On May 12, 2025, the U.S. Tax Court upheld a taxpayer's deduction for restoring amounts the taxpayer previously included in taxable income under a claim of right. Norwich Commercial Group, Inc. v. Commissioner, T.C. Memo. 2025-43. In doing so, the court applied the economic performance requirement in section 461(h) in a novel way that neither party had raised in its post-trial briefs. The effect was to allow the disputed deduction in full in 2014 rather than partly in 2014 and partly in 2015, a tax year over which the court also had jurisdiction.

Norwich Commercial Group, Inc. (Norwich) was a residential mortgage loan originator. Norwich would borrow funds under a line of credit (LOC), provide the borrowed funds to a homebuyer in exchange for a secured promissory note, sell the promissory note to a mortgage loan investor, use the sale proceeds to pay down the LOC, and keep any remaining sale proceeds as fee income. In 2014, Norwich and its lender discovered that accounting errors had caused historical sales proceeds to be underapplied to LOC repayments, thereby generating excess income for Norwich. To remedy this, Norwich provided a security interest in certain assets (collateral) to the lender in 2014 in an amount equal to the historical repayment shortfall and repaid the shortfall in 2014 and 2015. Norwich deducted the entire repayment in 2014. The IRS asserted that Norwich's repayment was a non-deductible loan repayment and alternatively that the economic performance requirement limits any allowable deduction to Norwich's actual repayments in 2014 and 2015.

The court began by holding that Norwich's repayments were a deductible expense. Although all amounts were originally advanced under the LOC, the court found "there was no explicit or implicit recognition of an obligation to repay the erroneous transfers by either Norwich or [the lender] until they were discovered in 2014."

The court then turned to the economic performance requirement. The IRS asserted that Norwich's liability to the lender was a payment liability for which economic performance occurs upon payment. See Treas. Reg. § 1.461-4(g)(7). Norwich's post-trial briefs did not dispute this. Nevertheless, the court rejected the IRS's assertion and held that Norwich's liability was a performance liability under section 461(h)(2)(B), which provides 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." The court then went on to conclude that economic performance occurred in 2014 when Norwich provided collateral to the lender.

We believe this is the first time a court has treated collateral as "property" when applying the economic performance requirement. It is also curious that the court did not address Treas. Reg. § 1.461-4(d)(4), which provides that when a liability requires a taxpayer to provide property to another person, economic performance occurs as the taxpayer incurs costs in connection with satisfying the liability. It is unclear when (or how) Norwich incurred costs in connection with providing collateral to the lender. We will be watching this case closely to see if subsequent developments address these issues.

For more information, please contact:

James R. Gadwood, jgadwood@milchev.com, 202-626-1574

George A. Hani, ghani@milchev.com, 202-626-5953

Summer associate Elsa Westerlund assisted with this article.

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