Policy Analysis of Tax Malpractice Recovery
May 27, 2008
By Finis Cowan III
Copyright © 2008 by the author.
(713) 582-6066
finis@finiscowan.com
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
2
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
Since tax malpractice includes claims against a number of disciplines, this paper uses “practitioner” to
describe any potential defendant in a tax malpractice case.
1
It is this paper’s contention that malpractice recoveries in which the taxpayer suffers a loss by incurring
costs that she would not have incurred but for the malpractice should not be taxable income.
2
The IRS’ 1997-98 “proper” tax PLRs, discussed infra at p. 12, attempt to distinguish taxability of recovery
for negligent return preparation and negligence which goes to the underlying transaction or “non-tax” facts.
This paper contends that the PLRs do not adequately justify such a distinction.
3
4
The quoted terms are from the PLRs discussed, infra at p. 19.
“In these ‘pie-in-the-sky’ situations the courts seem to measure damages by the difference between the
taxes actually incurred minus what taxes could have been payable with optimal advice. They do not factor
into this calculation the tax results promised by the tax advisor.” Jacob L. Todres, Tax Malpractice Damages:
A Comprehensive Review of the Elements and the Issues, The Tax Lawyer, Vol. 61, Spring 2008, at 100-101.
Also see Ducote Jax Holdings LLC et al. v. William E. Bradley, No. 04-1943, 2007 U.S. Dist. LEXIS 490088
(E.D. La. 2007) (successful prosecution of RICO violations in tax shelter case based on misrepresentation of
legality of tax strategies).
5
3

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
authority8 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
6
Since the taxation of malpractice recoveries is not likely to have an unduly negative effect on productivity
or the economy, incidence alone should probably not be a significant factor in determining the tax treatment.
However, as long as the Alternative Minimum Tax presents a serious risk to plaintiffs with modest recoveries
and large contingent attorneys’ fees, taxation of recoveries to plaintiffs can impact with such plaintiffs’ right
to pursue their rights through malpractice litigation.
7
Wood, Tax Treatment of Legal Malpractice Recoveries, February 12, 2007, Tax Notes p. 665 (references to
“Wood” in this paper refer to this article except where otherwise noted).
8
The article containing the most elaborate policy analyses in this area is by Jeffrey H. Kahn, The Mirage of
Equivalence and the Ethereal Principles of Parallelism and Horizontal Equity, 2005, bepress Legal Series,
Paper 715, 57 HASTINGS L.J. 645 (2006). This paper is also indebted to thoughtful papers authored by
Professors Lawrence Zelenak, Anthony E. Rebollo and Jacob L. Todres. See Zelenak, The Taxation of Tax
Indemnity Payments: Recovery of Capital and The Contours of Gross Income, 46 Tax L. Rev. 381, 386-87
(1991); Anthony E. Rebollo, Journal of Taxation *353, June 2006, Responding To 'Gross-Up' Claims In Tax
Malpractice Cases; and Todres, Tax Malpractice Damages, supra at n. 5.
9
Wood, p. 665 n. 1, supra n. 7, cites the leading cases for the origin of the claim doctrine: United States v.
Gilmore, 372 U.S. 39, 49 (1963) (payment received as a substitute for something that would have been an
gross income is taxable compensation); Hort v. Commissioner, 313 U.S. 28 (1941) (consideration for the
4
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
cancellation of a lease was essentially a substitute for rental payments and therefore taxable income rather
than a nontaxable return of capital).
10
Wood, p. 665, supra n. 7,
See Todres, pp. 10 – 40, supra, n. 5; Rev. Rul. 57-47 (interest on the amount deemed overpaid); IRC §
162(f) (penalties); Commissioner v. Glenshaw Glass Co., 348 U.S. 426 (1955) (punitive damages are
includible in gross income because they are not a substitute for any amounts lost by the plaintiff or a
substitute for any injury to the plaintiff or plaintiff's property); BNA Tax Management Portfolios, U.S.
Income Series Income, Deductions, Credits and Computation of Tax, 501-3rd 2008 FN2878: “See PLR
9728052; PLR 7749029 (indemnification payment for additional income taxes and related underpayment
penalties and interest, owed due to attorney's erroneous counsel, must be included in income).”
11
12
Milenbach v. Comm'n, 318 F.3d 924, 933 (9th Cir. 2003); Raytheon Prod. Corp. v. Comm'n, 144 F.2d
110, 113-14 (1st Cir.1944) ("in lieu of what were the damages awarded.")
13
Kahn, pp. 17-18, supra, n. 8.
14
Id. at 18, n. 35.
5
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
15
E.g., Rev. Rul. 57-47 distinguished tax free return of capital from recovery attributable to lost earnings on
the excess taxes that would have been taxable and the tax deductible fee. Cf. IRC § 111(a), which “provides
that gross income does not include the recovery of an amount deducted in an earlier year to the extent the
earlier deduction did not produce a tax benefit. In situations covered by § 111(a), Congress has determined
that a given type of expense or loss should be deductible, but the taxpayer's particular circumstances
precluded a benefit from the deduction.” Zelenak at 387, supra, n. 8. “Outside of §111, the nonstatutory tax
benefit doctrine probably still has vitality.” Wood, 38th Annual Employment Law Conf. p. 12, citing Dobson
v. Commissioner, 320 U.S. 489 (1943).
Also see Wood, p. 666 supra, n. 5, “That ‘did not and could not’ standard (from Clark v. Commissioner,
40 BTA 333, 335 (1935)) suggests that a tough tax benefit theory should apply to such analyses. It suggests that
there is a requirement that the plaintiff not only not have claimed a tax deduction for the loss, but also that he not
have been able to do so.”
Also see Gregg D. Polsky, The Contingent Attorney's Fee Tax Trap: Ethical, Fiduciary Duty, And
Malpractice Implications, 23 Va. Tax Rev. 615, at 634-35 (Winter 2004) (“a fiduciary duty/malpractice
plaintiff could argue that the damages she received represent a refund of attorney's fees previously paid and,
as a result, that the damages are excluded from gross income pursuant to the exclusionary component of the
tax benefit rule in section 111(a).”
Section 1.61-14(a) of the Income Tax Regulations provides that another’s payment of a taxpayer’s income
tax constitutes gross income to the taxpayer, unless otherwise excluded. Also see Old Colony Trust Co. v.
Commissioner, 279 U.S. 716 (1929).
16
17
Zelenak, p. 397-98, supra, n. 8, citing Old Colony Trust Co., 279 U.S. 716 (1929).
18
Centex Corp. v. U.S., 395 F.3d 1283, 1293 (C.A. Fed., 2005).
6
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
19
Federal Income Tax: Doctrine Structure and Policy, Third Edition, Dodge, Fleming, and Geier, 2004, p.
122. Also see Kahn, pp. 6 and 12, supra, n. 8 and authorities cited therein. “Horizontal equity requires that
persons in like net income positions pay the same amount of income tax . . . The goal of differently taxing
individuals with disparate net income is referred to as vertical equity. William Andrews, Basic Federal
Income Taxation 7-8 (5th ed. 1999). The goal of vertical equity generally includes a requirement that there be
an ‘appropriate’ difference in taxation. Also see Paul R. McDaniel & James R. Repetti, Horizontal and
Vertical Equity: The Musgrave/Kaplow Exchange, 1 Fla. Tax Rev. 607, 607 (1993).”
20
Wood, p. 667 supra, n. 5.
Kahn, p. 48, supra, n. 8 (describes the reasoning of PLR 9743035’s attempt to distinguish
Clark v. Commissioner, supra, based on whether taxpayers incurred more than their “proper”
tax. as “weak, at best.”). Rebollo at 358, supra, n. 8 describes the “proper” tax PLRs as
“wrong. “Silly” is the conclusion of Maule, 502-2nd T.M. (BNA), Gross Income: Tax
Benefit, Claim of Right and Assignment of Income, page A-5 (specifically referring to Ltr.
Ruls. 9743034 and 9743035 ); James P. Dawson, Fox Rothschild LLP Tax Litigation Blog,
July 15, 2007 (“(G)uidance needs to be issued by the IRS keeping in mind not its position but
the position of the Court’s (referring to Centex Corp. v. U.S., 55 Fed. Cl. 381, 389 (2003),
aff'd 395 F.3d 1283 (Fed. Cir. 2005)) as to the underlying cause of action. If the IRS looks at
the underlying cause of action(s) then the conclusion should be for non-inclusion.”)
21
PLR 200328033. Although this PLR is not based a tax malpractice case, it says, “The tax indemnity
payment that A received in this case is indistinguishable from the (malpractice) indemnity payments in Clark
and Rev. Rul. 57-47.”
22
7
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
23
Murphy v. IRS, 362 F. Supp. 206, 218 (D.C. 2005) citing Eisner v. Macomber, 252 U.S. 189, 207, 40 S.Ct.
189, 64 L.Ed. 521 (1920); Commissioner v. Banks, 543 U.S. 426, 25 S.Ct. 826, 160 L.Ed.2d 859 (2005).
Dodge, Fleming, and Geier, p. 244 and Kahn, p. 21, fn. 43, supra, n. 8: “The Haig-Simons definition of
income is the most commonly cited definition for tax policy purposes. It defines income for a period as the
sum of the increase in wealth accumulated by the person plus the market value of the person’s personal
consumption. See Henry C. Simons, Personal Income Taxation 50 (Univ. of Chi. Press 1980) (1938)”
24
25
GL-132608-04, *3-4, (1980) analyzing whether damages from a class action lawsuit against an insurer are
includible in the taxpayers’ income and concluding that they are not includible to the extent of the taxpayer’s
basis in the insurance policy because a return of basis is not generally classified as income within the
meaning of section 61.
8
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. Commissioner26 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 BTA29 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.
40 B.T.A. 333, 1939 WL 11, 1939 BTA LEXIS 864, (B.T.A. Jul 27, 1939). Wood notes, “It is a testament
to the lack of authority in this area that Clark is still a leading (and nearly the only!) case nearly 70 years
later.” Wood, p. 665 fn. 7, supra, n. 5.
26
The practitioner’s error of advising the taxpayer to file a separate tax return instead of a joint return
impaired the utility of a capital loss deduction.
27
28
40 B.T.A. at 335, 1939 WL at **5, citing Merchants Loan & Trust Co. v. Smietanka, 255 U.S.
509; United States v. Safety Car Heating & Lighting Co., 297 U.S. 88.
29
The Tax Court was formerly known as the Board of Tax Appeals.
30
40 B.T.A. at 335, 1939 WL at **4, 5.
9
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
31
32
G.C.M. 35164.
See fn. 19 to Concord Instruments Corp.
10
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 scope35 and validity of the Clark non-
33
PLR 200328033. The nature of the negligence and additional tax it caused were not disclosed in Rev. Rul.
57-47. As contrasted with private letter rulings, Revenue Rulings are affirmative statements of the position of
the IRS that may be relied on by taxpayers. Reg. 601.601(d)(2)(v)(e).
IRS Private Letter Rulings do not constitute authority, may not be used or cited as precedent and can
not bind courts. IRC Section 6110(k)(3); See Hanover Bank v. Commissioner, 369 U.S. 672, 686 (1962);
Snap-On Tools, Inc. v. United States, 26 Cl. Ct. 1045, 1060 (1992), aff’d, 26 F.3d 137 (Fed. Cir. 1994).
“Despite all their shortcomings, tax lawyers still look to private letter rulings for the IRS’ general position on
matters.” Wood, The Bottom Line: Tax Issues In Employment Cases, 2005 p. 5.
Rev. Proc. 2007-1 says a letter ruling “is a written determination issued to a taxpayer by an
Associate office in response to a written inquiry from an individual or an organization about its status for tax
purposes or the tax effects of its acts or transactions, prior to the filing of returns or reports that are required
by the revenue laws. A letter ruling interprets and applies the tax laws to the taxpayer’s specific set of facts
and is given when appropriate in the interest of sound tax administration. A letter ruling includes the written
permission or denial of permission by an Associate office to a request for a change in a taxpayer’s accounting
method or accounting period. Once issued, a letter ruling may be revoked or modified for any number of
reasons, as explained in section 11 (section 9.19 for a change in accounting method letter ruling) of this
revenue procedure, unless it is accompanied by a “closing agreement.”
34
Accord General Counsel Memorandum 35164 (1971) finding recovery of malpractice damages for failure
to elect "S" corporation status not taxable. The ruling looked to the character of the income that would have
been received had no malpractice occurred.
35
Wood, p. 666 supra, n. 5 (The IRS tried “to limit the breadth of the Clark holding” in these rulings.)
11
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
36
Rebollo, supra, at 357, supra, n. 8.
37
Wood, p. 670, supra, n. 5.
38
Id.
39
Kahn, p. 48, supra, n. 8.
12
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).
The distinction is difficult to understand and as Wood notes “difficult to apply.”41 These
later rulings have a number of significant flaws:
In the first place, the 1997 PLR conclusion that Clark paid more than his proper tax
glosses over the most critical, undisputed fact in the case. Clark’s irrevocable joint filing
status election that was so important to the IRS in 1939 is treated as if it was insignificant
in 1997. The IRS’ reasoning in 1997 implies that it collected an improper tax from Clark.
On the contrary, Clark paid the “proper” amount of tax computed for one filing a
joint tax return, a circumstance caused by his negligent tax practitioner. Both Clark and the
investment funds’ undesirable tax status was caused by their negligent tax practitioners.
The crux of both malpractice claims was that the practitioners’ negligence caused the
40
LTR 9743035.
41
Wood, p. 666, supra, n. 5.
13
taxpayers to incur additional “proper” tax that they otherwise would not have incurred.
Payment of more than their proper tax liability would have negated their malpractice
causation claims.
There is no indication in Rev. Ruling 57-47 that the taxpayer did not pay more than
the proper tax under the circumstances created by her negligent tax practitioner.
That the malpractice recovery “was not made to compensate Fund for a tax liability
in excess of Fund's proper federal tax liability” contradicts the factual description of the
PLRs and ignores the measure of damages used, “The reimbursement restored Fund to the
position it was in before the loss was incurred . . .”42
Whether this blatant misinterpretation of the basis of the parties’ settlement would
survive widespread objective judicial scrutiny seems unlikely. At least one court has
rejected the IRS’ “current view” in a non-malpractice context, Centex Corp. v. U.S., 55
Fed. Cl. 381, 389 (2003), aff'd 395 F.3d 1283 (Fed. Cir. 2005): “The judgment is not a
replacement of lost income. Instead, plaintiffs are receiving monies already subject to tax
once before.”
Centex at bottom involves a situation where a taxpayer paid the
correct amount of tax and then later received an
indemnification payment for a portion of that tax, and it was
the Government that argued for the application of Clark (to
successfully avoid plaintiff’s gross-up damages claim for
additional taxes). This certainly seems inconsistent with the
position the IRS has taken in its post-1991 letter rulings. Of
course, it is unclear whether the Department of Justice
consulted the IRS before advancing its Clark argument. 43
42
LTR 9211015.
43
Richard A. Wolfe, Tax Indemnity Insurance: A Valuable and Evolving Tool For Managing Tax Risks, pp.
32-33, The Tax Club, 2003.
14
The 1997 PLRs unequivocally ignore the principled reasons given in the 1992
PLRs:
A. If reimbursement is a replacement of capital, it is not includible in gross
income.
B. Payment by the one causing a loss that does no more than restore a taxpayer
to the position he or she was in before the loss was incurred is not includible
in gross income because there is no economic gain.
C. But for the preparer's error, the taxpayer would not have incurred the losses
for which it received reimbursement.
Finally, the emphasized 1997 language that the reimbursement was a tax payment is
directly contrary to the Clark interpretation.44
If LTR 9743034-35 were isolated rulings, perhaps they could be explained as
arising from a unique situation involving tax practitioners’ failures to ensure their client’s
underlying transactions complied with tax law. Instead, the uncertainty raised by 974303435 is exacerbated by two other malpractice PLRs and a Nondocketed Service Advice
Review (“NSAR”) which also followed the “proper” tax concept.45 The IRS again
concluded that these taxpayers, unlike Clark, did not pay more than their minimum proper
federal income tax liability. The “proper” tax PLRs and NSAR do not adequately explain
how the reimbursement was not a return of capital or how they differed from earlier,
40 BTA at 335 (Clark “paid his own taxes.”) But see Zelenak, 46 Tax L. Rev. at 383, supra, n. 8 (“By
itself, this is an absurd basis for distinguishing Old Colony. It suggests that the president of Old Colony
would not have been taxed if he initially had paid his own taxes on his salary, and his employer then had
reimbursed him for those taxes, despite the fact that the economic substance of that arrangement is identical
to the arrangement the Supreme Court held taxable in Old Colony.”) See Old Colony Trust Co. v.
Commissioner, 279 U.S. 716 (1929).
44
45
See LTR 9728052, LTR 9833007.
15
nontaxable settlements in Clark and Rev. Ruling 57-47. None of the later rulings provide
an adequate reason for distinguishing between (1) errors in filing returns or claiming
refunds which caused taxpayers to pay more than their minimum proper federal income tax
liabilities based on the underlying transactions and (2) errors which alter the taxpayer’s
underlying tax entity status. Nor is any explanation provided to distinguish “proper” from
“improper” tax liability.
In LTR 9728052, Doc 97-20252, 97 TNT 134-27, a defective alimony agreement to
pay the taxpayer’s ex-spouse’s estate disqualified an alimony deduction.46 The negligent
lawyer reimbursed the taxpayer for the extra taxes incurred as a result of the defective
agreement. The IRS ruled that the reimbursement was income to the taxpayer even though
it was compensation for negligence that cost the taxpayer readily avoidable taxes, just as in
Clark, was not derived from his capital or labor and (as the Clark and Concorde courts had
ruled) did not result in economic gain.47 The IRS’ stated reason for the distinction was that
the negligence “related to the underlying transaction, that is, the terms of the Agreement.”
LTR 9833007, Doc 98-25747, 98 TNT 158-12, involved a lottery winner whose tax
practitioner failed to advise the client as to certain deductions. This omission resulted in
more tax than otherwise would have been owed. The practitioner’s malpractice carrier
reimbursed the client for the additional taxes. Again, the IRS failed to follow Clark,
Kahn’s conclusion (Kahn, p. 51, supra, n. 8) that the amount of the damage in PLR 9728052 would be
“difficult, if not impossible,” to ascertain appears exaggerated. The calculation of such alimony provisions
typically includes a premium for the recipient’s tax at a lower tax rate than the payor’s anticipated rate.
Expert testimony would be expected, and would likely be contested, but proving such damages should not
have been significantly more difficult than in the lottery or RIC malpractice PLRs. Kahn is certainly correct
that (A) any unpaid alimony premium should have reduced the damages and (B) since the proof was
sufficient to justify an arms length settlement, the challenge of proving the taxpayer’s damages was overcome
and should have been no reason for the IRS to tax the reimbursement.
46
“This principle should apply with respect to errors in any type of agreement (not just divorce agreements)
that result in additional taxes, interest and penalties for which the taxpayer is indemnified. Under the ruling,
all such indemnification payments would be gross income to the taxpayer receiving them.” Federal Tax
Coordinator, Second Edition, J-5800, see language following reference to FN39.1.
47
16
Concorde and Rev. Ruling 57-47 and employed the questionable reasoning that additional
federal taxes were not caused by an error on the return itself. Instead, the negligence was
the failure to provide competent advice that would have reduced the tax liability. The
Service ignored that the Clark malpractice also involved negligent advice.48 Again, the
Service’s excuse was that unlike Clark, this taxpayer supposedly did not pay more than his
minimum proper tax.
Wood’s analysis of the IRS’s position post-Clark is that,
(T)he view that legal malpractice is nontaxable as a recovery of capital
appears to be quite narrow. At least one reading of the ‘‘authority’’
following Clark (bearing in mind that private letter rulings do not
constitute authority) is that it is limited to indemnification for negligent
tax advice. I believe that reading is too narrow.49
Still, the rulings say what they say, and extend tax relief only when
the claimant paid more than his ‘‘proper’’ minimum federal income tax
liability, and when the nature of the indemnification is related to the
underlying claim. When the IRS has declined to follow Clark, its
determination was based on the underlying nature of the transaction
giving rise to the discrepancy.50
What is an “improper” tax? Presumably, the IRS meant that the taxes in Clark and
Rev. Ruling 57-47 would not have been owed under the substance of the underlying facts,
i.e., if the form errors caused by negligence are disregarded. This is hardly a useful or
satisfying definition. Since all of the excess taxes involved were caused by negligence of
tax practitioners, that cannot be the distinguishing feature of an “improper” tax. Since none
of the errors could have been corrected by an amended return if the errors had been caught
48
40 BTA at 333.
49
The view on advice became even narrower in 2001 NSAR, infra, p. 23.
50
Wood, p. 667, supra, n. 8.
17
before expiration of the IRS statute of limitations, that misfortune cannot be the
distinguishing feature of an “improper” tax either.
The only malpractice situation in which the “proper tax” concept makes sense to
this writer is if the errant practitioner had promised “pie-in-the-sky” tax results for which a
taxpayer somehow obtained recovery of compensatory damages.51 The difference between
the higher proper tax and the improperly promised lower tax in such a situation would be
an accretion of wealth.52
This paper submits that the IRS’ “proper” tax concept should not be applied to a
malpractice case in which the tax exceeds what it should have been absent the malpractice,
regardless of the nature of the malpractice. Aside from causing the taxpayer’s loss, the
nature of the practitioner’s conduct is irrelevant to whether the reimbursement for
additional taxes is an accretion of wealth. No IRS pronouncement has articulated why the
nature of the malpractice is relevant beyond stating ipso facto that some malpractice is
distinguishable.
The following discussion demonstrates how the IRS adopted Professor Lawrence
Zelenak’s “proper” tax concept from his analysis of tax indemnity agreements.
A tax indemnity agreement is a guarantee of the tax treatment that a
taxpayer will have in a transaction and an agreement to indemnify the
taxpayer for any additional taxes incurred if the actual tax treatment is
different from the one that was promised.”53
This would not be consistent with the requirement that malpractice cause the excess tax. See Zelenak’s
example involving reimbursement for promised tax benefits which demonstrates that such a taxpayer suffered
no loss as had Clark, p. 397, supra, n. 8.
51
52
Zelenak, p. 397, supra, n. 8.
Kahn, p. 52, supra, n. 8. Also see Richard A. Wolfe, p. 22, supra, n. 42 (“Insurers that issue TIIPs actually
strengthen the integrity of our tax system . . . if a company is contemplating pursuing a particular tax plan,
and the CFO of the company tries to obtain a TIIP but cannot do so because the plan is too aggressive, the
company may be deterred from pursuing the plan . . . The recently issued tax shelter disclosure regulations
under section 6011 indicate the IRS recognizes that TIIPs do not help facilitate tax shelters . . . the TIIP
53
18
Despite Zelenak’s careful distinction between asset sale tax indemnity agreements
and malpractice,54 the IRS misapplied the “proper” tax concept to tax malpractice cases
involving actual losses. In other words, the IRS hijacked the “proper” tax argument that
was asserted solely against its rulings on the tax indemnity agreement cases and misused it
as a vehicle to tax a variety of distinguishable malpractice recoveries. The IRS’ assertion
of this argument out of its intended context violates the origin of the claim doctrine and the
accretion concept of income. By definition, ignoring such fundamental principles leads to
“unprincipled”55 result-oriented reasoning.
Anthony E. Rebollo agrees that “the reasons given by the Service for 'changing
directions' sound similar to” Zelenak’s analysis.56
Zelenak's law review article distinguished the fact patterns in the two
(indemnity agreement) letter rulings from the facts in Clark as
follows. In the letter rulings, the 'nontax facts' of the underlying
transactions dictated that the tax paid by the taxpayers was 'only the
correct tax, in the sense that they could not have paid any less tax
based on the underlying facts as they actually existed.' The Clarks,
on the other hand, 'could have paid less tax without any change in
the nontax facts of their situation, if their preparer had simply made
a different tax election.'57
underwriting process provides an informed assessment of complex tax risks by a sophisticated, neutral third
party -- a party with a strong economic incentive to confirm that the tax risk being insured conforms to the tax
laws.”
Zelenak, p. 399, supra, n. 8 (“By contrast, the payment from the negligent return preparer in Clark was
not in connection with an asset sale, so that treating that payment as nontaxable did not have the effect of
creating a form of tax-favored investment income not authorized by statute.
54
55
See Joseph M. Dodge, The Netting Of Costs Against Income Receipts (Including Damage Recoveries)
Produced By Such Costs, Without Barring Congress From Disallowing Such Costs, 27 Va. Tax Rev. 297,
313 (Fall 2007)
Rebollo, p. 358, n. 7 and 17, supra, n. 8, “See Letter Rulings, 'IRS Makes Clear Which Tax Indemnity
Payments are Taxable,' ('In separating itself from the prior authority that called for excluding the indemnity
amounts from income, it seems apparent that the Service has read articles such as Zelenak, 'The Taxation of
Indemnity Payments: Recovery of Capital and the Contours of Gross Income,' 46 Tax L. Rev. 381 (1991)').
56
57
Rebollo, p. 359, supra, n. 8.
19
Professor Rebollo is correct that, as applied to malpractice cases, the “proper” tax
argument ignores that the taxpayers could have paid less taxes but for the nontax facts
caused by the malpractice. Rebollo’s “problem with sorting out 'tax facts' from 'nontax
facts,' is that it will depend on one's perspective and how those terms are defined. But if the
propriety of a gross-up (i.e., recovery of the tax) turns on whether the claimant would have
been required to pay the underlying taxes in any event, then the amounts comprising the
indemnity payment may not constitute actionable damages in the first place.”58 Another
way of putting this is that the IRS’ stated reasoning for taxing these malpractice settlements
is oblivious to the tort requirement of proximate cause.
Professor Rebollo is also correct that the definition of “nontax facts” is unclear.
Presumably, he meant the non-malpractice-caused facts and non-indemnity-agreementinduced facts under which the taxpayers would owe the lowest possible tax.
Clark’s nontax facts were presumably that he was married and had capital losses.59
Clark could have properly paid less taxes based on these nontax facts. This is clear enough
until Zelenak adds that, “the tax liability determined on audit is the correct liability based
on the nontax facts.”60 Would not an audit of Clark have resulted in more liability than he
owed on the nontax facts, i.e., include tax caused by malpractice?
The nontax facts “as they actually existed” referred to by Zelenak with regard to
indemnity agreement letter PLR 8748072 were that the mortgage backed certificates did
not meet the requirements of IRC § 936 as represented.61 Similarly, the nontax fact in his
58
Id.
Zelenak, p. 397, supra, n. 8 (Clark “could have paid less tax without any change in the nontax facts of
their situation, if their preparer had simply made a different tax election”).
59
60
Id. fn. 81 of Zelenak’s article.
20
would-be-tax-favored-bond example were their failure to comply with IRC § 103.62 Why
noncompliance with the IRC is considered a “non-tax” fact is unclear but it is clear that the
taxpayers “could not have paid any less tax based on” these “nontax” facts.”63
The critical difference seems to be the actual cause of the tax that was reimbursed:
was the tax already owed or was the tax caused by malpractice?64
The “proper” tax malpractice PLRS and NSAR ignore this difference. The PLRs
do not mention nontax facts. The NSAR’s reference erroneously implies that Zelenak
advocated taxing malpractice recoveries:
He (Zelenak) concluded that if a taxpayer's tax liability, based on the
actual facts, was as low as legally possible, none of the tax he or she pays
should be classified as an “excess tax” which effectively invaded the
taxpayer's capital.65 Thus, any indemnification received as a result of
erroneous advice regarding the tax consequences of the transaction giving
rise to the liability could not constitute a return of capital.
The concept of nontax facts (i.e. facts not caused by the practitioner under which
the taxpayer owed the minimum tax) in them is also unclear because of the IRS’ chronic
mischaracterizations of causation.66 Presumably, the IRS would say such “nontax” facts
were the tax data of the alimony payer before alimony, the would-be RICs under
61
Zelenak, p. 398, supra, n. 8.
62
Id. p. 399.
63
Id.
64
“Non-malpractice facts” and “non-indemnity-agreement facts” would be more precise and useful terms.
This statement is a fair statement of Zelenak’s position on tax indemnity agreements but not on
malpractice.
65
E.g., 2001 IRS NSAR 0056: “in those PLRs the Service concluded the taxes the taxpayer was legally
obligated to pay were a consequence of the transaction he or she entered into, and not a result a result of any
mistake the tax advisor made.” In other words, the malpractice settlement was unfounded in the view of the
IRS.
66
21
subchapter C and the lottery winner and would be tax-free acquiring corporation with the
bad tax advice inflicted on them.67
While Zelenak’s article explains the difference between a “proper” tax and paying
more than a “proper” tax, the PLRs it spawned add no light as to why recovery for one is
deemed income and one is not in malpractice cases. The “nontax facts” of the PLRs did
not change the nature of the reimbursements to the taxpayers and could not logically
change the reimbursements into accretion of wealth.
Zelenak’s article concluded that while Clark “probably is correct,” tax indemnity
agreements “present issues not raised by Clark, and that extension of the Clark rationale to
such payments is not appropriate.”68 Zelenak’s article logically demonstrates how tax
indemnity agreement payments do not result in a loss. The IRS properly followed it in
revoking its indemnity agreement PLRs.69
However, the IRS’s implicit rejection of
Zelenak’s distinction between tax indemnity agreements and malpractice is the source of
the “proper” tax confusion under examination here.
The foundation of Zelenak’s argument is his reconciliation of Clark and Old
Colony Trust Co. v. Commissioner,70 in which an employer’s payment of its employee’s
67
2001 IRS NSAR 0056: (“if the facts developed in this case indicate that the recovery is being received on
account of erroneous tax advice indicating that the transaction in which *** acquire *** was nontaxable, we
believe the tax indemnification payment made on account of that erroneous advice will constitute taxable
income.”)
Zelenak, p. 382, 385, supra, n. 8 (The arguments against Clark are: “(1) that Clark is inconsistent with the
holding of Old Colony; (2) that allowing a tax-free recovery of a nondeductible loss is inconsistent with the
congressional decision that the loss should be non deductible; (3) that allowing a tax-free recovery of a
nondeductible loss results in inconsistent treatment of similarly situated taxpayers; and (4) that Clark is at
odds with fundamental principles of annual accounting in general, and with the Supreme Court's opinion in
Burnet v. Sanford & Brooks Co. (282 U.S. 359 (1931)) in particular. (Zelenak) concludes that none of these
arguments is persuasive and that the (Clark) case was decided correctly.” See Old Colony Trust Co. v.
Commissioner, 279 U.S. 716 (1929).
68
69
See PLRs 9226033, 9226032 and 9120014.
70
279 U.S. 716 (1929).
22
taxes was held to be income to the employee. Zelenak perceptively distinguished the two
cases based on the BTA’s finding of Clark’s loss.71 The cause of the excess tax is the
distinguishing feature:
What then justifies treating the taxes in Clark as a loss, even though it is clear from
Old Colony that payments of federal income tax ordinarily cannot be so treated?
The answer must be that the Board in Clark implicitly drew a distinction between
(1) taxes that were clearly and unavoidably owed given the taxpayer's economic
situation (such as taxes on salary), which cannot be characterized as a loss, and (2)
excess taxes that were not necessarily owed given the taxpayer's economic
situation, but were paid through a mistake of some sort, which can be characterized
as a loss because of the mistake.72
The 1997-98 “proper” tax PLRs ignore this crucial distinction in order to treat taxpayers in
the second (nontaxable) situation as if they were in the first (taxable) situation. Those
PLRs twist the following argument of Zelenak by making an opposite, even more
hypertechnical, form of it to argue that Clark paid more than the “proper” tax:
(O)ne could argue that in Clark there was no mistake and no excess tax, because
the Clarks in fact paid the proper amount of tax, given the election to file a joint
return. If one accepts the argument that the Clarks simply paid the proper amount
of tax, Clark becomes indistinguishable from Old Colony, and the recovery should
be taxable. That argument seems hypertechnical, however, given that the Clarks
could have paid a smaller amount of taxes based on exactly the same economic
facts, but for the ill-advised election which had no effect other than to increase
unnecessarily their tax liability.73
Although this implies that Clark paid more than tax than he should have; Zelenak’s
main point was that since the tax indemnity agreement recipients did not pay more than
their proper tax, they, unlike Clark, did not suffer a loss.74
71
40 B.T.A. at 333 (“to compensate him for a loss suffered on account of erroneous advice”).
72
Zelenak, p. 386, supra, n. 8.
73
Id.
74
Id. at 398.
23
As noted above, the IRS properly adopted the following Zelenak argument
supporting taxation of tax indemnity agreements: “If the taxpayer could not have paid any
less tax based on the actual nontax facts, there is no loss which can be recovered tax
free.”75 That seems like a perfectly valid and workable rule for both malpractice and tax
indemnity agreements. Unfortunately, the IRS misapplied it to malpractice cases by
mischaracterizing facts and ignoring the bases of the malpractice recoveries.
The lottery winner could have paid less tax had he been properly advised. The
alimony payer could have paid less taxes had his lawyer properly drafted his agreement.
The would-be RIC could have paid less tax had its CPA ensured it complied with
investment requirements. The IRS’ view of the factual bases of these malpractice
recoveries either fails to comprehend the fundamentals of tort compensation or deliberately
distorts the facts.
The IRS’ application of this “proper” tax concept out of its intended context
explains why the phrase “proper” tax makes so little sense in malpractice cases. In the
parlance of Daubert reliability of methodology, the IRS’ 1990s malpractice PLRs are
guilty of an analytical gap by utilizing an inapplicable, irrelevant principle and by ignoring
the fundamental accretion and return of capital principles of defining income. The
“proper” tax concept does not logically “fit” the malpractice cases to which it was applied.
The 2001 NSAR76 cited above by Rebollo confirms the IRS’ misapplication of
Zelenak’s tax reimbursement agreement “proper” tax concept to malpractice cases in a
75
Id. at 399.
2001 IRS NSAR 0056, 2001 WL 34056101. “In accordance with I.R.C. § 6110(k)(3), this Chief Counsel
Advice should not be cited as precedent.”
76
24
less than forthright manner. The NSAR held that taxable income includes malpractice
insurance reimbursement for claims that: (a) a tax advisor failed to advise of the correct
tax consequences of an attempted tax-free merger transaction that turned out not to be taxfree or (b) the advice provided regarding the tax consequences of the transaction was
incorrect. The taxpayer contended that the reimbursement should not be taxable income,
citing Rev. Rul. 57-47, 1957-1 C.B. 23; Concord Instruments Corp. v. Commissioner,
supra, and, Clark v. Commissioner, supra. The 2001 NSAR attempts to distinguish those
authorities based on the nature of the advice and the negligence:
(B)ad advice received by the taxpayer did not address how to structure a
transaction in order to minimize its tax consequences, but rather addressed
how to report the tax consequences of a transaction that was already
completed. That bad advice caused the relevant taxpayer to pay more tax
than he would legally have been required to pay, had he reported the
relevant transaction appropriately. And in Concord Instruments Corp.,
supra, the recovery was received in connection with a procedural mistake an
adviser made, and not as a result of mistaken substantive tax advice.
In the instant case, (the taxpayer) entered into a transaction whose tax
consequences were fixed, although possibly unexpected as a result of
erroneous tax advice that it apparently received.
The NSAR ignores that Clark’s joint return election was also irrevocably
fixed and that his loss was also a direct result of negligent advice.77 Again, this
attempted distinction is a non sequitur because the nature of the negligence does not
affect the nature of the reimbursement or transform it into income.
The 2001 NSAR cited Lawrence Zelenak’s article78 as “the leading analysis of the
tax consequences of receiving payments intended to indemnify a person for additional
77
40 BTA at 333.
78
The Taxation of Tax Indemnity Payments: Recovery of Capital and the Contours of Gross Income, 46 Tax
Law Review 381 (Spring 1991)
25
taxes incurred after the receipt of erroneous tax advice.” The NSAR revealed that Zelenak
“articulated the fundamental theory upon which the Service relied in a number of PLRs in
which it concluded that damages received for erroneous tax advice constituted income, i.e.,
that a tax indemnity payment should be considered to be income where the taxes that the
relevant taxpayer paid were the correct taxes due on the underlying transaction.”
The NSAR failed to disclose that the IRS’ “current view” of taxability of
malpractice recoveries was diametrically opposed to Zelenak’s conclusion as to the correct
result in malpractice cases, i.e., nontaxability:
Clearly there is a loss creating mistake if a taxpayer incorrectly calculates
his tax liability as being higher than it really is. It is universally agreed that a
refund resulting from such a mistake is not taxable. If no refund is
available because the statute of limitations has run, but the taxpayer
recovers an equivalent amount from his negligent return preparer, it is
equally clear that there has been a loss-creating mistake and that the
recovery is free of tax.79 (emphasis added)
Nowhere has the IRS acknowledged Zelenak’s explicit distinction between malpractice and
tax indemnity agreements: “there are crucial differences between the Clark situation and
the situations described in the (tax indemnity agreement) letter rulings . . . By contrast, the
payment from the negligent return preparer in Clark was not in connection with an asset
sale, so that treating that payment as nontaxable did not have the effect of creating a form
of tax-favored investment income not authorized by statute.”80
Immediately following the NSAR’s reference to a malpractice PLR, the NSAR
cited the tax indemnity agreement PLR 8748072 (that Zelenak distinguished from
malpractice) without noting Zelenak’s distinction between the two. The only similarity
79
Zelenak, p. 386, supra, n. 8.
80
Id., pp. 397, 399.
26
noted by the NSAR between the two cases was that they both involved additional taxes
caused by disqualifying asset holdings. The NSAR ignores Zelenak’s most fundamental
point, the critical difference that in the malpractice case, the reimbursement is for a true
loss while tax indemnity agreements do not involve a loss.
“To resolve whether two persons or circumstances are to be treated the same by the
tax law, it is necessary to determine whether the differences that exist are relevant for that
purpose.”81 The IRS has not demonstrated the purported relevance of the difference
between Clark’s negligent advice and return preparation and the advice in the PLR cases.
Note that the Service maintains that the exclusion of a
reimbursement depends on the nature of the bad advice. In Clark,
the exclusion was allowed when the advisor made an error in
advising his client and his wife to file a joint return rather than
separate returns. The Service distinguishes bad advice on a return
that causes the taxpayer to pay more than his minimum tax liability
from advice on a taxpayer’s underlying transactions that fails to
minimize the taxpayer’s liability. The Service has not allowed the
exclusion when the advisor’s error pertains to failure to advise a
client to take an action that would have resulted in lower federal
tax liability. See, e.g., P.L.R. 2003-28-033 (July 11, 2003).82
As further proof of its deficient analysis, the NSAR mischaracterizes PLR 9833007
as involving a “tax indemnity” case. 9833007 was actually a malpractice case not
involving a tax indemnity agreement, a type of case that Zelenak took pains to distinguish.
The 2001 NSAR seems like the result of the childhood “telephone” game where a
series of people whisper a message one to another to see how distorted the ultimate
message becomes. The NSAR writer could not have made a careful reading of Zelenak’s
81
Kahn, p. 94, n. 8, supra, n. 8.
82
Sophia Hudson, An Argument For Untidiness: Non-Parallel Treatment OF Exclusions and Deductions In
Federal Income Taxation, 32 Michigan Tax Lawyer, Fn. 5 at p. 35 – Winter 2006.
27
article and honestly concluded that Zelenak supported taxation of malpractice recovery.
Not that the IRS is bound by Zelenak’s opinions but in an age of increasing duties to “the
system,” intellectual honesty would indicate acknowledging a source’s primary distinction,
contrary conclusion and recognition of the difference in economic substance of the two
situations. The IRS’ failure to do so has resulted in its inconsistent application of the law
and unnecessary confusion.
Another indication of the IRS’ disregard of the substance of the underlying
transactions is that the NSAR perpetuates the errant PLRs’ decidedly different view of
proximate causation than did the taxpayers in the PLR malpractice cases. The basis for one
of the malpractice settlements was initially described as follows:
A is now negotiating with his attorney's malpractice insurer for an
indemnification payment. This payment will recompense A for the
additional federal income taxes . . .83
Compare that initial description with the IRS’ “current view”:
(T)he taxes the taxpayer was legally obligated to pay were a consequence of
the transaction he or she entered into, and not a result a result of any mistake
the tax advisor made.84
No court could legitimately award additional taxes as malpractice damages if this
were its finding. In effect, the IRS has indicated that it will reject the courts’ and parties’
arms length, objective conclusions that the malpractice caused the excess taxes and
substitute its own inaccurate and uninformed conclusion as to causation.
The “proper” tax rulings do not clarify the supposed significance of the distinctions
among different types of negligent advice and negligent return preparation. Nor do they
83
LTR 9728052.
84
2001 IRS NSAR 0056, 2001 WL 34056101. Also see PLR 9743035 and PLR 9833007.
28
explain why compensation for a loss caused by negligent advice may be income but
compensation for a loss caused by negligent return preparation is not income. If this
distinction continues as standard IRS practice, malpractice plaintiffs’ counsel would be
expected to frame their complaints as negligent return preparation whenever possible and
avoid pleading negligent advice as to prospective transactions.85 It is hard not to see the
“advice” distinction as unfair, arbitrary, and artificial.
Rebollo points out that plaintiffs in tax malpractice cases seeking to recover
damages for additional tax should be expected to rely on this “series of private letter
rulings issued in the 1990s, where the IRS 'changed directions,' ultimately concluding that
certain tax-based recoveries would be subject to tax, which arguably would support
requests for gross-ups” i.e., to award additional taxes caused by the malpractice.86
There are potentially serious administrative difficulties with the IRS and tax courts
second guessing and re-litigating parties’ and courts’ handling of what are often complex
underlying malpractice cases. A prime example is the “proper” tax PLRs’ chronic
mischaracterization of the reasons for the malpractice settlements. In addition, plaintiffs in
malpractice cases generally have to prove they would have prevailed in the underlying
“case within” the malpractice case to prove proximate causation. These practical
difficulties and judicial and administrative economy favor not having to (A) retry the
underlying cases or (B) rely on artfully selective drafting of underlying pleadings and
agreements to determine taxability. A better administrative rule would be to limit
application of the “proper” tax concept to taxing recoveries for asset sale tax indemnity
“(A) creatively and properly worded complaint can affect whether the amount received is determined to be
excludable from gross income.” Wood, p. 671 supra, n. 5, citing Getty v. Commissioner, 913 F.2d 1486 (9th
Cir. 1990).
85
86
Rebollo, at 356, supra, n. 8.
29
agreements, and sale of tax benefits and pie-in-the-sky misrepresentation cases. Taxpayers
whose tax is “exactly what it should have been,” based on the substantive facts of their
situation did not suffer a loss.87
(A) sham transaction cannot turn the tax on unrelated income into a
loss, so as to exempt the reimbursement of that tax from Old Colony
doctrine. If it could, the integrity of Old Colony would be at the
mercy of every sham transaction and every abusive tax shelter. If the
payment of the taxes one properly owes can be characterized as a
loss-thus making the recovery of that payment tax free-because one
might have reduced one's tax liability by making a legitimate tax
shelter investment, then the Supreme Court might as well overrule
Old Colony.88
The “proper minimum tax” PLRs and NCAR ignore the central reasoning in Clark
and Rev. Ruling 57-57, that reimbursement was for the taxpayers’ lost capital based on the
accountant’s error89 and the origin of claim doctrine. They also ignore the reality of the
losses incurred by the taxpayers.
“(I)t is difficult to see why Clark is distinguishable from the PLR cases where the
underlying tax-based damages could have been avoided or eliminated if proper advice had
been given.”90 In fact, since Clark was based in part on negligent advice,91 they are not
logically distinguishable. It is hard to see a difference, from the taxpayer’s perspective,
between bad advice to file a joint tax return and bad advice that alimony would be
deductible. In both situations, the practitioners’ mistakes cost the taxpayers additional tax
87
Zelenak, p. 402, supra, n. 8.
88
Id., p. 402, where Zelenak also explains why recipients of tax indemnity agreements should be allowed to
reduce their gain by their basis.
89
Kahn, p. 48, supra, n. 8.
90
Rebollo, p. 359, supra, n. 8.
91
40 B.T.A. at 333
30
that they would not have owed had the advice been competent. The taxpayers in the 199798 PLRs experienced no more accretion of income than Clark yet were taxed on their
recovery. Clark was made whole while the other taxpayers were not. The rulings do not
explain why these similarly situated taxpayers should be treated differently. The rulings
violate the policy principle of horizontal equity, that like-situated taxpayers should be taxed
the same, without any justification. The rulings also ignore the prevailing net accretion
definition of income92 and the Schanz-Haig-Simons concept of income as encompassing
“the change in the value of the store of property rights.”93 The rulings fail to adequately
articulate any “difference principle” or way of telling whether such taxpayers are alike or
different, and, if different, by what degree they are different.
Why shouldn’t all taxpayers forced to incur additional taxes because of their tax
practitioners’ fault, be allowed to exclude compensation for such loss from their taxable
income? Why should the difference in tax treatment be based on something largely out of
the taxpayer’s control such as the nature of the practitioner’s negligence, whether it is in
filling out a form, selection of language to use in an alimony agreement or advice on tax
planning? What does the fact that the practitioner’s negligence “related to the underlying
transaction and the terms of the agreement” have to do with whether the taxpayer enjoyed
an increase or accretion of wealth between the time that the unexpected tax was incurred
and when the taxpayer received compensation?
Zelenak offers a policy reason as to why tax indemnity agreement reimbursements
should be taxable: “it permits private parties to manufacture a ‘loss’ out of nothing, with
92
Jos.T. Sneed, The Criteria of Federal Income Tax Policy, p. 579 and note 45, Cf. Musgrave, The Theory of
Public Finance (1959) note 27, at 165.
93
Henry Simons, Personal Income Taxation (1938).
31
no regard to the actual nature of the asset in question, through the simple means of a
misrepresentation by the seller.” It is conceivable that such a conspiracy could occur in
the context of a property transaction in which the parties were cooperative enough to plan
a tax avoidance scheme but Zelenak concedes that it is hard to see such a risk occurring in
malpractice cases: “By contrast, the payment from the negligent return preparer in Clark
was not in connection with an asset sale, so that treating that payment as nontaxable did
not have the effect of creating a form of tax-favored investment income not authorized by
statute.”94
Kahn argues that the IRS should respect the amount of malpractice settlements
since the taxpayers and the malpractice carriers negotiate them at arms length, 95 i.e. the
carrier’s lack of incentive to overpay is indicia of reliability.96
There is no risk of collusion in this circumstance, and the bona fides
of such an agreement are beyond question, since the insurer has no
extrinsic motives (such as silencing the bad publicity that a dispute
would bring to the attorney) for settling the issue. Even if the
payment were made directly by the attorney, the possibility of
collusion or ulterior motive is not significant enough to change the
tax result.97
A Return To Clark?
94
Zelenak, p. 399, supra, n. 8.
95
Kahn, p. 48, supra, n. 8.
96
Also see Leandra Lederman, Statutory Speed Bumps: The Roles Third Parties Play In Tax Compliance, 60
Stan. L. Rev. 695, *695-96 (Dec. 2007)(“by harnessing the structural incentives of third parties . . . the
government can afford to free ride on the incentives of a third party in contexts in which the transfer of funds
from the third party to the taxpayer is a zero-sum game” i.e. where the third party has no incentive to collude
with the taxpayer.)
97
Kahn, p. 52, supra, n. 8.
32
The new millennium, and possibly the negative publicity concerning the IRS in the
1990s,98 resulted in an analogous pro-taxpayer private letter ruling. In LTR 200328033,
Doc 2003-16433, 2003 TNT 134-9, quoted above, the IRS ruled that a settlement was not
taxable when the taxpayer’s former employer’s error resulted in nontaxable disability
benefits being taxed. The IRS recognized and applied the Clark rule that the tax indemnity
payment the taxpayer received was compensation for the loss of capital suffered by
payment of taxes and indistinguishable from the reimbursement received by the taxpayer in
Clark. Without elaborating on the enigmatic “proper” tax, the IRS determined that the
taxpayer did not pay “more than his minimum proper federal tax.” Time will tell whether
this return to the principled reasoning of Clark and Rev. Ruling 57-47 is an aberration or
the IRS’ ultimate position.
IV.
If Tax Malpractice Recoveries Are Income, How Are They Taxed?
The origin of claim doctrine should determine the treatment, but again, the IRS
private letter rulings’ disregard of the return-of-capital and origin of claim doctrines raise
considerable uncertainty.
Tax malpractice claims typically include negligence, negligent misrepresentation,
breach of contract, breach of fiduciary duty and fraud. “There has been a good deal of
controversy over the tax treatment of fraud, misrepresentation and breach of fiduciary duty
claims.”99 Courts have generally treated recovery in fraud and breach of fiduciary cases as
98
E.g., October 13, 1997, The Washington Times, IRS Fights To Keep Up Morale Under Torrent Of Bad
Publicity, Senate hearings “featured tearful taxpayers testifying about IRS abuse, with the horror stories
confirmed by disguised IRS agents.”; Los Angeles Times, March 25, 1995 headline, ”Taxing Times: IRS
Reputedly Inefficient, Reckless, Spiteful Bureaucracy.”
99
Wood, The Bottom Line: Tax Issues In Employment Cases, 2005 p. 11.
33
ordinary income.100 Wood argues that such recoveries “may be capital gain, or even may
be a non-taxable return basis.”101
What if the malpractice caused the taxpayer to liquidate assets to pay the taxes and
penalties? “(I)n order to avoid a lost profits determination (with its ordinary income
consequences), it will be necessary to prove that the injury was related to a capital asset
and that the taxpayer had basis in that asset.”102
The basic direct or "core" damages for tax malpractice103 “typically involve four
types of injuries: additional taxes, interest paid the taxing authority, penalties104 and
corrective costs. Three different views have developed concerning the recoverability of
interest.105 The other core damages are normally recoverable.”106
100
Id. citing Griffiths v. Helvering, 308 U.S. 355 (1939) and Arcadia Refining Co. v. Commissioner, 118
F.2d 1010 (5th Cir. 1941).
Id. citing Dobson v. Commissioner, 320 U.S. 489 (1943), reh’g denied, 321 U.S. 231 (1944). “In Dobson,
the Supreme Court held that a taxpayer realized no income on recovering damages in settlement of a fraud
action against a seller of securities. The taxpayer had sold the securities at a loss, but realized no tax benefit
(owing to no taxable income). When he received a settlement, it was a recovery of his original investment.”
Also see Boehm v. Commissioner, 146 F.2d 553 (2d Cir. 1945), aff’d on other grounds, 326 U.S. 287 (1945)
(where a taxpayer sued because his stock had become worthless, this was deemed a recovery of capital (or his
original investment)).
101
102
Wood, The Bottom Line: Tax Issues In Employment Cases, 2005 p. 12 citing Biocraft Laboratories, Inc.
v. Commissioner, T.C. Memo 1980-268 (1980). See also H. Doud v. Commissioner, T.C. Memo 1982-156
(1982).
103
Todres, p. 10, supra, n. 5.
Id. at 39. “If the injured taxpayer is to be made whole, such penalties need to be recovered. . . . Unlike the
situation with interest imposed on an injured taxpayer where the taxpayer has had the benefit of having
money not belonging to him for a period of time . . . the incurrence of a penalty is simply damages flowing
directly from the tax advisor’s negligence, and the recovery of such amounts is not controversial.”
104
Id. at 11. “one approach (‘probably the majority view’ p. 27) permits the recovery of such interest from
the defendant, one approach denies any recovery of such interest (to prevent a windfall or because it is
speculative) and a third approach stands in between these two extremes and permits recovery of some
interest, but only to the extent the interest paid by the plaintiff to the government exceeds the interest earned
by the plaintiff on the tax underpayment.” Id. at 27 et. seq. for detailed discussion. See Streber v. Hunter,
221 F. 3d 701 (5th Cir. [Tex.] 2000) for application of third, net “interest differential” approach.
105
34
There should be no recovery for taxes that the taxpayer would have owed regardless
of the malpractice.
Although Zelenak makes a cogent argument that proceeds from tax indemnity
agreements should be “fully taxable,”107 his two references to allowing credit for the
taxpayer’s basis108 leave it unclear whether his preferred treatment is to tax them as
ordinary income (as he apparently persuaded the IRS to do), or as the IRS originally treated
them, a return of capital. This writer’s interpretation and recommendation is that they be
treated as a return of capital but that that the recipient only be allowed to offset as basis the
cost of the indemnity agreement, or the fee to the tax shelter promoter, and not any taxes
that she hoped to avoid.
V.
Can Clients Recover the Extra Tax (“Gross-Up”
Damages) Caused By Tax Malpractice?
If malpractice recovery is includible in the gross income of the plaintiff, should the
amount of the claim be increased (“grossed-up”) to offset the tax? Wood’s 2007 articles109
on this remedies question describe the uncertainty of the answer as “maddening.” He
discerns that the “current trend of case law suggests that tax gross-up claims and discount
requests (from damage awards for tax benefits conferred) are more favored today than they
were in the past” but that courts are “usually unsympathetic to such claims.”110 Todres
106
Id.
107
Zelenak, p. 398, supra, n. 8.
Id., pp. 400 (treating the “the payment as an adjustment of the purchase price . . . would be recovery of
capital treatment, but not in the same sense as Clark. Here, the recovered capital would be part of the cost of
the investment, not amounts paid in tax . . . ) and 402, where he recommends that the recipient be allowed to
recover his basis paid for the contract, but not for any tax he paid.
108
109
Taxes As an Element of Damages, 29 Civil Litigation Rptr. 177, Oct. 2007 and Damages for Tax
Consequences, Tax Notes 475, Aug. 2007.
110
29 Civil Litigation Rptr. at 178.
35
reports that “most states allow recovery of the additional taxes caused by the malpractice,”111
but he also concludes that “whether the basic damage award should be grossed-up so that an
injured plaintiff should be made whole on an after-tax basis” is one of the “most salient”
unresolved tax malpractice issues.112
Which of these accomplished writers’ seemingly divergent conclusions is more
accurate? Does the divergence mean that allowing recovery of additional taxes caused by
malpractice113 is a separate issue than the mathematical “gross-up” methodology used to
prove the additional taxes?114 It would appear from Centex v. U.S. that denying the right to
gross-up would also deny the right to recover additional taxes. How else can one recover
additional taxes? This paper leaves a detailed analysis of those state law damages issues to
others and instead attempts to focus on the policy issues.
One issue circles back to whether malpractice awards are in fact taxable as a
condition of causation and recoverability. The other arises from the battle between
compensation and speculation arguments.
There seem to be competing policy concerns here. On the one
hand, not to gross-up, i.e., to ignore any tax consequence of the
damage award, would be consistent with the approach taken with
Todres, p. 10, supra, n. 5. “What is not recoverable is other taxes incurred by the plaintiff, i.e., taxes that
would have been incurred even in the absence of the malpractice.”
111
112
Todres, p. 105, supra, n. 5.
113
Todres, pp. 11-14, supra, n. 5, cites cases from at least eight jurisdictions that have followed what he
deems to be the general rule allowing additional taxes as damages (fn. 40-54) and one that did not. (p. 14).
Wood’s tally is more mixed but the tax malpractice count is unclear. 29 Civil Litigation Rptr. at 179-180.
Todres, p. 106, supra, at n. 5. “One explicitly refused to permit gross-up while two others explicitly did
permit it” citing Pytka v. Gadsby Hannah, LLP, 2002 Mass. Super. LEXIS 461 at *26 n.1 (gross-up request
refused, indicating that the basic damage award likely was not subject to federal tax) and Oddi v. Ayco Corp,
947 F. 2d 257 (7th Cir. 1991); Jobe v. International Ins. Co., 933 F. Supp. 844, 860 (D. Ariz. 1995), order
withdrawn pursuant to settlement, 1 F. Supp. 2d 1403 (D. Ariz. 1997).
114
36
respect to any tax benefit generated by the injury, -- it is
disregarded. On the other hand, if the focus is on the basic theory
of damages in this area -- to put the plaintiff in the same position as
she or he would have been with non-negligent advice,-- then it
would be necessary to gross-up any damage award.”115
Todres concludes that the policy favoring compensation should prevail, “if the goal of
the law is to put the injured party as close as possible to where they would have been with
non-negligent tax advice, then the . . . damage award should be grossed-up. This, however,
assumes the damage award is taxable, which may not be certain.”116
This uncertainty is the focus of Rebollo’s analysis of claims for gross-up damages
from a decidedly more defense oriented perspective. He advocates against their
recoverability and outlines possible defenses.
He asserts that “gross-up claims can
significantly inflate the total amount at issue and thereby artificially magnify the size and
seriousness of the case. 117
In tax malpractice cases, claimants (who may or may not have been
clients) typically will seek damages from a tax professional arising
out of tax, interest, and penalties that already have been assessed, or
that 'might be' assessed, by the IRS or state tax authorities . . . Is such
a gross-up request well-founded? In some cases, the answer to the
question is quite clear. In other factually analogous cases, however,
the opposite conclusion is reached, often on the basis of 'subtle'
distinctions.
Texas recently passed tort reform legislation requiring courts to instruct jurors as to
whether certain claims are taxable and requiring such plaintiffs to submit their claims net of
income tax.118 The statute could foreseeably be applicable in cases based on estate tax
115
Todres, pp. 95-96, supra, n. 5.
116
Id. p. 97.
Rebollo, p. 355, supra, n. 8, cites examples where “the gross-up component can more than double the
amount at issue.”
117
118
Tex.Civ.Prac. & Rem.C. § 18.091.
37
malpractice or a would-be non-profit organization’s failure to qualify as such which
resulted in loss of “contributions.” A state-by-state analysis is beyond the scope of this
article but Texas’ “affirmative approach” has been contrasted with “less informative
instructions used by several other jurisdictions that merely instruct the jury not to consider
the tax consequences, if any, of the award.”119
Wood notes that plaintiffs typically “want to ensure that the judge and/or jury is
aware that taxes will apply to a recovery . . . If the court and/or jury considers some of the
award to be excludable, instructions or evidence about the tax treatment of the recovery
might result in a larger award.”120 He also notes a potential countervailing disadvantage to
plaintiffs. If there is evidence of “the plaintiff’s assertions that the recovery is fully
taxable . . . a later claim that any portion is excludable . . . may be less credible.”121
Are “Audit Damages” Recoverable?
Jacob L. Todres recently examined the public policy issues of whether tax
malpractice recovery can or should be allowed for “tax deficiencies not related directly to
the negligent tax advice, but which are discovered as a result of an audit caused by the
negligent tax advice.”122 Assuming cause it fact, it “is certainly foreseeable that once an
audit is triggered, other deficiencies on the tax return are likely to be discovered.”
On the other hand, from a public policy standpoint it is difficult, if
not impossible, to imagine that a taxpayer has the right to misreport
119
Hogan and Hogan, Charging The Jury In Changing Times , 46 S. Tex. Law Rev. 973, Summer 2005
(also referred to proposed federal jury instructions).
120
121
122
Wood, 38th Ann. Empt. Conf., p. 22.
Id.
Todres, p. 78, supra, n. 5.
38
deductions or income on a tax return and has the further right to be
free from a tax audit. In addition, while it is likely that the error of
the negligent return preparer in misreporting the capital loss as an
ordinary loss triggered the tax audit, is it ever possible to be
absolutely certain? Perhaps the IRS finally has caught up with this
taxpayer. Perhaps, she or he would in any event have been audited
this year.123
Todres reports no cases discussing recoverability of such claims124 and opines that
as “a matter of public policy audit damages generally should not be recoverable. Allowing
their recovery would seem to endorse the notion that taxpayers have the legal right to play
the audit lottery, an unacceptable concept.”125 Allowing such claims would arguably
violate the fairness norms of horizontal equity, assuming, perhaps naively, that most
taxpayers report properly. A number of writers have emphasized the critical importance of
public perception of fairness of the tax system to its functioning and longevity.126
VI. Parallelism Is Trumped By Administrative Enforcement
Policy and Third Party Involvement.
A leading contender for the most surreal title of a tax policy article is The Mirage of
Equivalence and the Ethereal Principles of Parallelism and Horizontal Equity by Jeffrey
H. Kahn.
123
Id. at 79.
124
Id. at 80 although he mentions Slaughter v. Roddie, 249 So. 2d 584 (La. App. 1971) in which the claim
was not proven or discussed.
125
Id. at 81.
126
Kahn, p. 12, supra, n. 8 and Lederman, Statutory Speed Bumps: The Roles Third Parties Play In Tax
Compliance, 60 Stan. L. Rev. 695, 710 (2007) (“the importance of the administrability or practicality of a tax
system reflects the notion that a tax system that appears equitable is not so if it is not enforceable in a manner
that reaches equitable results”), citing Danshera Cords, Tax Protestors and Penalties: Ensuring Perceived
Fairness and Mitigating Systemic Costs, 2005 BYU L. Rev. 1515, 1522 (citing Am. Inst. of Certified Pub.
Accountants, Understanding Tax Reform: A Guide to 21st Century Alternatives 6, 29 (2005)).
39
Parallelism means that “similar, but not necessarily identical, situations are given
the same tax treatment.”127 Strictly parallel treatment would “exclude from income the
receipt of a recovery or reimbursement for a loss or expenditure and also allow an
unrestricted deduction to a taxpayer who incurred the same type of loss or expenditure but
who was not reimbursed.”128 In the context of litigation recovery, parallelism would afford
the same tax treatment to plaintiffs whether they recover damages or not. “Nonparallel
treatment results in disparate tax treatment of taxpayers who occupy similar positions, and
that difference violates the principle of horizontal equity.”129 The principal issue that Kahn
addresses is “whether parallelism should be a compelling goal of the tax system.”130
Why are similarly situated taxpayers afforded different tax treatment?
(T)here can be different considerations applicable to reimbursed
expenditures and losses than apply to unreimbursed items. There may be
compelling reasons for excluding a reimbursement from income that do not
apply to the determination of whether to allow a deduction for unreimbursed
items. And, there can be compelling reasons to deny a deduction for an
unreimbursed item that do not apply to the treatment of reimbursements.131
In other words, the apparent equivalence of the deduction and exclusion is
deceptive because different policy considerations can apply to each. So, the
crucial question in such cases is whether the goal of parallel treatment is
sufficiently strong to outweigh the other considerations . . . parallel
treatment not only is not compelled, it is not always desirable because of
countervailing considerations that weigh more heavily.132
127
Kahn, p. 5, supra, n. 8.
128
Kahn, p. 4, supra, n. 8.
Kahn, p. 5, supra, n. 8, citing IRC § 104(a)(2) which “excludes from income compensatory damages
received by a taxpayer on account of a physical injury” but does not allow a deduction for losses suffered by
similarly injured taxpayers, i.e., “provides no corresponding relief for a taxpayer who is not compensated.”
129
130
Kahn, p. 8, supra, n. 8.
131
Citing Zelenak, p. 387, supra, n. 8.
132
Kahn, p. 9, supra, n. 8. Examples of policies that outweigh parallelism are provided in Kahn, pp. 16. 23,
26, 32-33, 35-40: favoritism for employees and homeowners, statute of limitations, administrative burdens,
the tax benefit rule, excessive points of contact with personal consumption, non-commercial nature of the
transaction, allowing relief for taxpayers whose property is involuntarily converted into cash, that taxing the
40
A number of commentators urge examination of each nonparallel situation on its
own merits rather than presuming that lack of horizontal equity is a systemic flaw.133
Kahn extols the norm of fairness as the foundation for an analysis of horizontal
equity.134
(D)isparate treatment raises serious issues of propriety whether or not those issues
are classified as violations of horizontal equity. Regardless of the name given to this
problem, it is a goal of the tax system to avoid its occurrence. The establishment of
equal treatment of the same items not only serves the normative goal of “fairness;”
it also provides the taxpaying public with confidence that they are being treated
fairly; and that perception is as important as the reality. Fairness of treatment then is
a normative value on which the parallelism concept is based.135
If A gets good tax advice and saves taxes while B gets bad advice and is
reimbursed, horizontal equity would support excluding B’s compensation from his gross
income. Kahn examines what should happen if A and B both get bad advice which causes
them to owe additional taxes and A’s practitioner reimburses A while B’s practitioner
cannot.
By providing A an exclusion (the equivalent of allowing A a deduction for
the loss) and denying a deduction to B, the tax system has violated
horizontal equity since A and B are taxed the same amount even though A
accreted more wealth that year than B. . . A effectively is allowed a
victim on compensatory damages might cause a dramatic increase in the amount of damages awarded and
insurance premiums, difficulty of valuing an uncompensated loss, the “framing effect” differences in
appearance, e.g. the difference in appearance between “rapaciously” taxing an injured person’s compensation
and not allowing a deduction by uncompensated victims.
133
Kahn, p. 9, supra, n. 8, citing Hudson (the reason for repeal of an exclusion should be to eliminate an
unwarranted tax benefit rather than to obtain parallel treatment even though one consequence of the repeal
would be the elimination of the nonparallelism that existed); p. 89 fn. 183; and p. 11, citing McDaniel and
Repetti (it is better to go directly to the underlying problem than to focus on the fact that a flaw in the tax
system has caused some persons to be treated inequitably.)
“Horizontal equity requires that persons in like net income positions pay the same amount of income tax.”
Kahn, fn. 15 at p. 6, supra, n. 8.
134
135
Kahn, p. 12, supra, n. 8.
41
deduction for his injury (offsetting the compensation received), while B is
denied a deduction for a virtually identical (but uncompensated) injury.136
Kahn notes that “while nonparallel treatment will contravene the principle of
horizontal equity, it is only one of the ways in which equity can be violated.”137
The soundest reason for the different tax treatment afforded the reimbursed and the
unreimbursed is administrative.138 Lederman explains that involvement of third parties,
such as courts, defendants and insurers, in determining the basis for taxes, enhances
enforceability. Since defendants have no incentive to overpay, there is an objective thirdparty mechanism and objective evidence to support exclusion.
(T)he payment by the tortfeasor eliminates questions about the
existence of the injury and the magnitude of the damage . . .
By contrast, a deduction for uncompensated (losses) . . . would
amount to an invitation for cheating. Without a requirement of the
receipt of compensation, a taxpayer could fabricate an injury or
exaggerate the consequences of an injury in order to reduce tax
liability and gamble on the small chance of losing the audit lottery.
This example perhaps most clearly illustrates the important point
that, contrary to the notion that exclusions and deductions are
mathematically equivalent, and thus interchangeable,139 they are not
equivalent once compliance considerations are taken into account––
Kahn, pp. 7-8, supra, n. 8 (“Not allowing a deduction for a loss, but treating a recovery of the loss in a
later year as a return of capital, yields the same result – no net income – as allowing a deduction for the loss
and taxing the recovery.”).
136
137
Kahn, fn. 17, supra, n. 8.
Leandra Lederman, Harnessing the “Invisible Hand” to Foster Income Tax Compliance, 2006,
www.law.ku.edu/events/MLEA/Lederman.abstract.pdf
138
Id. at p. 4, n. 17 citing Kahn, 57 HASTINGS L.J.at 647, supra n. 8 (“Since the exclusion and deduction
approaches generally are identical for tax purposes, one might expect there to be parallel treatment of
reimbursed and unreimbursed expenditures and losses. . . . The disparate treatment of reimbursed and
unreimbursed taxpayers in those cases seems inequitable to some who believe that either deductions should
be allowed for unreimbursed items or, if not, no exclusion should be allowed for the receipt of a
reimbursement.”); Richard L. Schmalbeck & Zelenak, Federal Income Taxation 490 (2004) (“There is no
obvious policy justification for this general disfavoring of deductions relative to exclusions.”) (quoted in
Kahn, 57 Hastings L.J. at. 647, supra, n. 8.
139
42
unlike a deduction, exclusion has the natural limitation that it
reduces existing tax liability.140
As Professor Larry Zelenak has stated, “Allowing the loss [on a
transaction] to offset the recovery, so as to prevent the creation of
taxable income from a transaction which was an economic wash, is
not necessarily inconsistent with a refusal to allow a deduction of the
loss against unrelated income.”141
Third-party involvement “helps explain a number of cases of seeming inequity or
lack of parallel treatment.”142 Absent the third party role in determining the amount of
recoveries, as Kahn notes, “There are serious administrative difficulties in determining the
value of an uncompensated physical injury, the presence of which is itself one of the
reasons for not allowing a deduction for those losses.”143 Kahn explains that, “while
horizontal equity can be obtained by allowing a full deduction for such losses, that remedy
contravenes other policies. Horizontal and vertical equity, as is true for parallelism, are
merely one of the myriad goals of a good tax system and so must give way when weightier
considerations point in a different direction.”144
The Code contains numerous provisions “where a reimbursement of an expenditure
or loss is excluded from income even though no deduction is allowable” for the
unreimbursed expenditure or loss.145
One might expect there to be parallel treatment of reimbursed and
unreimbursed expenditures and losses. That is, one might expect a
140
Id. at pp. 3-4.
141
Id. quoting Zelenak, p. 387, supra, n. 8.
142
Id. at 3.
143
Kahn, p. 7, fn. 16, supra, n. 8.
144
Kahn, p. 8, supra, n. 8.
145
Kahn, pp. 3-4, supra, n. 8.
43
taxpayer who incurs an expenditure or loss to be treated the same
by the tax law whether the item is reimbursed or not. Yet, there are
many cases in which that is not so. The disparate treatment of
reimbursed and unreimbursed taxpayers in those cases seems
inequitable to some who believe that either deductions should be
allowed for unreimbursed items or, if not, no exclusion should be
allowed for the receipt of a reimbursement.146
This result has been questioned, and the situation posed as one in
which no matter what the treatment of the taxpayer who was
compensated with by the preparer, it will not be parallel with
somebody.147 However, the results under current law are completely
explainable once compliance considerations are taken into account.
...
(A) deduction for amounts allegedly overpaid with respect to a year
in which the statute of limitations on refund claims has expired and
for which no preparer is compensating the taxpayer would open the
door to false claims that could not be verified without an audit.148
Thus, even if such an error were made by a business––say, by a
corporate taxpayer––a deduction should not be allowed.149
What are the difference and relationship between parallelism and horizontal equity?
Parallelism, equal treatment of similar items, is a widely accepted ideal of tax fairness.
Horizontal equity, that persons in like net income positions pay the same amount of income
tax, must often give way to other factors such as administrative ease of determination and
146
Lederman, p. 4, n. 17, citing Kahn, n. 14, p. 6 and n. 9, p. 9, supra, n. 8 and authorities cited therein.
147
Lederman, p. 5. n. 23, , supra, n. 128 citing Kahn, 57 HASTINGS L.J. at 665-66, supra, n. 8; William A.
Klein Et Al., Federal Income Taxation 124 (14th ed. 2006) (“We cannot avoid committing one or the other of
these two ‘errors’ (of the overall tax system . . .) given that [the two hypothetical individuals] are not being
taxed correctly relative to each other.”); cf. Zelenak, p. 389, supra at n. 8 (“If the Clarks are allowed the
exclusion, they are treated equitably compared to some taxpayers and too favorably compared to other
taxpayers. If they are not allowed the exclusion, they are treated equitably compared to some taxpayers and
too harshly compared to other taxpayers. The basic point is that, once a decision has been made by Congress
not to allow a deduction for a particular kind of loss, a taxpayer who later recovers such a loss is going to be
taxed unfairly as compared with someone else, no matter how the recovery is treated.”).
148
Lederman, p. 5, supra, n. 128.
Id. Note 25 contrasts Kahn’s view, 57 Hastings L.J. at 653-54, supra, n. 8, that “disallowance of a
deduction for overpaid federal income taxes in his example involving overpaid taxes for the year 2000 is
justifiable because the ‘loss from the overpayment was not business or profit-seeking in nature . . . deduction
is allowed for a loss only if there are compelling reasons for it.’”
149
44
practical, cost-effective enforceability. “Parallelism is related to the horizontal equity
principle in that nonparallel treatment will result in unequal treatment of some persons.”150
Parallelism “must be taken into account in evaluating” tax provisions, which “does
not mean that it must prevail over other legitimate goals of the tax system with which it is
in conflict . . . parallelism is merely one factor to be considered . . .”151 Nonparallel
treatment “has been given little weight by tax policy makers,” and, in Kahn’s opinion,
“justifiably so.”152 Kahn refers to the “Beguiling Attractiveness of Parallelism:”
Lack of parallelism instinctively appears to be unfair. Indeed, there
is a perverseness in the tax law’s more favorable treatment of the
reimbursed party than is provided to the one who is not compensated
for his loss or expenditure since the latter is more deserving of
sympathy.153
Kahn’s thesis “is that there can be different considerations applicable to reimbursed
expenditures and losses than apply to unreimbursed items . . . the apparent
equivalence of the deduction and exclusion is deceptive because different policy
considerations can apply to each. So, the crucial question in such cases is whether the goal
of parallel treatment is sufficiently strong to outweigh the other considerations.”154
As Zelenak explains:
(A)llowing an exclusion for a recovery of a nondeductible loss is much
narrower than allowing a deduction for the original loss. The former allows
the loss to offset only a recovery of the loss, while the latter would allow the
loss to offset any income. Allowing the loss to offset the recovery, so as to
150
Kahn, p. 14, supra, n. 8.
151
Kahn, pp. 13-14, supra, n. 8.
152
Kahn, p. 42, supra, n. 8.
153
Kahn, p. 14, supra, n. 8
154
Kahn, p. 9, supra, n. 8.
45
prevent the creation of taxable income from a transaction which was an
economic wash, is not necessarily inconsistent with a refusal to allow a
deduction of the loss against unrelated income. Since there are various
reasons for the nondeductibility of losses and expenses, it is necessary to
consider separately the recovery of different types of items, in order to
determine whether the exclusion of a particular recovery is inconsistent with
the policy justifying the nondeductibility of the original loss or expense.155
While there are “strong policy reasons to deny a deduction for an unrefunded
overpayment of taxes” (administrative and finality of limitations), there are “no policy
reasons to tax a refund, (and) there are policy considerations that require its exclusion”156
such as only taxing income once.
The critical question then is whether the goal of parallel treatment is
important enough to warrant either granting a deduction for the unrefunded
overpayment or, instead, taxing the refund. In other words, does the goal of
parallel treatment outweigh either of the considerations discussed above?
The resolution of that question turns on value judgments.157
Kahn believes that parallel treatment in the case of malpractice recovery is
less important than the countervailing administrative considerations.158 He notes that
in the case of tax malpractice recoveries, the IRS would like to “provide parallel
treatment by denying exclusion for the reimbursed taxpayer.”159 However, the IRS
has not articulated this policy reason or any other in its malpractice “proper” tax
rulings that attempt to distinguish Clark and Rev. Ruling 57-47.
In examining Clark, Kahn notes that “whichever way the court ruled, the policy
would fail in some manner the principle of horizontal equity.”160 There will either be lack
155
Zelenak, p. 389, supra, n. 8.
156
Kahn, p. 18, supra, n. 8.
157
Id.
158
Id.
159
Kahn, p. 43, supra, n. 8.
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of horizontal equity between the reimbursed and the unreimbursed (as in Clark) or between
the reimbursed and the taxpayer who received competent tax advice. Kahn concludes that,
“horizontal equity often is not a useful tool for policy analysis.”161
(P)arallelism is not a strong enough consideration to promote a
deduction when there are no other factors that favor it. This suggests
that parallelism is not a major goal for those that write the tax laws
and that it is not a sufficient policy in itself to affect tax decisions.
It appears that Kahn et al are describing parallelism advocates’ likely view of
Clark162 in explaining that the BTA:
held for the taxpayer, thereby committing the ‘error’ that Clark was
undertaxed163 as compared to others who overpaid but were not able to
recover anything from their preparer. This decision created nonparallel
treatment for these types of expenditures. That is, the court provided
exclusion if the taxpayer is reimbursed for their overpayment, but no
deduction is allowable if the taxpayer is not reimbursed.”164
Kahn and Zelenak disagree on whether “the taxpayer’s tax payment has to be
classified as a loss in order for the reimbursement to be excluded.”165 Zelenak argues that
it does, maintaining “that otherwise the repayment is taxable under the Old Colony
doctrine.”166 Kahn does not address Old Colony and simply says it:
is sufficient that the party making the reimbursement (the accountant
in the letter ruling) made an error that caused the taxpayer to pay out
dollars that he would not have had to pay if the accountant had not
160
Kahn, p. 44, supra, n. 8.
161
Kahn, p. 45, supra, n. 8.
162
Kahn, p. 44, fn 82, supra, n. 8.
Contrast the IRS’ view that Clark paid more than his “proper” minimum tax in its 1997-98 PLRs, supra,
pp. 12 et seq.
163
164
Kahn, pp. 45-46, supra, n. 8.
165
Kahn, p. 49, supra, n. 8.
166
Id.
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made an error. It is sufficient that there is a nexus between the third
party’s error and the amount of payment that was reimbursed. It
should not matter that the taxpayer actually owed the tax he paid;
the significant fact is that the third party’s error caused the taxpayer to
have a greater tax liability than he would have incurred if the third
party had not made the error.”167
The simplicity and clarity of Kahn’s argument is appealing but he provides no basis for the
emphasized assertion that actual tax liability is irrelevant. Perhaps Kahn meant that
whether a malpractice plaintiff paid more than his “proper” tax based on the underlying,
“nontax” facts should not matter. Kahn provides no support or explanation for his
dismissal of Zelenak’s argument, that without the implicit distinction between Old Colony
and Clark, based on Clark’s loss, the situation in Clark would be no different than that in
Old Colony. Kahn’s unexplained rejection of Zelenak’s distinction between the two cases
is unpersuasive and unnecessary to his concurrence with other commentators that the IRS
got the 1997-98 “proper” tax malpractice PLRs wrong.168
Kahn also questions Zelenak and the IRS’ approach as to how tax indemnity
agreement payments should be treated. Zelenak’s example of reimbursement for the tax
difference on would-be tax-free bonds supports his argument that the “the indemnity
payment should be fully taxable.”169 The IRS ultimately agreed.170 Kahn argues they are
no more income than a contingent price reduction171 or casualty insurance proceeds and
167
Kahn, pp. 49-50, supra, n. 8.
168
Kahn, pp. 53-54, supra, n. 8.
169
Zelenak, p. 399, supra, n. 8.
170
LTR 9226033 and LTR 9226032.
171
Kahn cites as a supporting analogy, Freedom Newspapers, Inc. v. Commissioner, 36 T.C.M. 1755 (1977)
(broker’s contingent agreement to refund part of purchase price held not income), p. 61, supra, n. 8
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simply require a basis decrease.172 Zelenak’s rationale for taxing them was because of the
risk of fabrication of losses “with no regard to the actual nature of the asset in question,
through the simple means of misrepresentation by the seller.”173 Kahn concedes that the
administrative burden of discerning which tax indemnity agreements are abusive “is a
strong policy reason to tax such indemnification payments.”174
“There also exist strong reasons not to tax the indemnification payments and to treat
them as a reduction of the purchaser’s basis - i.e., the transactional view that the
arrangement constitutes a reduction of the purchase price, and the insurance analogy.”175
Kahn concedes that distinguishing these problem agreements “would impose a great
burden on the Service.”176 If empirical evidence showed that “the occurrences of sham
transactions are rare, the remedy of disregarding them may be adequate.”177
Kahn distinguishes seller-provided tax indemnity agreements from third-party tax
indemnity agreements, concluding that there seems “to be no potential for abuse” in the
latter.178 Wolfe agrees, basing his argument on the due diligence of such insurers.179 The
IRS’ current approach of including such payments in income would seem to be a deterrent
to third-parties’ offering this form of insurance. The policy argument made by Todres
against allowing recovery of “audit damages,” (i.e., to not encourage playing tax audit
172
Kahn, pp. at 54-55, supra, n. 8.
173
Zelenak, at 397, supra, n. 8.
174
Kahn, p. 59, supra, n. 8.
175
Id.
176
Id.
177
Id. at 60 (applying the sham transaction doctrine).
178
Id. at 60.
179
Wolfe, p. 22, supra, n. 42.
49
lottery) would seem to support this treatment.180 Wolfe points out that since most buyers
of such policies are large companies subject to regular audits, they are not within the audit
lottery class of taxpayers.181
Since malpractice recoveries have much less “potential for abuse” than
tax indemnity agreements, the policy for taxing malpractice recoveries is far weaker.
Conclusion
Regardless of the substantive basis for obtaining recovery against a tax practitioner,
a plaintiff who incurs additional taxes as a proximate result of malpractice should not have
to recognize income because he has not accreted an increase in wealth through the
experience of being overtaxed and reimbursed.
One tax policy issue that is sorely lacking in this area is certainty. Wood notes that,
It is difficult to predict the tax treatment of legal malpractice recoveries.
Very little authority exists . . . (it) is hardly consistent or satisfying.
Those tax-centric cases and rulings seem to turn on artificial distinctions
rather than on basic principles. At the same time, the origin of the claim
doctrine nowhere seems to be cast aside, either explicitly or implicitly.
Thus, I believe the origin of the claim doctrine should be the center of
any analysis of the tax treatment of a malpractice recovery.182
One blogger analogizes, “when you get your oil changed and they forget to put the
plug back in and you drive off and your engine blows up and the oil change dealer buys you
a new engine should the oil change dealer give you a 1099 for the new engine?”183 Another
Todres, p. 79, supra, n. 5 (“from a public policy standpoint it is difficult, if not impossible, to imagine that
a taxpayer has the right to misreport deductions or income on a tax return and has the further right to be free
from a tax audit.”)
180
181
Wolfe, p. 7, n. 22, supra, n. 42.
182
Woods, p. 672, supra, n. 8.
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answered, “Regarding the motor replacement, the new motor is not income. It is a
replacement of a damaged asset. The dealer will not replace it with a new engine, but a
comparable used engine. I know, this exact thing happened to me.”
183
Kevinh5 and talkadits on Tax Almanac, December 2007.
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