District Court Holds That Settlement Proceeds Were Nontaxable, but Disallows Deduction of Legal Fees

(Parker Tax Publishing January 2018)

A district court held that a taxpayer who settled a lawsuit against an accounting firm for failing to properly form an S corporation and an employee stock ownership plan, did not have to include $800,000 in settlement proceeds in income because the proceeds constituted a nontaxable return of capital. However, the taxpayer could not deduct the legal fees he incurred as business expenses because they were personal to him. The court also disallowed a deduction for the difference between the taxes paid as a result of the accounting firm's error and the settlement proceeds. McKenny v. U.S., 2018 PTC 2, (M.D. Fla. 2018).

In the late 1990s, Joseph McKenny hired accounting firm Grant Thornton (GT) to help him with the finances for his car dealership consulting business. GT advised him to form an S corporation, which would in turn form an employee stock ownership plan (ESOP). This structure would allow the income of the S corporation to flow through the ESOP, and under then-current law, the ESOP would pay no tax on the income. The law was later changed to eliminate the ESOP strategy, but at the time, the ESOP structure was not illegal.

GT failed to properly file the necessary documents to establish the S corporation and did not properly form the ESOP. GT also advised McKenny to form another S corporation to acquire a 25 percent interest in a car dealership and further advised the dealership to characterize its payments to the S corporation as management fees rather than partnership profits.

A 2005 IRS audit determined that the ESOP strategy was an abusive tax shelter and that the dealership's payments were improperly characterized for tax purposes. McKenny ultimately settled with the IRS and paid approximately $2.2 million in taxes, interest and penalties for 2000-2005. In 2007, McKenny and the IRS entered into a closing agreement in which McKenny agreed that he was not entitled to any other deductions and/or business losses relating to the ESOP transaction. The closing agreement specified that no amount would be allowed as an ordinary loss for the years at issue.

In 2008, McKenny sued GT for malpractice, breach of contract, and violations of state law, claiming damages in excess of $7.9 million. McKenny also sought to recover punitive damages, attorney's fees, and interest. McKenny and GT settled in 2009 with GT paying $800,000. McKenny claimed he incurred over $400,000 in legal fees in the lawsuit against GT.

On his 2009 tax return, McKenny excluded the $800,000 settlement proceeds as a recovery of capital and deducted the $400,000 legal fees as a business expense. He also deducted the $1.4 million difference between the settlement and the taxes he paid as an unreimbursed loss. The IRS disallowed all of these deductions and exclusions and McKenny paid an additional $813,000 in taxes, interest and penalties. When the IRS denied his refund claim, McKenny sued in a district court.

The IRS argued that the settlement proceeds could not be attributed solely to the amount McKenny paid in taxes because of GT's alleged malpractice because the lawsuit against GT included numerous claims including state law claims for punitive damages. It also said that any harm from the failed ESOP was too speculative because there was no guarantee that the IRS would have approved the ESOP strategy. Regarding McKenny's legal fees, the IRS pointed out that McKenny sued GT individually, not on behalf of his company, the settlement was paid to him personally, and he attempted to deduct the settlement amount from his personal income taxes, not the company's taxes. With respect to the $1.4 million deduction for the difference between the settlement and the taxes paid, the IRS made two arguments. First, it said that because the settlement payment was not a return of capital, the difference between that payment and the taxes McKenny paid was similarly not deductible. Second, the IRS asserted that because the ESOP strategy was an abusive tax shelter, it would be contrary to public policy to allow McKenny to deduct the taxes and penalties he paid because the strategy failed.

The district court held that McKenny could exclude his settlement proceeds from income but could not deduct his legal fees or the difference between the taxes he paid and the settlement proceeds. The court explained that lawsuit proceeds are not taxable income if they are payments by a person causing a loss that restore the taxpayer to the position he was in before the loss. The court pointed out that McKenny's compensatory damages claims against GT were for the taxes he paid because of GT's alleged malpractice. The fact that McKenny also sought punitive damages did not change the amount of his actual damages, which the court said were undisputedly over $2 million. Thus, in the court's view, the $800,000 settlement could be directly attributed to what McKenny paid in excess taxes and penalties because of GT's alleged malpractice. The district court did not agree with the IRS that McKenny's harm was too speculative; the court pointed out that the ESOP strategy was legal at the time and that the IRS provided no authority for its claim that it could have denied approval for the ESOP.

However, the district court agreed with the IRS that McKenny could not deduct his legal fees. The court found that the legal fees were personal to McKenny and not expenses of his business, and that McKenny attempted to deduct the settlement amount from his personal income tax, not the company's taxes. The court also disallowed the deduction for the difference between the taxes paid and the settlement as an unreimbursed loss, finding that McKenny had specifically promised in the 2007 closing agreement not to claim any other deductions or losses with respect to the ESOP strategy.

For a discussion of the taxability of income from lawsuits, see Parker Tax ¶74,130.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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