Decisions – Led Astray

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Image source: Ibra99 (Own work) [CC0], via Wikimedia Commons

Image source: Ibra99 (Own work) [CC0], via Wikimedia Commons

When you sue your tax preparer and win, are the proceeds taxable?

If you refer to the internal revenue code definition of income—gross income means all income from whatever source derived (section 61)–the answer seems obvious.

Yet as is so often the case in tax law, the obvious answer could be wrong.

For example, lawsuit proceeds are taxable as ordinary income if they are for damages taking the place of items that would have been taxed as ordinary income (such as lost profits). But proceeds that replace or recover capital generally are not taxable income (to the extent of your basis).

The underlying rule is this: The taxability of the settlement depends upon the nature of the claim and on the origin and character of the claim.

Here are four situations where a taxpayer sued a return preparer and received a settlement. The question in each is whether the proceeds are a nontaxable return of capital or income.

1.

The IRS audited a married couple’s joint return and determined that capital losses had been deducted in full instead of being limited. The couple’s tax preparer admitted he made a mistake. He also discovered that had the couple filed separate returns, the overall tax would have been lower by $19,941.10.

Because the election to file jointly was irrevocable, the tax preparer paid the couple $19,941.10.

The IRS said the payment constituted taxes paid for the taxpayers by a third party and that, consequently, it was income to them.

What would you decide?

or

Link to decision: Clark v. Commissioner of Internal Revenue

 

2.

A taxpayer lost a decision in tax court and the tax attorney failed to file for an appeal before the due date. The taxpayer paid the IRS, then made a claim against the attorney’s professional liability insurance company because of the failure to file a timely appeal. The taxpayer claimed damages of $466,034, consisting of $160,020 in deficiency and $265,012 in interest to the IRS and $41,002 in interest to a bank.

The insurance company paid $125,000 in full settlement of the claim. The taxpayer did not report the settlement as income, saying the insurance claim was not for lost profits. Instead, the attorney’s failure to appeal caused a loss and the payment was a return of capital because the taxpayer paid the tax deficiency from its capital funds and borrowed funds. The taxpayer filed the claim to have capital and interest costs restored.

The IRS said the payment was income because the attorney’s conduct did not cause the taxpayer to owe additional tax. The IRS argued that any error by the attorney was harmless because the case was correctly decided by the Tax Court. Therefore, the funds the taxpayer received were an economic benefit and not compensation for injury.

 What would you decide?

or

Link to Decision: Concord Instruments Corporation v. Commissioner

 

3.

After the statute of limitations for amendment had passed, a taxpayer discovered her preparer made an error on her return that caused her to overpay her tax. The preparer paid her the difference between the tax she would have owed and the correct tax, as well as interest on that amount. The preparer also repaid the taxpayer for his fee, which she had deducted on the return.

 What would you decide?

or

Link to Decision: Revenue Ruling 57-47

 

4.

On advice from an accounting firm, a taxpayer entered into a tax shelter transaction designed to increase basis on a commercial rental property. The taxpayer did not realize the tax shelter was abusive until the IRS audited the return and disallowed the resulting deductions.

The taxpayer amended federal and state tax returns for the years in question, sued the accounting firm, and received a settlement of $375,000. The taxpayer did not include the settlement in income in the year it was received.

The IRS said this case differs from previous cases. Here, the taxpayer did not suffer a loss because the abusive tax shelter created the opportunity to pay less than the minimum proper federal tax, as opposed to previous cases where the preparer’s error caused taxpayers to pay more tax than was actually due.

In this case, the subsequent payment of tax on the amended returns constituted payment of minimum tax liabilities, and the taxpayer never paid more than the minimum proper amount of tax. The later payments were only making up the difference between the incorrect underreported amount and the proper amount of tax due. Therefore, the settlement should be included in income.

 What would you decide?

or

 

Link to Decision:  T.C. Memo. 2014-186 (Cosentino)

***

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Right answer!
Sorry, wrong answer :(
For the taxpayer. The payment was not includible in the taxpayer’s income because it constituted “compensation for a loss which impaired * * * [the taxpayer’s] capital.”
Right answer!
Sorry, wrong answer :(
For the taxpayer. We reject the IRS’s position and hold that, except for the portion of the malpractice payment that reimbursed the taxpayer for interest paid to the IRS of $265,012 and interest paid to a certain bank of $41,002 that the taxpayer deducted, the malpractice payment “was to compensate petitioner for a loss similar to that in Clark v. Commissioner.”

 Editorial Note: Under the tax benefit rule, the court held that the portion of the malpractice payment reimbursing the taxpayer for the interest the taxpayer had deducted was includible in income. (The taxpayer benefitted from claiming the deduction on the tax return.)

Right answer!
Sorry, wrong answer :(
No taxable income is derived from that part of the recovery received by the taxpayer which does not exceed the amount of tax which she was required to pay because of the error made by her tax consultant.

Editorial Note: Under the tax benefit rule, the remainder of the recovery must be included in computing taxable income. (The taxpayer benefitted from the deduction of the fees, and the interest was compensation for the loss of use of the funds which she could have retained except for the error.)

Right answer!
Sorry, wrong answer :(
We conclude the IRS’s argument that earlier decisions (Clark, Concord Instruments, and Rev. Rul. 57-47) do not control resolution of the issue presented here is not only factually flawed, it also is legally flawed. Those authorities establish that an amount paid to a taxpayer in order to compensate the taxpayer for a loss the taxpayer suffered because of the erroneous advice of the taxpayer’s tax consultant generally is a return of capital and is not includible in the taxpayer’s income.

 Editorial Note: Under the tax benefit rule, part of the recovery must be included in gross income. (The settlement included fees and interest the taxpayer deducted on the return.)

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