April 2, 2016

Payment from Accounting Firm to Settle Claim Excluded From Income

Houston Tax Attorney Blog

Houston Tax Attorney

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The IRS released Action on Decision 2016-01 to disagree with a court case that held that a payment from an accounting firm to settle a claim against the firm for selling an abusive tax shelter was not taxable to the recipient.

The case is Cosentino v. Commissioner, T.C. Memo. 2014-186. In Cosentino, the taxpayers held rental real estate in a partnership. The taxpayers wanted to sell the property. Their accounting firm suggested that they enter into an abusive tax shelter which would inflate the tax basis in the property. The taxpayers reported little gain on the sale of the property. Later, upon learning that the transaction was a tax shelter, the taxpayers filed amended tax returns to report the correct tax and to disclose their participation in the tax shelter. The taxpayers then filed suit against the accounting firm to recover their losses. The accounting firm settled the claim and paid the taxpayers. The taxpayers did not report the payment as income on their tax return.

The U.S. Tax Court held that the payment was excludible from income as it was a return of lost capital. The court reasoned that the taxpayers paid tax and penalties that they would not have paid if they had not followed the accounting firms bad advice.

The IRS disagrees with the court’s holding as it asks “in lieu of what were the damages awarded?” The IRS concluded that the taxpayers ended up paying the correct amount of tax; therefore, the payment was not for extra taxes. The IRS believes it was additional compensation–which should be subject to tax.

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