In an Action on Decision (AOD), IRS has announced its nonacquiesence with a Tax Court decision that held that a portion of the amount a taxpayer received from an accounting firm that advised it to enter into an abusive tax shelter — as settlement in the taxpayer’s suit for the firm’s fees, losses from the transaction, taxes, interest and penalties — was nontaxable.
Background. In Clark, (1939) 40 BTA 333, a husband and wife made an irrevocable election to file a joint federal income tax return rather than separate returns on the advice of their return preparer. Subsequently, IRS examined the return and assessed a deficiency. The deficiency existed because the return preparer took a larger deduction for long-term capital losses than was allowed by law. If the taxpayers had filed separate returns employing the proper deduction for long-term capital losses, their combined tax liability would have been almost $20,000 less than the amount of tax assessed and paid by them. The preparer indemnified the taxpayers in that amount, and IRS included the payment in the taxpayers’ income as an amount attributable to the return preparer’s payment of the taxpayers’ income tax liability. However, the Court viewed the excess of the taxpayers’ tax liability on their joint return over what their liability would have been on separate returns as a loss caused by the return preparer’s negligence and the reimbursement of this excess amount as compensation for a loss that impaired their capital. Thus, it held that the indemnification payment received by the taxpayers was a nontaxable recovery of capital.
In Rev Rul 57-47, 1957-1 CB 23, a tax consultant made an error in preparing and filing an individual’s return. The error caused more tax to be paid than if the correct method had been used. The statute of limitations had run by the time the error was discovered, so the tax consultant paid the taxpayer a sum of money that included a reimbursement of the additional tax. IRS concluded that the reimbursement of the additional tax wasn’t includible in the taxpayer’s gross income.
In Concord Instruments Corp, TC Memo 1994-248, a company sued its counsel for failing to file a timely notice of appeal from a prior decision as the company had instructed. The taxpayer alleged that the counsel’s failure caused it to pay more tax than it should have paid and that it also incurred interest expenses to pay the tax. The Court held that, except for the portion of the malpractice payment that reimbursed the taxpayer for interest paid that the taxpayer had deducted — which the Court held to be includable in income — the malpractice payment was to compensate the taxpayer for a loss similar to that in Clark and was excludable from income.
Facts. Garey and Jo-Ann Cosentino received a payment of $375,000 in settlement of a lawsuit filed by them. In the complaint, the Cosentinos alleged that an accounting firm was negligent and breached its fiduciary duties by advising them to use what the Cosentinos later discovered was an abusive tax shelter in order to dispose of certain commercial rental property.
Under the tax-avoidance plan, the taxpayers entered into certain transactions in an attempt to increase their basis in the rental property. They then disposed of the rental property in a Code Sec. 1031 like-kind exchange with boot. The gain that otherwise would have been recognized upon disposition of the rental property in return for like-kind property and boot was largely offset by the property’s inflated basis as a result of the tax-avoidance plan. On discovery of the tax-avoidance nature of the plan, the taxpayers filed amended Federal and State returns and paid additional tax, interest and penalties based on the correct basis for the property.
If the Cosentinos had known the tax-avoidance nature of the plan, they would not have entered into the transaction. The Cosentinos’ real estate transaction was part of a plan to maximize and accumulate wealth during their lives in order to provide for their permanently disabled adult daughter both during their lives and after their deaths. Under that plan, they had on at least two occasions caused the dispositions of certain appreciated residential rental properties in Code Sec. 1031 like-kind exchanges without boot. The taxpayers intended to continue to defer indefinitely tax on any gain realized on the dispositions of appreciated properties by implementing Code Sec. 1031 like-kind exchanges without boot.
In the complaint, the Cosentinos alleged damages for:
- Fees paid to the accounting firm;
- Costs and losses incurred in connection with the purchase and sale of Treasury Bonds;
- Federal and States income taxes paid, including for the lost opportunity to use legitimate tax deferral methods under Code Sec. 1031;
- Interest payable to IRS;
- Penalties payable to IRS; and
- Penalties payable to the State, plus additional tax shelter penalties.
Parties’ arguments. The Cosentinos argued the $375,000 wasn’t includable in income because it represented a replacement of capital. Where the recovery represents a replacement of capital destroyed or damaged, it generally doesn’t constitute taxable income to the extent that it doesn’t exceed the basis of the destroyed or damaged property. (Sager Glove Corp, (1961) 36 TC 1173, affd (CA7 1962) 11 AFTR 2d 325)
IRS contended that Clark,Concord Instruments, and Rev Rul 57-47 were inapplicable to the taxpayers’ situation. In each of those cases, the errors made by the taxpayers’ return preparers caused the taxpayers to pay more than their minimum proper federal income tax liabilities based on the actual underlying transactions. In this case, the Cosentinos did not pay any amount in excess of their minimum proper tax liabilities for the sale of their commercial property — the later payments only made up the difference between the incorrect, underreported amount and their minimum proper income tax liabilities for the transactions in which they engaged.
Court’s conclusion. The Tax Court, in Cosentino, TC Memo 2014-186, determined that the Cosentinos paid more in Federal and State income tax than they would have paid, and paid other expenses that they would not have paid, if they had not followed the advice of their accountants and used the tax-avoidance plan that the firm recommended. Instead, they would have disposed of the rental property and deferred tax on any gain realized on that disposition by implementing only a Code Sec. 1031 like-kind exchange without boot, as had they had done before.
The Tax Court concluded that the damages that the Cosentinos alleged in the complaint were damages that they sought in order to compensate themselves for the loss that they suffered because the accountants were negligent and breached their fiduciary duties by advising them to use the tax-avoidance plan in order to dispose of the rental property. The $375,000 payment that the taxpayers received was to compensate them for a loss that was similar to the respective losses in Clark,Concord Instruments, and Rev Rul 57-47 . The Court allowed the Cosentinos to exclude all of the $375,000 except a portion of that amount that it allocated to reimbursements for amounts that the Cosentinos deducted on their tax return and to amounts that the Cosentinos included in their original complaint but that the Court wasn’t convinced that they actually incurred.
IRS nonacquiesence. IRS has announced its nonacquiesence with the Tax Court’s holding.
It said that, unlike the taxpayers in Clark and Concord Instruments, the taxpayers in this case paid the correct amount of Federal income tax based on the transaction they entered into. In this transaction, the taxpayers received taxable boot as part of their consideration upon the disposition of the rental property. When the artificially inflated basis was disregarded, the boot resulted in gain recognition from the exchange and the imposition of tax on that gain. Once this transaction was completed, no choices were available to the taxpayers to reduce this taxable gain. It was the facts of the transaction, and not a failure to make an election or a failure to timely file an appeal, that caused the taxpayers to incur additional tax.
In light of the underlying gain recognition transaction, the amount of tax imposed was not more than what they properly owed on that transaction and, consequently, the taxpayers did not sustain a loss. Accordingly, the settlement amount the taxpayers received was not a restoration of lost capital, but was instead compensation by the accounting firm for a portion of the Federal income tax the taxpayers properly owed that should be included in the taxpayers’ gross income as an accession to wealth.
IRS also noted that, in reaching its holding, the Court considered the taxpayers’ plan to use a lifetime series of tax-free exchanges, followed by a step up in basis at death, to permanently avoid paying taxes on the gain from these transactions. IRS disagreed with the Court’s reliance on these facts. The taxpayers’ ability to execute that tax planning strategy was purely speculative, and a change in the taxpayers’ circumstances, or even a change to the provisions of the Code, could have altered the strategy at any time.