Policy Analysis of Tax Malpractice Recovery

May 27, 2008

By Finis Cowan III

(713) 582-6066

The author is a Tax LLM student at the University or Houston Law Center, a 1985 graduate of Baylor Law School and a partner with the firm of Forrest & Kelly LLP.

The author expresses his thanks to Professor Ira Sheperd and

classmate, Terrence Botha, for their thoughtful input.
Table of Contents

I. Questions and Principles………………………………………..3

II. Are Tax Malpractice Recoveries Income?...... 8

III. IRS Treatment…………………………………………………10

IV. If Tax Malpractice Recoveries Are Income, How Are They

Taxed?...... 33

V. Can Clients Recover the Extra Tax (“Gross-Up”

Damages) Caused By Tax Malpractice?...... 35

VI. Parallelism Is Trumped By Administrative Enforcement

Policy and Third Party Involvement…………………………..39

I. Questions and Principles

This paper analyzes the tax policy issues involved when taxpayers recover

compensation for tax malpractice.[1] Malpractice recoveries raise a number of tax policy

issues:

· Should malpractice recoveries be treated as taxable income?[2]

· Should the tax treatment depend on the nature and the consequences of the malpractice?[3]

· Should taxability differ depending on whether the malpractice was (A) negligent advice or return preparation that cost the taxpayer additional taxes or (B) conduct that did not cause the taxpayer to pay more than the “proper minimum tax” under the “nontax” facts?[4]

· Should it matter whether the practitioner promised tax benefits to which the taxpayer never had a legitimate right?[5]

· Should malpractice recovery be treated as ordinary income or a return of capital?

· What role should tax policy play in whether and how to tax such recoveries?

· What is the “incidence” of the tax, i.e., who actually bears the tax burden and should this have any significance to tax policy?[6]

· Should recovery be permitted for losses incurred when an IRS controversy is triggered by malpractice, i.e., “audit damages”?

· Is the origin of the claim the malpractice claim, the “non-tax facts” or the underlying tax benefit the taxpayer lost because of the malpractice?

Prolific tax article author, Robert W. Wood,[7] notes a surprising paucity of authority[8] on tax treatment of legal malpractice recovery. Wood notes the following general principles:

1. Litigation recoveries should be taxed according to the origin, nature and taxability of the underlying claim.[9]

2. There is no income from simply being restored to the position a taxpayer would have occupied were it not for the malpractice.[10]

3. The preceding exclusion does not generally apply to recovery for interest, delay damages, punitive damages or penalties.[11]

Other relevant principles include:

4. A return of capital is not included in income.[12] In other words,

(T)here are strong reasons not to tax someone on the recovery of his own money because the taxpayer has not realized a gain in any meaningful sense. The entire system of utilizing basis to determine gain rests on the notion that one should not be taxed on the recovery of one’s own money. [13]

An exception to that policy occurs when the tax benefit rule

applies to a recovery because the taxpayer had previously taken a deduction that provided him with a tax benefit . . . The reason for this exception is to prevent the taxpayer from retaining a tax benefit for an expenditure which he subsequently recovered. The policy of preventing a

taxpayer from retaining a deduction for which he is no longer entitled outweighs the policy of not taxing a return of capital.[14]

5. The tax benefit rule requires taxpayers who enjoyed a tax deduction for the amount later recovered (e.g. business taxpayers who deducted the interest and fees later recovered) to include such recoveries in their income.[15]

6. Payment of taxes by a third party is income to the taxpayer.[16]

7. Ordinarily the payment of federal income taxes cannot be properly characterized as a loss.[17]

8. For tax purposes, the ordinary rule is that a loss deduction may not be taken in the absence of actual economic loss.[18]

9. Tax fairness requires that like-situated taxpayers should be taxed the same (horizontal equity) and differently situated taxpayers should be taxed differently (vertical equity).[19]

Wood posits that tax treatment of malpractice recoveries “should be based on the item the plaintiff would have received but for the attorney’s malpractice. That, after all, is the sine qua non of the origin of the claim doctrine.”[20]

The IRS’ views on this subject have been inconsistent and widely criticized.[21] Its recent general view of litigation recoveries does conform to the origin of claim doctrine:

Whether the proceeds received in a lawsuit or the settlement thereof constitute income under section 61 depends on the nature of the claim and the actual basis for recovery. Rev. Rul. 81-277, 1981-2 C.B. 14. If the recovery represents damages for lost profits, it is taxed as ordinary income; similarly, replacement of lost capital is treated as a nontaxable return of capital. Id. at 15, citing Freeman v. Commissioner, 33 T.C. 323 (1959); see also Estate of Taracido v. Commissioner, 72 T.C. 1014, 1023 (1979). Payments by one causing a loss that do no more than restore a taxpayer to the position he or she was in before the loss was incurred are not includible in income because there is no economic gain.[22]

II. Are Tax Malpractice Recoveries Income?

"Gross income" is broadly defined, for purpose of federal income taxation, as "all income from whatever source derived." 26 U.S.C. § 61(a). The Supreme Court has broadened its interpretation from "the gain derived from capital, from labor, or from both combined," as established in 1920 in Eisner, to a more all-encompassing standard, including "all economic gains not otherwise exempted."[23] In general, gross income refers to inflows, i.e., realized accessions to wealth.[24]

Any receipt of funds or other accessions to wealth received by a taxpayer is presumed to be gross income unless the taxpayer can demonstrate that the funds or accessions fit into one of the exclusions provided by other sections of the Code. Commissioner v. Glenshaw Glass Co., 348 U.S. 426, 430-31 (1955). However, the receipt constituting a return of basis is generally not classified as income within the meaning of section 61 because it is not an accession to wealth. For payments received in settlement of a lawsuit, payments by the one causing a loss that do no more than restore a taxpayer to the position he or she was in before the loss was incurred are not includible in gross income because there is no economic gain to the recipient. See Raytheon Products Corp. v. Commissioner, 144 F.2d 110 (1st. Cir. 1944)(stating if a recovery is treated as a replacement of capital, the damages received from the lawsuit are treated as a return of capital and are taxable only to the extent that the damages exceed the basis of the property replaced).[25]

The IRC § 104 statutory exclusion of compensation for “personal physical injuries,” while inapplicable to tax malpractice, most closely approaches the normative rationale of excluding from income compensation for loss of a non-taxable right or benefit, i.e., making an injured party as whole as possible and restoring her pre-loss condition to the extent possible with monetary compensation.

Clark v. Commissioner[26] is the seminal case for nontaxability of malpractice recovery. It held that a tax lawyer’s malpractice settlement payment was not includible in his client’s gross income because it was compensation for a loss that impaired the client’s capital. [27] Clark cited a variety of cases for the theory that “recoupment on account of such losses is not income since it is not ‘derived from capital, from labor or from both combined.’"[28] The client did not, and could not, deduct the loss and was merely being made whole.

The BTA[29] disposed of the IRS’ argument that a third party’s payment of taxes is income to the taxpayer by recognizing that the lawyer’s payment was compensation for a loss and not payment of Clark’s taxes.[30] Clark’s loss was caused by negligent advice and return preparation that resulted in a tax that the client would otherwise not have incurred, i.e., could have legally avoided.

A 1971 IRS General Counsel’s Memorandum says that return of capital is the “clearest” example that not all receipts are income and noted analogous treatment for tax malpractice damages:

(T)he courts and the Service have held certain payments to be excludable from gross income, where the payments, often called damages, compensate a taxpayer for the loss of something that would not itself have been includible in his gross income. Mr. Justice Frankfurter, in his concurring opinion in United States v. Kaiser, 363 U.S. 299 (1960), says at page 311:

The principle at work here is that payment which compensates for a loss of something which would not itself have been an item of gross income is not a taxable payment.[31]

In Concord Instruments Corp. v. Commissioner, T.C. Memo 1994-248, the Tax Court held that a taxpayer was entitled to exclude from income a malpractice insurance recovery paid to compensate the taxpayer for a failure by his tax counsel to timely appeal an adverse court decision. The Court held that the recovery was designed to compensate the petitioner for a loss of capital, and thus, did not constitute income. The Court cited Rev. Rul. 81-277, 1981-2 C.B. 14, where the Service indicated that, "Payments by one causing a loss that do no more that restore a taxpayer to the position he or she was in before the loss was incurred are not includible in income."[32]

III. IRS Treatment

After nearly two decades of nonacquiescence to the Clark nontaxability rule, the

IRS in Rev. Rul. 57-47, C.B. 1957-1, 4, 23, ruled that tax malpractice recoveries are not

taxable:

(A) tax consultant made an error in preparing and filing a taxpayer’s individual income tax return. That error caused the taxpayer to pay more than her minimum proper income tax liability . . . the reimbursement of the additional tax paid earlier is not includible in the taxpayer’s income.[33]

The portion of the recovery attributable to lost earnings on the excess taxes that would have been taxable and the tax deductible fee was not excluded under the tax benefit rule.[34]

In GCM 35164 (1972) the IRS again determined that a recovery of reimbursement for tax malpractice that resulted in the overpayment of taxes was not subject to tax under the return of capital theory followed in Clark.. The malpractice was failing to qualify the taxpayer as an electing small business corporation but that difference was deemed not sufficient to distinguish the case from Rev. Rul. 57-47 and Clark.

In the 1990s, the IRS cast doubt on the scope[35] and validity of the Clark non-taxability rule in a series of private letter rulings. “In the end, the IRS distinguished Clark (as well as Rev. Rul. 57- 47) in each of the fact patterns at issue, and therefore held that the various tax-based recoveries considered in the rulings were subject to tax.”[36]

It is difficult, if not impossible, to reconcile Clark and Rev. Rul. 57- 47 with these rulings. Wood’s distillation of the rulings is that they “suggest that an exclusion from income is appropriate only when the taxpayer pays more than his ‘proper’ minimum federal income tax liability based on the underlying transaction.”[37] He articulates the taxpayers’ expected response, “but for the accountant’s error, the . . . transaction would have . . . been nontaxable. That is arguably not a question of whether the taxpayer owed the correct amount of tax, but whether the transaction is taxable at all.”[38]

The consensus of commentators is that the Clark reasoning should have controlled the PLRs and required a different, nontaxable outcome. The negligent practitioners were “simply repaying the taxpayer for lost capital based on the accountant’s error. This should be treated similarly to payments made for causing damage to property . . . the replacement of dollars is equivalent to a replacement of basis, both of which represent a return of capital.”[39]

IRS’ “Minimum Proper Tax” Rationale

Four of the PLRs were to investment funds that failed to qualify as regulated investment companies (“RIC”) due to their CPAs’ negligence. LTR 9211015 and LTR 9211029 followed the holding and reasoning of Clark and Rev. Rul. 57-47 by holding that malpractice recoveries are a nontaxable return of capital. LTR 9743035 and LTR 9743034 revoked the earlier PLRs because they were no longer “in accord with the current views of the Service.” The later rulings attempted to distinguish Clark and Rev. Rul. 57-47 because in those cases the:

preparers' errors in filing returns or claiming refunds caused the taxpayers to pay more than their minimum proper federal income tax liabilities based on the underlying transactions for the years in question. In this case, however, the CPA firm's error altered the underlying entity status of Fund. Fund incurred the minimum proper federal income liability as a subchapter C corporation during the period it did not qualify as a RIC. The CPA firm's reimbursement, unlike the reimbursements in Clark and Rev. Rul. 57-47, was not made to compensate Fund for a tax liability in excess of Fund's proper federal tax liability for the tax years relating to the firm's negligence. Instead, the reimbursement was a payment of Fund's proper tax liability.[40] (emphasis added).