When I tell people that I’m a tax accountant, they invariably ask, “Is the tax law really as complicated as people say it is?”
OK, that never really happens, because as a tax accountant, I generally avoid engaging other humans in conversation. But if that question ever WERE asked, I would finally, FINALLY, have a story that sums up just how difficult the tax law is.
Consider the fate of poor Joseph McKenny. He was making good money, so he hired a reputable tax firm to advise him on his affairs, and they advised him straight into an illegal tax shelter, an IRS audit, and a $2 million payment of back taxes to the IRS. Rightfully pissed, McKenny sued the accounting firm, won a settlement of nearly $1 million, and then engaged ANOTHER accounting firm to advise him on how to treat THAT payment, and, well…according to the 11th Circuit Court of Appeals, that advice was also wrong. So if you’re scoring at home, this means that McKenny now owes tax to the IRS on an amount he collected from his old CPA firm related to tax he owed the IRS because of his old CPA firm. Circle of life, and all that.
So how did McKenny hire all the right people and still manage to become a living symbol of the complexity of the Code? Let’s find out.
Facts in McKenny
In the late 1990s, Joseph McKenny hired Grant Thornton to help him with his finances for his car-dealership consulting business. Grant Thornton recommended that McKenny structure his consulting business as an S corporation for tax purposes. McKenny would be an employee of the corporation, but all of the stock would be held by an Employee Stock Ownership Plan (ESOP). Under the law applicable at that time, this strategy would be doubly advantageous to McKenny, because 1) S corporations do not pay income taxes at the corporate level; instead, an S corporation’s income passes through to its owners, and 2) ESOPs are tax-exempt employee retirement plans, meaning any income allocated to the ESOP would accumulate tax-free until distributed to the ESOP’s sole beneficiary, McKenny. Put it all together, and all of the income earned by the S corporation would escape current taxation.
McKenny bit on the planning idea, and greenlighted Grant Thornton to form the S corporation and ESOP in 2000. There were just two small problems: according to McKenny, Grant Thornton never properly elected S corporation status, nor did it properly establish the ESOP.
Years later, the IRS audited McKenny’s businesses for the years 2001-2005. In 2001, the IRS had identified the S corporation/ESOP strategy as an abusive tax shelter, and changed the tax law to make the strategy illegal, effective January 1, 2005.
As a result, McKenny owed substantial tax to the IRS, ultimately settling with the Service by paying $2.2 million in tax, interest and penalties.
In 2008, McKenny sued Grant Thornton for malpractice, breach of contract, and violations of the Missouri Merchandising Practices Act, claiming “total actual damages” in excess of $7.9 million. While the taxes, penalties, and interest McKenny was forced to pay to the IRS was only the aforementioned $2.2 million, he sought additional damages for punitive damages, attorney’s fees, interest, and the lost tax benefits of the now-useless ESOP.
Grant Thornton settled all claims by paying McKenny $800,000 in 2009. McKenny, presumably based on the advice of a firm OTHER than Grant Thornton, excluded the payment from income on his 2009 tax return. In addition, McKenny deducted $419,000 of legal fees as a business expense, which was by this time was reported on his Schedule C, as the former S corporation had become a sole proprietorship.
But did McKenny treat these items correctly?
Before we get into what the District Court and 11th Circuit had to say, some background on the relevant law is necessary.
Taxation of Legal Judgements and Settlement Payments, In General
When it comes to determining the taxability of a legal judgment or settlement, there are a couple of considerations. For an individual, the preference is to fit the payment under Section 104, which provides that legal judgments or settlements paid to compensate an individual for “personal injury or physical harm” are not included in taxable income. Unfortunately, Section 104 is anything but straight forward, and if you need evidence to support that statement, you can read here, here, and here.
To determine the tax treatment of a non-personal injury judgment or settlement, a taxpayer must look to the “origin of the claim.” In other words, what did they sue to recover? If the taxpayer was looking to recover lost profits, then any payment made to the taxpayer will be taxed as ordinary income, just as the lost profits would have been had they actually been received by the taxpayer.
But…when a judgment or settlement payment is made to replace “capital” of the taxpayer that was destroyed or damaged, then the payment is only taxed if it exceeds the previous loss of capital. To illustrate, in Revenue Ruling 81-152, when condo owners sued the builder for shoddy workmanship, the judgment proceeds received were not income, but rather a reduction of capital that reduced the taxpayers’ basis in their homes.
When presented in that context – you paid for a home, it was damaged, you sued and won, and thus the payments only “restore” the damage done – the replacement of lost capital concept make sense. But how do you apply the rules to the facts of McKenny, where individual taxpayers allege that a legal recovery is intended to make them “whole” for extra taxes that bad advice from their tax advisor caused them to pay? How does a taxpayer prove that 1) a tax adviser caused harm to their capital, and 2) that any payment recovered from the adviser is intended to compensate them for that harm?
Surprisingly, it’s an issue not without some degree of precedent, and that precedent stretches back all the way to 1933.
Clark v. Commissioner
In Clark v. Commissioner, 40 B.T.A. 333 (1939), acq. 1957-1 C.B. 4, the Board of Tax Appeals held that the taxpayers, a husband and a wife, could exclude an amount they received from their tax counsel to compensate them for additional income tax they had to pay because of the tax counsel’s error in return preparation. The tax counsel had prepared the taxpayers’ joint return, and in doing so, caused the taxpayers to pay $19,941 more in tax than they would have paid had they filed separate returns. When the tax counsel paid the taxpayers $19,941 to fix their mistake, the Board concluded that the payment was compensation for the taxpayers’ “loss which impaired [their] capital,“ or a return of the lost capital. Clark thus established a critical precedent: when a taxpayer can prove that an error by a tax advisor caused an increase in tax over what the taxpayer would have paid in the absence of that error, that excess is the amount of “capital” lost by the taxpayer. In turn, any payment from the tax advisor to the taxpayer — up to the amount of lost capital — is tax-free.
In Rev. Rul. 57-47, the Service analyzed the nearly same facts as in Clark. The Service once again held (1) that no taxable income is derived from the portion of settlement proceeds that does not exceed the amount of tax that the taxpayer was required to pay because of the return preparer’s error; and (2) that the remainder of the proceeds that represented interest on the overpaid tax and the fees that the taxpayer paid to the preparer and deducted must be included in gross income.
Lastly, in Concord Instruments v. Commissioner, T.C. Memo. 1994-248, a taxpayer received $125,000 in settlement of a malpractice claim against an attorney who failed to file a notice of appeal from a Tax Court decision against the taxpayer. The taxpayer was seeking compensation for additional costs incurred (including the deficiency it paid) because of the attorney’s failure. Relying heavily on Clark and Rev. Rul. 57-47, the Tax Court held that the portion of the $125,000 settlement attributable to the Federal income tax deficiency was excluded from gross income as a restoration of capital, because the taxpayers could show that they had paid additional tax in excess of that amount due to the failings of their attorney.
After Concord, things went quiet on the issue for 20 years, until the Tax Court’s 2014 decision in Cosentino v. Commissioner, TC Memo 2014-186. In Cosentino, the taxpayers had a long history of engaging in completely tax-free Section 1031 exchanges. It was a practice they intended to continue until their death, so they could pass on the appreciated properties tax-free to the children, one of whom was severely disabled.
The Cosentinos were introduced to tax advisors, however, who convinced them to do a Section 1031 exchange that involved cash boot that would normally be taxable, only in this case, the boot would be offset against an artificially inflated basis in the relinquished property. The Cosentinos followed their advisors’ lead, only to later learn that the strategy they had implemented was a widely known abusive tax shelter. As a result, they immediately filed amended returns, paying additional federal and state tax, along with penalties and interest.
The Cosentinos then set about suing the tax advisors, claiming the following damages:
- $45,000 they had paid the advisors to implement the plan,
- $456,000 in additional federal tax and state income tax, and
- $120,000 in additional penalties and interest.
The advisors settled for $300,000, and the Cosentinos excluded the payment from their tax return in the year of receipt. The IRS argued that the payment represented taxable income, but the Tax Court sided with the taxpayers. In reaching its decision, the court reasoned that had the tax advisors not come along and sold the taxpayers on a tax shelter, the Cosentinos would have merely continued to engage in completely tax-free Section 1031 exchanges. Thus, every dollar of additional tax paid by the taxpayers was due to the faulty advice of their advisors, and any payment made to compensate the taxpayers for that excess tax liability should be treated as a return of capital. The court concluded by seemingly strengthening the precedent set by Clark and Concord by stating that “an amount paid to a taxpayer in order to compensate the taxpayer for a loss that the taxpayer suffered because of the erroneous advice of the taxpayer’s tax consultant is generally a return of capital and is not includible in the taxpayer’s income.”
Recall, however, the “origin of the claim” concept that we previously introduced in this article. In the Cosentinos’ suit, they sought recovery not only for taxes previously paid, but also penalties, interest, and advisor fees. And the key is, some of those amounts — namely, the state income taxes and advisor fees — had been deducted by the taxpayers on their return. This brings into play the “tax benefit” rule of Section 111, which requires a taxpayer to include in income any recovery of an amount previously deducted. To see this concept in action, consider an individual who receives a state refund of previously deducted taxes: this amount is included in income to the extent the taxpayer received a benefit from the previous deduction.
Here, the taxpayers had settled for $300,000 to cover ALL claims, and thus the court required the Cosentinos to allocate the recovery among all the claims pro-rata, and to the extent the proceeds were allocated to amounts previously deducted, the taxpayers were required to recognize those amounts in income, while any remaining proceeds were tax free as a return of capital.
The IRS, however, refused to acquiesce in Cosentino. The Service distinguished Cosentino from Clark and Concord. For example, in Clark, the IRS argued, the entire excess tax liability was caused not be the result of a transaction, but rather by the advisor’s simple mistake in filing a joint return rather than separate ones. To the contrary, in Cosentino, the taxpayers chose to participate in a transaction, and the tax they ended up paying was the correct amount based on the transaction they engaged in. It was the facts of the transaction, and not the advisor’s failure to file the correct filing status or timely file an appeal (as was the case in Concord), that caused the Cosentinos to owe more in tax. Stated in another way, the IRS argued that the Cosentinos paid the RIGHT amount of tax given the transaction they chose to engage in.
In addition, the IRS criticized the Tax Court for assuming that had the tax shelter not been made available, the taxpayers would have held the property until death, eliminating all gain and tax. This was purely speculative, but yet an important part of the court’s decision in concluding that the taxpayers had been forced to pay more tax by engaging in the shelter than they “otherwise would have.”
Treatment of Legal Expenses, In General
Section 162 of the Code allows deductions for “all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business.” But for an expense to be deductible under Section 162(a), it “must be one that has a business origin.” Historically, whether litigation costs are deductible as a business expense depends on whether the litigation is “business or personal”—the question is “whether … the claim arises in connection with the taxpayer’s profit-seeking activities.”
What’s at stake for an individual who pays a legal expense? If the expense is a business deduction, Section 62 makes the expense deductible regardless of whether or not the payor itemizes their deductions. But if it is a personal deduction, it is only deductible as an “other miscellaneous itemized deduction,” meaning the taxpayer will only receive a benefit from the payment if 1) the taxpayer itemizes their deductions, and 2) the sum of ALL other miscellaneous itemized deductions exceeds 2% of the taxpayer’s AGI.
Or at least, that’s how the law USED to be. Starting in 2018, the Tax Cuts and Jobs Act makes all “other miscellaneous itemized deductions” nondeductible until 2026. While this doesn’t impact McKenny, it means under current law, a taxpayer who wins a settlement may get whipsawed: the proceeds may be fully taxable, while the legal expenses paid to procure the settlement may be entirely nondeductible.
Back to McKenny
The IRS challenged McKenny’s treatment of the $800,000 in settlement proceeds received from Grant Thornton as tax-exempt income, as well as the deduction for the $420,000 in legal expenses. The dispute would land McKenny in both District Court and, upon appeal, in the 11th Circuit.
The District Court reached a split decision. With regard to the $420,000 legal fee deduction, the court sided with the IRS, noting that McKenny sued Grant Thornton in his individual capacity, not on behalf of his company. And in turn, the settlement was paid to McKenny individually, rather than the company. Thus, the deduction was NOT a business deduction, but rather a miscellaneous itemized deduction subject to the 2% of AGI floor.
With regard to the $800,000 in settlement proceeds, the District Court sided with McKenny, agreeing that the payment represented a recovery of lost capital. Because McKenny was forced to pay over $2 million to the IRS due to what McKenny maintained — and the District Court was very willing to believe — was Grant Thornton’s faulty advice, the $800,000 in settlement proceeds did not enrich McKenny, but rather made him (partially) whole.
The District Court’s decision left both parties unsatisfied: McKenny believed his legal fees were deductible as business expenses, and the IRS continued to maintain that the $800,000 settlement payment was taxable.
As for the legal expenses, McKenny again argued that their legal costs were deductible because their lawsuit against Grant Thornton was “related to” and “regarding” his business operations.
The 11th Circuit, however, once again sided with the IRS. In reaching its decision, the court stated that “it is not enough for a legal claim to be merely related to a business. Rather, the determinative factor is “the origin and character of the claim with respect to which an expense was incurred.”
So just as the taxability of a legal judgment or settlement rests on the origin of the claim, so too does the treatment of the legal expenses. In the instant case, the litigation between McKenny and Grant Thornton was personal in its character and origin. The lawsuit concerned McKenny’s’ personal tax liability, not the tax liability of any business; the complaint alleged that Grant Thornton breached an agreement with McKenny, not his businesses; and the complaint alleged malpractice as to services provided to McKenny, not the businesses. In short, the lawsuit’s essential contention was not that Grant Thornton failed to adequately support the businesses’ income-producing activities, but rather that Grant Thornton failed to help McKenny reduce his personal tax liability. Thus, the origin of the legal claim was of a personal nature, rather than a business nature, and as a result, the legal expenses were deductible only as a miscellaneous itemized deduction.
Next, the IRS renewed its argument that the $800,000 in settlement payments must be taxed as ordinary income. The Service argued that Clark —discussed above — is limited to situations in which an accountant makes a mistake in preparing a tax return or in advising the taxpayer on how to prepare the return. This is the same argument the IRS made in its refusal to acquiesce to Cosentino. Clark, the IRS insisted, does not apply to settlements based on claims that an accountant committed malpractice in giving advice about, structuring, or implementing a transaction. In the Service’s view, the Grant Thornton settlement involved the latter scenario and was essentially a payment to McKenny of a portion of his tax liability, which has long been held to represent taxable income (see Old Colony Trust).
This time, the 11th Circuit sided with the IRS, though it took the easy way out. Rather than address whether Clark applies to transactional advice, the court took a different tack, determining that McKenny hadn’t actually proven that the $2M in tax owed to the IRS related to the S corporation/ESOP tax shelter was caused by Grant Thornton.
The 11th Circuit noted that the District Court simply took a number of McKenny’s claims at face value. For example, while McKenny claimed that Grant Thornton failed to properly make an S election for his business, the IRS exam report noted that the election was accepted by the Service. Thus, as the 11th Circuit dug deeper, it found that McKenny had never actually proven that had Grant Thornton done its job correctly, McKenny would not have owed any of the $2 million in tax it was required to pay to the IRS upon audit. Similar to what the IRS said in its refusal to acquiesce to Cosentino, the 11th Circuit explained that McKenny hadn’t proven that the tax he was required to pay the IRS wasn’t the RIGHT amount of tax it should have paid given the transaction it entered into, rather than an additional, unnecessary tax caused by the bad advice of his tax advisor.
The court summed up its opinion as follows:
In short, aside from claiming that the ESOP strategy would have automatically resulted in no taxes in the years at issue, the McKennys did not present any evidence concerning how the strategy would have actually operated on the ground. They did not submit anything about Mr. McKenny’s consulting business (or its revenues) in the relevant years, or about how the ESOP would have been structured, or about what tax benefits the strategy would have provided, or about how Mr. McKenny’s interest in the car dealership would have affected (or not affected) the strategy. And they did not offer the testimony of a tax expert with regard to how the S/ESOP strategy would have played out had Grant Thornton implemented it.
Because McKenny could not prove he was “harmed” by Grant Thornton’s tax advice, he could not claim that the $800,000 settlement payment compensated him for that harm. As a result, the amount was taxable as ordinary income.
McKenny’s saga was a long and ultimately painful one. But it did serve as a powerful reminder: yes, the tax law is every bit as complicated as it’s rumored to be.