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Eleventh Circuit Reverses Lower Court; Couple Can't Exclude Award from Income

(Parker Tax Publishing September 2020)

The Eleventh Circuit reversed a district court decision and held that a couple could not exclude from income an $800,000 malpractice claim award received from an accounting firm which the couple had sued. However, the court affirmed the district court's holding with respect to the denial of legal expense deductions and losses the couple took that also related to transactions involving the accounting firm. McKenny v. U.S., 2020 PTC 272 (11th Cir. 2020).


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. For many years, McKenny and his wife paid little or no federal income taxes.

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. In the settlement agreement, however, GT expressly denied the claims against it and all liability related to the tax advice it provided to the McKenny and his wife.

Over the following three years, the McKennys filed tax returns with several deductions and exclusions related to their lawsuit against GT. On their 2009 tax return, they (1) deducted $419,490 in legal fees they allegedly paid to litigate the malpractice claim; (2) claimed an unreimbursed loss representing the difference between the settlement payment they received from GT and the settlement payment they made to the IRS; and (3) excluded the $800,000 settlement payment from their gross income. Based on these deductions and exclusions, the McKennys claimed a net operating loss, which they carried forward to reduce their tax liability in 2010 and 2011.

In September of 2013, the IRS issued a notice of deficiency rejecting all of these claimed deductions and exclusions. First, the IRS recharacterized the legal expenses as a miscellaneous itemized deduction rather than a business deduction, which meant that the expenses were deductible only to the extent that they exceeded two percent of the McKennys' adjusted gross income. Second, the IRS disallowed the loss deduction. Third, the IRS denied the exclusion of the settlement payment.

In July of 2016, the McKennys sued the government, seeking a refund of about $586,000 - the amount of the disallowed exclusions and deductions for 2009 and 2011. The parties filed cross-motions for summary judgment, and a district court granted in part and denied in part both motions. The district court concluded that the legal expenses incurred in the GT litigation were not deductible business expenses because the McKennys sued GT on their own behalf, rather than on behalf of the consulting business. As to the purported unreimbursed loss, the district court ruled that the McKennys were barred by their 2007 settlement with the IRS from claiming any losses related to the ESOP transactions. Finally, as to the exclusion of the $800,000 settlement payment, the district court agreed with the McKennys that the settlement was a return of capital and therefore excludable from gross income. Each side appealed to the Eleventh Circuit.

On appeal, the McKennys argued that the district court erred in denying their deductions of their legal fees as a business expense and of their purported unreimbursed loss. The McKennys argued that their legal costs were deductible because their lawsuit against GT was "related to" and "regarding" Mr. McKenny's business operations. Regarding the $800,000 settlement payment, the McKennys cited the Tax Court's decision in Clark v. Comm'r, 40 B.T.A. 333 (1939), which held that that gross income does not include a payment made as compensation for damages or loss that was caused by a third party's negligence in the preparation of a tax return, for the proposition that the $800,000 was excludible from income. The Tax Court in Clark agreed with the taxpayers that a payment received from their negligent tax counsel constituted compensation for damages or loss caused by the error of tax counsel, and held that the amount received by the taxpayers in the tax year, by way of recompense, was not then includable in the taxpayers' gross income.

The government, in its cross-appeal, contended that the district court erred in concluding that the $800,000 GT settlement was a return of capital rather than gross income. The government asserted that Clark was distinguishable because it relies principally on Old Colony Trust Co. v. Comm'r, 279 U.S. 716 (1929), which holds that a third party's payment of a taxpayer's tax liability is generally included in gross income, regardless of the form of that payment. It also argued that Clark 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, but does not apply to settlements based on claims that an accountant committed malpractice in giving advice about, structuring, or implementing a transaction. In the government's view, the GT settlement involved the latter scenario and was essentially a payment to the McKennys of a portion of their tax liability. The government also argued that the McKennys failed to carry their burden with respect to the $800,000 and that the district court erred by assuming critical facts in the McKennys' favor.


The Eleventh Circuit affirmed the district court's summary judgment in favor of the government as to the litigation expenses and the $1.4 million loss deduction. And, with respect to the $800,000 exclusion of the GT settlement from the McKennys' income, the Eleventh Circuit reversed the district court's grant of summary judgment in favor of the McKennys and concluded the $800,000 was includible in taxable income. The Eleventh Circuit noted that the question of whether the $800,000 constituted taxable income to the McKennys was an issue of first impression.

The court began its analysis by addressing the deductibility of the legal fees from the McKenny's lawsuit against GT. The court concluded that the litigation between the McKennys and GT was personal in its character and origin because the lawsuit concerned the McKennys' personal tax liability, not the tax liability of any business. The Eleventh Circuit thus affirmed the district court's grant of summary judgment to the government as to the litigation expenses.

The court then considered the McKennys approximately $1.4 million deduction for the loss which represented the difference between the sum they paid to settle the IRS audit and the amount they received from GT to settle the malpractice suit. The court looked to Code Sec. 7121 which authorizes the IRS to enter into written settlement agreements and found significant the fact that, under Code Sec. 7121(b), these agreements are final and conclusive and are not to be reopened as to the matters agreed upon. The court rejected the McKennys' argument that the $1.4 million loss was not related to those transactions, but rather was due to GT's failure to fully reimburse them in the lawsuit. The court found that argument to be a distinction without a difference after noting that the McKennys did not - and could not - dispute that their $2.2 million tax payment to the IRS was related to the ESOP transactions. Accordingly, the court affirmed the district court's grant of summary judgment to the government as to the $1.4 million deduction.

Finally, the court analyzed the McKennys' exclusion of the $800,000 GT settlement from their gross income. The court noted that, in a refund suit such as theirs, the McKennys had the burden of proving both their entitlement to the exclusion and the amount of that exclusion by a preponderance of the evidence. With respect to their reliance on the Clark decision, the court observed that the IRS had acquiesced to that decision in Rev. Rul. 57-47 and that Clark has been followed by several Tax Court decisions. The court briefly touched on the issue of whether Clark was correctly decided and, if it was, whether it applied in the instant case where the accountant's malpractice is not about the preparation of the taxpayer's return but rather negligent advice or implementation concerning an underlying transaction. But the court concluded that it need not decide such difficult questions because, assuming that Clark was correctly decided, and that its rationale applies in the instant case where the accounting malpractice related not to the preparation of a tax return but to the structuring of an underlying transaction, the McKennys did not sustain their burden of demonstrating that the $800,000 settlement was excludable from income.

In concluding that the McKennys did not sustain their burden of proving both their entitlement to the exclusion and the amount of that exclusion by a preponderance of the evidence, the Eleventh Circuit found that the district court erred by assuming critical facts in the McKennys' favor. The court noted that the McKennys had listed a number of steps that GT allegedly failed to take that they maintained would have lowered their tax liability by the precise amount they were required to pay the IRS. The Eleventh Circuit observed that there were numerous factual and legal assumptions baked into that contention, which the government disputed and the McKennys did not prove, yet the district court accepted them as true in granting summary judgment to the McKennys. As an example, the court cited the fact that the district court assumed that GT did not properly file the documents necessary to register the company as an S corporation, but the IRS exam report, which the McKennys themselves submitted at summary judgment, showed that the S corporation elections were filed and accepted by the IRS. The court stated that, while there is no strict rule for what taxpayers must do to establish their entitlement to an exclusion or to establish its amount, it was not enough for the McKennys to simply make a bald assertion, devoid of specifics, that they overpaid taxes or would not have incurred any federal taxes (or penalties) had GT followed through on the S/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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