What do you do when you discover that you took in $7.5 million in income that you’re not entitled to over seven (count ’em, seven) tax years? You give it back and deduct it, of course, says Norwich Commercial Group, Inc., T. C. Memo. 2025-43, filed 5/12/25. No, says IRS, because the money came from the line of credit {LOC} Norwich had with a CT bank, hence it was repayment of a loan. And Norwich had to collateralize the overdraft in year of discovery because they couldn’t repay it all at once.

Norwich was a mortgage originator, borrowing money from the CT bank to underwrite and fund home mortgages, unload mortgages to investors, send the payments from the investors to the CT bank, which would fund Norwich’s operating account. Norwich would send the info to the CT bank, who would transfer the money as directed. Except the CT bank didn’t.

Neither the CT bank nor Norwich’s trusty CPA found the mistakes. It took months to unscramble this frittata.

This kind of accounting garbuglio is a walk in the park for Judge Elizabeth A. (“Tex”) Copeland.

“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… LOC draws deposited into Norwich’s clearing account were required to be repaid. The key to these cases is that because [CT bank] accidentally advanced more funds than it should have and failed to properly secure repayments from sales to investors; both parties (Norwich and [CT Bank]) 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.'” T. C. Memo. 2025-43, at p. 18.

So the overstated income was received and reported under a claim of right, except Norwich was wrong. And when Norwich and CT bank finally got the numbers right, Norwich hocked whatever it had to CT bank to secure repayment, which it made over the next two years.

So when does Norwich deduct the repayment? Norwich is an accrual basis taxpayer, so the all-events test comes into sharp focus.

“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.’” T. C. Memo. 2025-43, at p. 23. See also Reg. Section 1.1341-1(e). And Norwich and CT bank signed the collateralization agreement in year when Norwich claimed the deduction.

Norwich wins.

Interesting how this cascading mess evolved during the Great Mortgage Meltdown.