690 15

20,102,799

There is no dispute that Norwich received funds from 2007 to

2014 originating from various LOCs and correctly reported those

liabilities. There is likewise no dispute that mortgage receivables were

overreported. Finally, there is no dispute that funds transferred from

Norwich’s clearing account to its operating account at Liberty were used

in Norwich’s business operations and not available to pay down the

Liberty LOC when the undercollateralization error was discovered. The

funds were unavailable because both Liberty and Norwich had assumed

they were earned mortgage fee income and allowed their transfer to

Norwich in earlier years. In fact, it took Norwich two years to restore

the funds. Had the errors not been made, Liberty could have simply

moved the funds back from the clearing account.

Here, both Liberty and Norwich understood Norwich to be

entitled to the moneys transferred from the clearing account. In fact it

took several months for TVM and Sobel to determine the total amount

of erroneous advances. According to its understanding, Norwich

recorded its receipt of the erroneous advances as income and adjusted

its asset accounts for the “Mortgage receivables” on its financial

statements and tax returns. The liability on the Liberty LOC was

correctly recorded and reported. The assets supporting that LOC were

reported in error. Unlike the taxpayer in Smarthealth, Norwich was

unaware until 2014 that the erroneous transfers were not actually

income. Norwich and Liberty were both equally unaware that the assets

supporting the LOC were overstated. This lack of awareness was due

in large part to incorrect statements provided by Liberty to Norwich and

15 The tax returns and financial statements for 2014 and 2015 do not separately

state the mortgage receivables held for sale that collateralized the LOC from Liberty

(i.e. Liberty mortgage receivables) or the amount of the Liberty LOC, as in prior years.

The amounts stated in the table are the mortgage receivables and LOC balance

determined as of November 6, 2014, from the subsequent audit by TVM.

20

[*20] relied on by both parties in maintaining the LOC. There was no

implicit consensual recognition between Norwich and Liberty that the

funds would later be repaid, as evidenced by the mutual acceptance of

transfers that were swept into the operating account. We hold 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.

B.

Farmington B Mortgage Loan

The Farmington loan proceeds deposited into the wrong account

do not present the same issue as the Liberty mutual mistake of fact.

Farmington did not improperly transfer funds to Norwich. The mistake

with the Farmington proceeds seems to have been entirely due to

Norwich’s error. Farmington had no control over the Liberty clearing

account and could not have caught or corrected the error. Petitioner has

conceded that the $242,000 Farmington C mortgage loan proceeds were

never taken into income, which leaves only the Farmington B mortgage

loan proceeds of $383,728 received in 2012 and repaid in 2014 for

consideration. Both parties agree that those loan proceeds were

included in income by Norwich for 2012, and the 2012 Notice of

Deficiency provides an adjustment for that improper inclusion. The only

explanation provided for the $383,728 overstatement of taxable income

during 2012 was that during TVM’s review of the Liberty LOC it was

discovered that mortgage loan proceeds from Farmington were

mistakenly deposited into Liberty Bank’s clearing account. That error

does not present the same mutual mistake of fact as the Liberty errors.

The Farmington B mortgage loan proceeds error that was mistakenly

taken into income for 2012 is best addressed by the adjustment that the

Commissioner has already made for this item such that 2012 mortgage

fee income should be reduced by $383,728, and the remaining income

adjustments for 2012 found in the Notice of Deficiency that reduced

mortgage fee income should be reversed.

C.

The Allowable Deduction, Timing, and Amount

Given our holding that Norwich’s inclusion in its 2007–13 taxable

income of erroneous transfers from Liberty was in accordance with the

claim of right doctrine, we must next address whether Norwich’s

deduction for 2014 should be respected. Norwich argues that the

expenditure was an ordinary and necessary business expense under

section 162, or in the alternative, a deductible loss under section 165.

Norwich also argues that the entire amount of the error was deductible.

21

[*21] The Commissioner argues it was not a deductible expense or loss;

and if it was, the deduction should be allowed only for the year of

economic performance (i.e. limited to the amount and time of

repayment). Thus, we must address (1) whether the payments and

credits were a deductible expense or loss, and if so, (2) whether the

deduction should be claimed for the year the payment obligation was

established or the year of actual payment, and (3) the amount of the

deduction.

1.

Deduction

Section 162(a) provides that “[t]here shall be allowed as a

deduction all the ordinary and necessary expenses paid or incurred

during the taxable year in carrying on any trade or business,” and

section 165(a) provides that taxpayers are entitled to deduct “any loss

sustained during the taxable year and not compensated for by insurance

or otherwise.” We note at the outset that these cases present a dilemma

similar to that faced by the Supreme Court in Skelly Oil Co., 394 U.S.

at 683, where there was “some dispute between the parties about

whether the [repayments] in question [were] deductible as losses under

[section] 165 of the 1954 Code or as business expenses under [section]

162.” In that opinion, the Supreme Court explained that “[a]lthough in

some situations the distinction may have relevance, cf. Equitable Life

Ins. Co. of Iowa v. United States, 340 F.2d 9 (C.A. 8th Cir. 1965), we do

not think it makes any difference here.” Id. at 683–84. Similarly, here,

a deduction under section 162 or 165 will not make a difference to the

tax deficiencies ultimately determined in these cases. What is relevant

here is that Norwich was required by Liberty to provide adequate

interim collateral for the LOC and then pay down the LOC to the actual

mortgage receivable balance. It was required to do so in order to be able

to continue its mortgage origination line of business using the Liberty

LOC in the future. Such an expenditure was necessary for Norwich to

remain in business as it is difficult to envision a scenario in which any

banking institution would continue to lend funds on an LOC to a

mortgage originator who refused to maintain adequate collateral in

support of the LOC. The payment can be construed as a payment related

to a loss of the “[m]ortgage receivables” assets on Norwich’s books and

records that were found to be overstated. 16 Accordingly, Norwich may

16 We note that Norwich’s writedown of its mortgage receivables might likewise

be construed as a writedown of worthless receivable assets under section 166(a)(1),

which provides that “[t]here shall be allowed as a deduction any debt which becomes

worthless within the taxable year.” Of course, in this context it is a debt receivable

22

[*22] claim a deduction as it clearly qualifies. See also Dominion Res.,

Inc., 219 F.3d at 369 (allowing deduction of refunds paid to public utility

customers related to moneys previously reported as income in error

despite the fact that the refunds were not to the exact same customers,

but they were required to be repaid and “therefore deductible expenses

for purposes of the statute”).

2.

Timing

Having determined deductibility, we must address the year or

years for which Norwich may claim deductions. Because of the delay in

payment, the Commissioner argues that Norwich’s deduction should be

limited to the amount actually paid each year. He asks us to evaluate

the economic performance doctrine in determining when to allow a

deduction. Norwich argues that the repayment accrued in 2014 or in

the alternative 2014 and 2015.

Importantly here, most cases arising under the claim of right

doctrine involve cash basis taxpayers, but that does not dictate the

proper treatment of an accrual basis taxpayer. “One of the basic aspects

of the federal income tax is that there be an annual accounting of

income.” Healy v. Commissioner, 345 U.S. at 281. Section 461(a)

provides that income tax deductions are “taken for the taxable year

which is the proper taxable year under the method of accounting used

[by the taxpayer] in computing taxable income.” Norwich is an accrual

basis taxpayer.

Generally, an accrual basis taxpayer may deduct expenses for the

years in which it incurred the expenses, regardless of the actual

payment dates. Courts have recognized “the general rule on the timing

of deductions when repayment of funds received under a claim of right

is required: ‘Any amount repaid is deductible in the year of repayment

(on the cash basis) or the year in which the liability to repay becomes

fixed (on the accrual basis).’” Quinn v. Commissioner, 524 F.2d 617, 624

(7th Cir. 1975) (quoting Estate of Whitaker v. Commissioner, 259 F.2d

379, 382 (5th Cir. 1958), aff’g 27 T.C. 399 (1956)), aff’g 62 T.C. 223

(1974). However, we must also consider that the all events test governs

whether a business expense has been incurred to permit its accrual for

tax purposes. See Morning Star Packing Co., L.P. v. Commissioner, T.C.

asset that was written down, not a liability written down as the Commissioner has

argued. We do not consider this analysis further as it was not advanced by the parties.

23

[*23] Memo. 2020-142, at *14, aff’d, Nos. 21-71191, et al., 2024 WL

5165718 (9th Cir. Dec. 19, 2024).

“[I]n determining whether an amount has been incurred with

respect to any item . . . the all events test shall not be treated as met any

earlier than when economic performance with respect to such item

occurs.” I.R.C. § 461(h)(1). The Commissioner agrees that we must

respect the general rule in section 461(a) that “[t]he amount of any

deduction or credit allowed by [the Code] shall be taken for the taxable

year which is the proper taxable year under the method of accounting

used [by the taxpayer] in computing taxable income.” However, he

suggests that we must focus on when economic performance occurred

under section 461(h). He suggests that absent any other economic

performance rules, “economic performance occurs as the taxpayer makes

payments in satisfaction of the liability to the person to which the

liability is owed.” See Treas. Reg. § 1.461-4(g)(7).

Section 461(h) sets forth parameters for determining when

economic performance occurs, and section 461(h)(2) outlines the timing

rules for economic performance. Given that the claim of right doctrine

effectively creates a liability for repayment of overstated income in the

year of discovery, the most applicable timing provision is found in

section 461(h)(2)(B), which establishes that “[i]f the liability of the

taxpayer requires the taxpayer to provide property or services, economic

performance occurs as the taxpayer provides such property or services.”

Here, Norwich was required to immediately provide property by

restoring collateral for the LOC and then to quickly pay down the LOC.

As previously discussed, the parties’ November 21, 2014, agreement

gave Liberty “a first lien on and security interest in” all of Norwich’s

business assets. See supra p. 8. Thus, economic performance occurred

when the agreement was signed and collateral was given.

In fact Treasury Regulation § 1.1341-1(e) bolsters this conclusion,

providing:

The provisions of section 1341 and this section shall be

applicable in the case of a taxpayer on the cash receipts and

disbursements method of accounting only to the taxable

year in which the item of income included in a prior year

(or years) under a claim of right is actually repaid.

However, in the case of a taxpayer on the cash receipts and

disbursements method of accounting who constructively

received an item of income under a claim of right and

24

[*24] included such item of income in gross income in a prior year

(or years), the provisions of section 1341 and this section

shall be applicable to the taxable year in which the

taxpayer is required to relinquish his right to receive such

item of income. Such provisions shall be applicable in the

case of other taxpayers only to the taxable year which is

the proper taxable year (under the method of accounting

used by the taxpayer in computing taxable income) for

taking into account the deduction resulting from the

restoration of the item of income included in a prior year

(or years) under a claim of right. For example, if the

taxpayer is on an accrual method of accounting, the

provisions of this section shall apply to the year in which

the obligation properly accrues for the repayment of the

item included under a claim of right.

Treasury Regulation § 1.1341-1(e) can thus be harmonized with section

461(h) such that the year in which the obligation to restore an accrual

basis taxpayer’s overstated income is secured by providing cash or other

collateral establishes the year of deduction.

Here, the obligation to correct prior errors was memorialized in

2014, when Norwich provided additional collateral to Liberty and when

Norwich and Liberty signed an agreement ensuring the reduction of the

LOC. That agreement was amended in March 2015 after further

detailed analysis of the LOC’s undercollateralization by both parties.

Under the terms of the agreement, Norwich provided substitute assets

for the missing mortgage receivables, received an interest credit of

$599,112, paid $1.2 million in 2014 and agreed to pay down the LOC by

an additional $5,476,577 in 2015. Because providing collateral as a

substitute for the underreported mortgage receivables satisfied section

461(h)(2)(B), all events relating to that obligation were met in 2014 and

that is the year for which the deduction is appropriate. Thus, we reject

the Commissioner’s position that the deduction should be allowed only

for the years of cash payment and uphold the deduction for 2014, but

only in the amount more fully set forth below.

3.

Deductible Amount

Turning to the amount of the deduction, we note that while

Norwich claimed a “CLAIM OF RIGHT DOCTRINE ADJUSTMENT”

deduction of $7,580,507 on its 2014 Form 1120, Norwich now claims

25

[*25] entitlement to a total deduction of only $7,337,847. 17 Norwich

calculates the deduction by subtracting from total Liberty erroneous

advances of $7,275,689 the $321,572 erroneously advanced by Liberty

in 2014 (and therefore corrected before it was included in taxable income

that year) and adding the Farmington B mortgage loan of $383,728. 18

The Commissioner requests that we disallow any deduction for the

interest adjustment. Norwich argues that it is entitled to the full

amount of the improper inclusion in income (including the adjustment

for $599,112 credited back for interest overpayments).

First and foremost, we have held above that the claim of right

involved only the mutual mistakes between Norwich and Liberty and

that the amounts ultimately paid to Farmington are not deductible for

2014. See supra p. 20. That leaves us to consider the $599,112 credit

that Norwich took into income for 2014. Norwich included in 2014

income the interest credit because it involved the return of interest

payments that had been deducted for prior years. But that does not

resolve whether that credit should also be considered in the claim of

right related adjustment. The effect of the credit was as if Liberty had

made a payment to Norwich to return the amount of overpaid interest

and then Norwich paid that exact amount back to Liberty. First, the

credit involved interest income accrued, paid, and deducted on the

Liberty line of credit in 2007–14; consequently, it was properly included

in income when the corresponding credit was received. However, the

credit also served to restore funds distributed by mistake and should be

respected as part of the claim of right related deduction for 2014 for all

of the reasons stated in this Opinion. Overall the 2014 deduction is

limited to the 2007–13 overreporting of income related to the mistake of

fact with Liberty that Norwich corrected by supplying additional

collateral and subsequently repaid through cash payments and a credit

from Liberty. The deductible amount is $6,954,117 calculated as

follows: $7,275,689 of total Liberty overreporting less the $321,572

amount already corrected for 2014.

IV.

Conclusion

For the 2012 tax year the Commissioner reduced Norwich’s

income by $1,676,752 to account for Norwich’s overreporting of

17 This $242,660 difference is the result of Norwich’s concession that the

Farmington C mortgage loan should not be included in determining its total

overstatement of mortgage fee income.

18 This calculation equals $7,337,845. The additional $2 difference is due to

rounding. See supra note 9.

26

[*26] mortgage fee income; however, because Norwich received most of

that income from Liberty under a claim of right, the correct reduction is

only $383,728 related to Norwich’s reporting loan funds from

Farmington as income in error. For 2014 Norwich may deduct

$6,954,117 for the erroneous prior year actions by Liberty in

transferring to Norwich’s operating account more than it was entitled

to, actions that were corrected in 2014. For all years at issue, the NOLs

must be adjusted. Any additional particulars related to the adjustments

may be addressed by the parties in their Rule 155 computations.

To reflect the foregoing and other concessions by the parties,

Decisions will be entered under Rule 155.