Eleventh Circuit: Settlement proceeds not return of capital, but taxable income

Eleventh Circuit: Settlement proceeds

The U.S. Court of Appeals for the Eleventh Circuit today, in a case of first impression, held that an amount ($800,000) that the individual taxpayers received in settling an action against their accounting firm was taxable income to the taxpayers and not a return of capital.

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The case is: McKenny v. United States, No. 18-10810 (11th Cir. September 1, 2020). Read the Eleventh Circuit’s decision [PDF 131 KB]

Summary

The taxpayers implemented a tax strategy recommended by their accounting firm. After an examination by the IRS, the taxpayers eventually conceded all claimed tax benefits from the transactions, acknowledged that they owed unpaid taxes, and ultimately paid the IRS over $2.2 million in income taxes, interest, and penalties. They then sued the accounting firm in state court, and that case was resolved with the accounting firm paying $800,000 to the taxpayers, but expressly denying the claims against it and all liability related to the tax advice it provided to the taxpayers.

For purposes of their income tax returns, the taxpayers: (1) deducted about $420,000 in legal fees that they allegedly paid to litigate their claim in the state court action; (2) claimed an unreimbursed loss representing the difference between the settlement payment that they received from the accounting firm and the settlement payment they made to the IRS (approximately $1.4 million); and (3) excluded the $800,000 settlement payment from their gross income.

The IRS denied these claims, and the taxpayers eventually paid the deficiency and then filed an administrative refund claim that was followed by a refund action in federal district court. The district court granted summary judgment to the government on the first two claims (legal fees and the unreimbursed loss) but agreed with the taxpayers that the settlement of $800,000 was a return of capital and therefore excludable from gross income.

The Eleventh Circuit today affirmed the district court’s grant of summary judgment concerning the legal expenses as not being deductible business expenses (because the taxpayers sued the accounting firm on their own behalf, rather than on behalf of their consulting business), and with regard to the claimed deduction of $1.4 million (the difference between the $2.2 million deficiency that the taxpayers paid and the $800,000 that they received in settlement from the accounting firm).

However, the Eleventh Circuit reversed the district court’s finding that the $800,000 was a return of capital, and therefore remanded the case back to the district court for entry of judgment for the government.

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