The IRS has your back if you have to repay money for some reason and you’ve already claimed it as income—and paid tax on it—in a prior year. Usually, the payment to you was a mistake, so you were obligated to return it.
Before the enactment of the Tax Cuts and Jobs Act (TCJA) in late 2017, you could claim a Section 1341 credit on a subsequent tax return, or you could claim the repayment as an itemized miscellaneous deduction if it was less than $3,000. But the TCJA eliminated most itemized miscellaneous deductions from the U.S. tax code, at least through the end of 2025, when the law potentially expires.
Now, your only recourse in this situation for 2022 is the Section 1341 “claim of right” credit, assuming you qualify to claim it. Section 1341 of the Internal Revenue Code addresses “repayment of income previously reported.”
Definition and Example of the Section 1341 Credit
Section 1341 of the tax code provides that you’re entitled to take back any tax you paid on certain income, typically wages, if you had to return that money to the source that paid it. The Section 1341 credit can be subtracted from your taxable income in a subsequent tax year, provided the error and repayment in question was more than $3,000.
You may be out of luck if the repayment was less than $3,000. You have limited options to correct the situation until the TCJA potentially expires in 2026, if Congress doesn’t renew either the law or this particular provision of the legislation.
Section 1341 does not apply to canceled debts that you had to claim as income in a previous year when a creditor has a continuing right to pursue you for payment, even after the debt has been forgiven. Nor does it apply to small business owners who reimburse customers for returns. The key term in both these cases is that you did not have an “unrestricted right” to the income when you received it and reported it on your tax return. It was subject to possible repayment terms.
You can file Form 1040-X, for an amended tax return, if you claimed canceled debt as income on a previous year’s return so it was taxed as income, then you ultimately paid the debt. You can amend your return to delete the repaid amount from your taxable income for that year, even though Section 1341 doesn’t apply.
Say you received a $5,000 payment from your employer in 2020 that was unrestricted. It was yours to keep, no matter what. But then the money turned out to be restricted due to factors not known at the time, so you were obligated to reimburse that $5,000 to your employer. However, you already reported it as income in 2020 when you were in a 24% marginal tax bracket. You paid taxes on that income at that rate. You therefore can claim a credit for that $5,000 on your 2021 tax return if your marginal tax rate is now lower, say at 22%.
- Alternate name: claim-of-right provision
How Does a Section 1341 Credit Work?
The Section 1341 credit lets you avoid filing an amended tax return for the year in which you claimed the income. But the key here is filing an amended return. Claiming the credit isn't just a simple matter of checking a box on your current tax return.
You must still roll up your shirtsleeves and redo your Form 1040 tax return for the year in which you claimed the payment as income. This time, you won’t include that income you were forced to repay. Your credit amounts to the difference in tax when that reimbursed payment is removed from the equation.
The Section 1341 credit works to restore you to the tax situation you would have been in if you had not previously had to claim and pay taxes on restricted income.
Your state might also recognize a claim-of-right doctrine if you included this type of income on a previous year’s state tax return. For example, Massachusetts allows its taxpayers to claim a deduction on a subsequent year’s return for money they repaid in that year they weren’t entitled to. Check with a local tax professional to find out where your state stands on this issue.
Requirements for Claiming a Section 1341 Credit
You must file Schedule 3 with your tax return to claim the Section 1341 credit. This is the “Additional Credits and Payments” form. Enter the calculated amount of your credit on Line 13d on the second page of the tax form. Write “IRC 1341” in the box beside the line. The total for all payments and credits entered on Page 2 of Schedule 3 is entered on Line 14, then transferred to Line 31 of your Form 1040 tax return.
You can claim the credit in the same year you made the repayment if you use the cash method of accounting, which is typical for most individual taxpayers.
- A claim-of-right Section 1341 credit may be available to you if you included money as income on a previous year’s tax return but that money turned out to be “restricted” and you had to repay it.
- Restricted income means the money is subject to repayment if certain conditions aren't met.
- You can claim a credit for the difference between the tax you paid in the previous year and the tax you would have owed if you hadn’t included that money in your income.
- The IRS has warned taxpayers about "frivolously" attempting to claim a Section 1341 credit by asserting that income wasn’t taxable in a previous year for a reason they don’t qualify for.