January 19, 2021 - Douglas Myser

Malpractice settlement payment was taxable. In our ongoing series of Tax Court cases, we look at McKenny v. U.S. which was heard before the 11th Circuit in 2020. The Eleventh Circuit Court of Appeals reversing a District Court, has held that a CPA firms malpractice settlement was taxable income to its former clients. When a taxpayer's legal claim is resolved by a settlement, whether that settlement constitutes taxable income depends on what the damages were awarded for. Gerstenbluth v. Credit Suisse Sec. (USA) LLC, (CA2 2013) 112 AFTR 2d 2013-5791. However, a third party's payment of a taxpayer's tax liability is generally included in gross income, regardless of the form of that payment. The Tax Court has held that gross income doe snot 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. Malpractice settlement payment was taxable.

IN a refund suit, the taxpayer has the burden of proving both their entitlement to the exclusion form income and the amount of that exclusion by a preponderance of the evidence. In this case Mr. McKenny had a car dealership consulting business. His accounting firm, Grant Thornton advised him to form an S Corporation. The S Corporation  would in turn be owned by an ESOP. The S Corporation's income would flow through the ESOP and, under the tax laws in effect at the time, the ESOP would not pay any income tax on that income. (The S Corp ESOP strategy was later banned by Congress but was legal until December 31, 2004. When McKenny was audited in 2005, the IRS determined that the S Corporation ESOP strategy was an abusive tax shelter and that the dealership's payments were improperly characterized for tax purposes. Mr. McKenney and his wife who filed jointly, had to pay an additional $2.2 million in penalties, interest and taxes.

When McKenney sued and won he forgot to pay taxes on the settlement and the IRS ruled it was taxable.