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Tax Treatment Of Malpractice Damages Paid By An Accountant

  What if an accountant admits that he gave you bad tax advice when he advised you to go into a tax shelter? and then pays you a large settlement amount? Do you have to pay taxes on the award? A review of Section 104 after being amended by the Small Business Jobs Protection Act of 1996 (“SBJA”) would indicate that damages for a tort claim are only excludible in the instances of physical injury and a narrow spectrum of emotional distress. This memorandum provides a potential basis for claiming that the recovery received is non-taxable.

Cases dealing with malpractice awards paid by accounting include Clark v. Commissioner, 40 B.T.A. 333 (1939); Concord Instruments Corporation, T.C. Memo 1994-248, and Centex Corporation, et al, 91 AFTR 2d 2003-1262. After examining these cases, one might think that they do provide the strongest support available for taking the that the damages received are not taxable – although in the case of Clark and Concord Industries, not for the reasons one might suppose when first reviewing them.

The Clark and Concord Industries cases are particularly attractive on first glance since their subject is the tax treatment of an award for damages received by a taxpayer because of an accountant’s malpractice. Still the government will strenuously try to distinguish these cases from the recoveries realized in a post-SBJPA year. This is evident from a series of Private Letter Rulings where taxpayers have requested rulings under Clark that damage payments made by accountants or attorneys for erroneous tax advice are non-taxable and these requests have been denied.

A statement made by the Court in Clark and echoed in Concord Industries that may provide a reasonable basis for the position that the recovery is in whole or in part not taxable. The Court stated: “Recovery of capital includes amounts paid to a taxpayer to compensate for a loss suffered because of erroneous advice from his tax counsel.”

In fact, an examination of these cases reveals a similarity between these cases which goes beyond the commonality of the fact of malpractice awards paid by accountants, namely, the recovery of capital – a common basis which is discovered by applying the “origin of the claim doctrine” which has long been an instrument of the courts in determining whether a particular recovery received on account of litigation or threatened litigation is taxable or non-taxable.

Concord Industries involves a case where an attorney failed to file an appeal and thus lost the opportunity to prevail in Court or a least come to an agreement with the government based on the hazards of litigation the government faced. The gravamen of the claim was that taxes that could legally have been avoided had sound counsel been provided and the Court agreed. The key here is that tax savings are not taxable. When a taxpayer claims a legitimate deduction or credit against tax, the tax benefit enjoyed is not taken into taxable income.

The Court in Concord basically found the award to be a substitute for lost tax benefits and that benefit, had it been realized, would have added to the taxpayer’s capital (his net worth or his money available for investment) and that addition would have been non-taxable. Since the realization of those tax benefits would not have been taxable and it was acknowledged the benefits would have been realized absent the accountant’s error, the recovery was not taxable.

The same rationale holds true for Clark where the attorney filed an erroneous return resulting in a deficiency, but the large part of the deficiency could nevertheless have been avoided had the attorney advised the clients otherwise. In Clark this would have been advice for the husband and wife to file separately, not jointly. So again, the loss relates to an item which had it been realized would not have been taxable. The origin of the claim in both Concord Industries and Clark was the non-realization of what would have been, in the absence of the accountant’s error, a non-taxable addition to the claimant’s wealth. The rationale for non-taxability is not that these cases involved a recovery due to an accountant’s malpractice, but that the amounts sought as damages were a substitute for non-taxable wealth which was lost because of the accountant.

This becomes even clearer when the Centex case is considered. Here the taxpayers had a contractual relationship with the United States relating to the acquisition of distressed banks which, from a financing standpoint, was predicated on certain federal tax credits. When the government changed the law doing away with the credit, the taxpayers sued for breach of contract. The Court assessed damages equal to the credits they were deprived of on account of the law change. The taxpayers asked for a gross-up fearing the recovery would be taxable, but the Court looked at the nature of the claim and determined that a gross-up was unnecessary. The enjoyment of a tax credit is not a taxable event. The damages were in lieu of an item which was not taxable, so the damages were not taxable.

These cases and Centex, as well, are all instances of the application of the “origin of the claim” doctrine. The IRS gives this description of the origin of the claim doctrine in a 2002 Field Service Advice (FSA 200228005):

Issue 1: Treatment of Settlement Proceeds

Section 61(a) provides that, except as otherwise provided, gross income means all income from whatever source derived. Whether an amount received as settlement proceeds constitutes income depends on the nature, origin, and character of the claim giving rise to the settlement. See Byrne v. Commissioner, 90 T.C. 1000, 1007 (1988); Pistillo v. Commissioner, T.C. Memo 1989-329. In characterizing settlement payments, courts consider the question, “In lieu of what were the damages awarded?” Raytheon Prod. Corp. v. Commissioner, 144 F.2d 110, 113 (1 st Cir. 1944). Settlement payments that represent reimbursement for lost profits, royalties, or other items of taxable income are generally taxable. See Raytheon, 144 F.2d at 113; Mathey v. Commissioner, 177 F.2d 259, 260-61 (1 st Cir. 1949). However, if a payment represents a return of capital, it is not gross income to the extent of the taxpayer's basis in the capital asset. See, e.g., Wheeler v. Commissioner, 58 T.C, 459, 461 (1967); Big Four Indus., Inc. v. Commissioner, 40 T.C. 1055, 1060 (1963), acq., 1964-2 C.B. 4; Freeman v. Commissioner, 33 T.C. 323, 327 (1959). [Emphasis added.]

The origin of Taxpayer's claim against A relates to the purchase of the Purchased Property. Taxpayer sought recovery for environmental damage to the land it purchased from A. Because land is a capital asset, the settlement proceeds represent amounts for injury or damage to a capital asset. Therefore, the proceeds should be treated as a recovery of Taxpayer's basis in the land. Any settlement proceeds in excess of Taxpayer's basis in the land should be treated as capital gain.
In Concord Industries, the Court in determining whether damages paid because of an accountant’s error constitute a recovery of capital begins its analysis with the origin of the claim doctrine:

The United States Court of Appeals for the Sixth Circuit has stated the test for whether amounts received as a result of a controversy are recovery of capital as follows: " 'The fund involved must be considered in the light of the claim from which it was realized and which is reflected in the petition filed.' " Durkee v. Commissioner, supra at 186 (quoting Farmers' & Merchants' Bank v. Commissioner, supra at 513); Swastika Oil & Gas v. Commissioner, supra. Thus, we look to petitioner's claim to decide whether the amounts are recovery of capital.
“In lieu of what were the damages awarded?” This is the touchstone of income characterization represented by the origin of the claim doctrine. And doesn’t money available for investment constitute capital?

Courts resort to the common usage of words in the absence of a technical, statutory meaning. The American Heritage Dictionary of the English Language states that capital is: Any form of material wealth used or available for use in the production of more wealth.

This would certainly include money or savings available for investment. Similarly, the court in Friedlander v. U.S., 51 AFTR 2d 83-328, states:

The meaning of capital is not limited to "inventories, plant, machinery, or other equipment." . . . Here P & J Wholesale's purchases of merchandise were dependent upon credit extended by its suppliers. Without that credit it would have had to obtain other forms of capital—its own funds, financing through banks or other financial institutions or customer pre-payments. The extension of credit was as much capital as these other forms [of capital].
Money invested in a disallowed tax shelter pursuant to an accountant’s advice which is reasonable relied on is an outlay of capital in the form of after-tax savings available for investment. It is in lieu of the loss of capital that malpractice damages are awarded.

The Court in Clark states that when the tax benefit which was clearly realizable with proper advice was lost, this resulted in an “impairment of capital.” Similarly, with Concord Instruments, the Court glosses Clark in applying that decision by stating that the “reimbursement was not includable in gross income because it was compensation for a loss which impaired the taxpayer’s capital.” Certainly, the bad advice of an accountant to invest in a tax shelter which resulted in outlays of after-tax money is every bit as much, if not more so, the loss of capital. Damages paid in lieu of such lost capital takes on the income characterization of that capital. Savings are not taxed, so it follows damages paid to replace lost savings are not taxable either.

In summary, the origin of the claim doctrine when applied to the recovery of amounts invested in a tax shelter on the bad advice of an accountant who could be reasonably relied on leads to a claim for lost capital. Damages paid as a recovery of capital are not taxable.

Now if recovery includes a loss of investment opportunity component, this is to say, the time value of money is factored in as part of the loss, then this is really an interest component. Prima facie, this interest component should be taxable if recovered since interest is generally speaking taxable. However, if in reaching a settlement without having to calculate the net after tax return on interest that could have been earned, it is agreed in the interest of to assume earnings on tax exempt bonds at a rate available at the time of the investment in the tax shelter, the entire award may be non-taxable.

Note on Section 104. The Small Business Protection Act of 1996 modified the long-standing rule that tax free recoveries for injuries no longer included “tort-type” claims such as libel or slander, but are limited instead, with narrow exceptions, to physical injury. With regard to a concern that a recovery based on return of capital might be treated as a Section 104 recovery under previous law, note that the U. S. Supreme Court in its opinion in Commissioner v. Glenshaw Glass Co., 348 U.S. 426, 432, fn. 8 states that “[t]he long history of departmental rulings holding personal injury recoveries nontaxable [is based] on the theory that they roughly correspond to a return of capital.” If something “roughly corresponds” to something it’s not the same as that thing. At most, personal injury roughly corresponding to return of capital might be a sub-class of a return of capital, but not coextensive with it.

DISCLAIMER Documents provided under “Notes, Briefs, & Memoranda” at are intended solely to provide examples of engagements and analysis representative of the type and quality of services provided by Tax Counsel, Ltd. and may not be relied on as tax advice. This is because tax consequences are highly dependent on the facts and circumstances of a given situation and, in addition, even in identical situations, cases referenced can be reversed by subsequent statute or case law. Also tax statutes and related Treasury Regulations change often and are sometimes even given retroactive effect. Further, to ensure compliance with requirements imposed by the IRS under IRS Circular 230, please be advised that any tax commentary contained in this communication is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.