OVERVIEW: Accountant Settlement Payment Not Excluded From Gross Income

Taxpayers owed not only tax after the IRS rejected the claimed benefits of a tax shelter, but also settlement tax paid by the accountant who set up the tax shelter.

In addition, taxpayers owed the government its litigation costs to defend its position on the imposition of the settlement, a federal appeals court recently ruled (McKenny v. United States, n ° 18-10810, 2020 BL 332090 (11th Cir. 9/1/20))

Grant Thornton, an accountancy firm, recommended that Joseph McKenny structure his S corporation consultancy business. Grant Thornton also recommended that S corporation be 100% owned by an ESOP whose sole beneficiary would be McKenny. McKenny also acquired a 25% stake in a GMC car dealership. Based on the advice of Grant Thornton, this 25% stake was formally held in a separate S corporation. This other company S was in turn 100% owned by ESOP.

Following a 2005 audit, the Internal Revenue Service determined that Mr. McKenny and his wife had underpaid their taxes. According to the audit, the McKenny’s tax strategy towards the car dealership was an illegal and abusive tax shelter. The audit also identified unpaid debts relating to the consulting business.

The McKennys have settled their unpaid debts with the IRS. They ultimately paid the IRS $ 2.24 million in income taxes, interest, and penalties. The McKennys sued Grant Thornton in state court. They alleged that the firm had committed accounting malpractice and was therefore liable for their unpaid tax obligations. In 2009, Grant Thornton settled the lawsuit by paying the McKennys $ 800,000. In the settlement agreement, however, Grant Thornton expressly denied the claims against her and any liability relating to the tax advice she provided to the McKennys.

In their 2009 tax return, the McKennies deducted the legal fees they paid to litigate the malpractice claim and excluded payment from the settlement from their gross income. The district court found that the legal fees were not deductible business expenses because the McKennys sued Grant Thornton on their own behalf, rather than on behalf of the consulting firm. The district court agreed with the McKennys that the settlement was a return of capital and therefore excluded from gross income. Each side, unhappy with only a partial victory, sought full justification from the United States Court of Appeals for the Eleventh Circuit.

Origin of the complaint

Whether litigation costs are deductible as a business expense depends on whether the litigation is “business or personal”. The question was whether the claim arose out of “the gainful activities of the taxpayer”. The determining factor was “the origin and nature of the claim for which an expense was incurred”.

The dispute between the McKennys and Grant Thornton was personal both in nature and in origin. The lawsuit concerned the McKenny’s personal tax liability, not the tax liability of a business. The complaint alleged that Grant Thornton had breached an agreement with the McKennys, not Mr. McKenny’s businesses; and the complaint alleged professional misconduct in the services provided to the McKennys, not the businesses. In short, the essential argument of the lawsuit was not that Grant Thornton had not adequately supported the income-generating activities of the companies, but rather that Grant Thornton had not helped the McKennys reduce their staff tax liability. “We have therefore,” the court said, “affirm the granting by the district court of summary judgment to the government as to the costs of the litigation.”

Repayment of capital

The McKennies relied on a venerable United States Tax Court ruling that gross income did not include a payment made as compensation for damages caused by the negligence of a third party in preparing for ‘a tax return. See Clark v. Commissioner. The IRS acquiesced to the Clark decision. See Tax decision 57-47.

The government claimed that Clark was distinguishable. It relied mainly on Old Colony Trust Co. v. Commissioner, which considers a third party payment of a taxpayer’s tax debt to be generally included in gross income. He also argued that Clark is limited to situations in which an accountant makes an error in preparing an income tax return or advising the taxpayer on how to prepare the return. Clark, the government said, “does not apply to settlements based on allegations that an accountant has committed professional misconduct in providing advice, structuring or implementing a transaction.(Emphasis added.) In the government’s view, Grant Thornton’s settlement involved the latter scenario and essentially consisted of a payment of a portion of his tax liability.

Was Clark correctly decided? If so, does it apply where, as here, the accountant’s misconduct does not relate to the preparation of the taxpayer’s return but rather negligent advice or implementation regarding an underlying transaction?

According to the IRS ‘position, the payment of an indemnity or the refund of the taxpayer’s “appropriate tax liability”, as opposed to a refund of taxes in excess of the taxpayer’s tax liability, when this excess is caused by the negligence of the tax advisor, represents a gain which is included in gross income. See DPP 9743035, July 28, 1997.

We do not need, the court said, to decide these difficult questions. Assuming that Clark was properly decided, and that its rationale applies in a case like this where the accounting misconduct was not related to the preparation of a tax return but to the structuring of an underlying transaction, the McKennies did not bear their burden of showing that the $ 800,000 settlement was excludable.

In the district court, the government argued that it was entitled to summary judgment because the McKennies could not establish the factual predicate of their argument about the exclusion from the settlement. The government argued that their “alleged harm was entirely speculative” and nothing in the file showed that they “would have been entitled to ESOP or its tax benefits”. The government noted that the McKennies “had not named any expert witnesses who could testify that they would have received tax benefits had Grant Thornton acted differently, and offered no admissible evidence or credible means that they could prove that they had the sole right to ESOP tax shelter benefits.

The district court rejected the government’s argument, explaining that the ESOP strategy was legal when Grant Thornton proposed it to the McKennys. The government, the court of appeal said, was right. The general legality of the S / ESOP strategy at the time was, in itself, insufficient for the McKennies to meet their burden. “It is not enough for the McKennies to simply state, without details, that they overpaid taxes or that they would not have incurred federal taxes (or penalties) if Grant Thornton had followed the S / ESOP strategy. ., ”(Emphasis added) the Court of Appeal declared. In addition, the S / ESOP strategy was rejected on December 31, 2004 and therefore could not have provided the McKennies with tax benefits (or at least not the same tax benefits) in the 2005 tax year.

“In short, other than claiming that the ESOP strategy would have automatically resulted in no taxes over the years in question, the McKennies have presented no evidence as to how the strategy actually worked on the ground. They did not submit anything ”on the tax benefits that the strategy would have provided. They did not offer testimony from a tax expert on how the S / ESOP strategy would have played out if Grant Thornton had implemented it, the appeals court said.

The government was therefore entitled to summary judgment regarding Grant Thornton’s $ 800,000 settlement. The appeals court upheld the district court’s summary judgment in favor of the government on the costs of the proceedings. With respect to the $ 800,000 exclusion, “we set aside the grant of summary judgment by the district court in favor of the McKennys.”

Since the court never asked whether Clark has been correctly decided; and / or the nature and type of payments to which the Clark rationale applies correctly, the question of whether Clark should be relegated to the historical trash will unfortunately remain unanswered.

This column does not necessarily reflect the opinion of the Bureau of National Affairs, Inc. or its owners.

Author Info

Robert Willens is president of the New York-based Robert Willens LLC tax and consulting firm and an assistant professor of finance at Columbia University Graduate School of Business.