Malpractice lawsuit settlement payment is not a return of capital

By James A. Beavers, CPA, CGMA, J.D., LL.M.

The Eleventh Circuit held that a taxpayer who settled an accounting malpractice claim against an accounting firm could not exclude the settlement payment from income as a return of capital, deduct the legal fees from the claim, or take a loss related to the settlement.


Joseph McKenny worked as an independent consultant providing advisory services to car dealerships. In the late 1990s, he hired an accounting firm to advise him on tax strategy and preparation.

The accounting firm recommended that McKenny structure his consulting business as an S corporation for tax purposes. It also recommended that the S corporation be wholly owned by an employee stock ownership plan (ESOP), of which McKenny would be the sole beneficiary. Following this plan would allow McKenny to defer tax on his consulting income, with the income earned by the business passing through the S corporation without being subject to corporate income tax, and then accumulating tax-free in the ESOP until it made distributions to McKenny.

The plan was (supposedly) implemented in 2000. McKenny became the sole employee of an S corporation called Joseph M. McKenny Inc. This S corporation was intended to be owned by the Joseph M. McKenny Inc. ESOP (JMM ESOP), of which the sole beneficiary was McKenny.

According to McKenny, however, the accounting firm did not quite do things as it had promised. McKenny claimed that the firm improperly filed the S corporation election for the company. Furthermore, no ESOP was created or approved because the accounting firm failed to prepare or provide proper documents for the ESOP and the related trust, and failed to take actions to ensure that the ESOP was properly formed and operated.

McKenny also acquired a 25% interest in a GMC car dealership in Florida, and, on the advice of the accounting firm, he held this interest in a separate S corporation that, like the other S corporation, was in turn wholly owned by the JMM ESOP. For tax purposes, the accounting firm told McKenny that the car dealership's payments to the S corporation should be characterized as management fees rather than as a share of profits.

Beginning in 2000, McKenny and his wife jointly filed tax returns reflecting the accounting firm's tax strategy, paying little or no federal income tax for several years. Alas, the good times did not last, and the IRS audited the McKennys in 2005. It determined in this audit that between 2000 and 2005 the McKennys had underpaid their federal income taxes. The IRS claimed that McKenny's tax strategy with respect to the car dealership was an unlawful and abusive tax shelter.

In 2007, the McKennys settled their unpaid liabilities with the IRS. In the settlement agreement, they conceded all claimed tax benefits from the ESOP transactions and acknowledged that they owed unpaid taxes as to both the consulting business and the stake in the car dealership. They further agreed to the full amount of the liabilities from the ESOP transactions and ultimately paid the IRS almost $2.25 million in income taxes, interest, and penalties.

In 2008, the McKennys sued the accounting firm in state court, alleging that the firm committed accounting malpractice and was responsible for their unpaid tax liabilities between 2000 and 2005. The complaint alleged that the accounting firm had failed to:

  • Submit the ESOP to the IRS for a determination letter;
  • Advise the McKennys that annual and continuing contributions would have to be made to the ESOP in order to maintain its qualification on a going-forward basis;
  • Provide the McKennys with instructions regarding the timely adoption and execution of the ESOP and related trust documents;
  • Advise the McKennys regarding the requirement that the ESOP engage an independent appraiser to perform an annual appraisal;
  • Advise the McKennys to maintain annual administrative records for the ESOP;
  • Advise the McKennys regarding the removal of the initial trustee;
  • Advise the McKennys regarding the nondiscrimination testing requirements under the Code; and
  • Provide proper ESOP documents that satisfied the Code's qualification requirements.

In 2009, the accounting firm, though it continued to deny any wrongdoing, settled the suit by paying the McKennys $800,000.

In 2009 through 2011, the McKennys filed tax returns with several deductions and exclusions related to their lawsuit against the firm. On their 2009 tax return, they (1) deducted over $400,000 in legal fees they allegedly paid to litigate the malpractice claim; (2) claimed an unreimbursed loss of $1.4 million representing the difference between the settlement payment they received from the accounting firm and the payment they made to the IRS to settle their audit; and (3) excluded the $800,000 settlement payment from their gross income. Based on these deductions and exclusions, the McKennys claimed a net operating loss, which they carried forward to reduce their tax liability in 2010 and 2011.

The IRS issued a notice of deficiency rejecting all of these claimed deductions and exclusions. The IRS found that the legal expenses were not deductible because they were miscellaneous itemized deductions rather than business deductions, subject to the 2%-of-adjusted-gross-income (AGI) floor; disallowed the loss deduction in its entirety; and denied the exclusion of the settlement payment. These adjustments resulted in the McKennys' having an additional tax liability of a tad over $800,000.

The McKennys then filed a refund claim for that amount with the IRS, but the Service denied the refund as to the 2009 claim and did not respond to the 2011 claim before the McKennys filed a refund suit in 2016. The McKennys sought a refund of about $586,000 — the amount of the disallowed exclusions and deductions for 2009 and 2011. The parties filed cross motions for summary judgment, and the district court granted in part and denied in part both motions.

The district court concluded that the legal expenses incurred in their battle with the accounting firm were not deductible business expenses because the McKennys sued the accounting firm on their own behalf, rather than on behalf of the consulting business. The court also ruled that the McKennys were barred by their 2007 settlement with the IRS from claiming any losses related to the ESOP transactions, so they could not claim the unreimbursed losses. However, the district court agreed with the McKennys that the settlement was a return of capital and therefore excludable from gross income.

This satisfied neither the McKennys nor the IRS. The district court's decision was appealed to the Eleventh Circuit. The parties again filed motions and cross motions for summary judgment regarding the deductions and the exclusion.

The Eleventh Circuit's decision

The Eleventh Circuit, partially reversing the district court, held that in addition to not being entitled to deduct the losses related to the ESOP or to deduct the fees incurred in their legal action against the accounting firm, the couple could not exclude the malpractice settlement payment from income.

Legal fees: The McKennys argued that their legal fees for the malpractice suit were deductible as Sec. 162 business expenses because the lawsuit was related to and regarding McKenny's business. The court agreed that they were related but found that this was not enough to make them deductible business expenses. Instead, the characterization of the expenses depended on the origin and character of the claims for which the expenses were incurred.

The Eleventh Circuit affirmed the district court's holding that the legal fees were personal expenses deductible as miscellaneous itemized deductions subject to the 2%-of-AGI floor. The court found that the suit against the accounting firm was personal in origin and character because McKenny, not his businesses, was the plaintiff; the malpractice alleged in the complaint was related to services provided to McKenny; and the tax liability at issue was that of McKenny, not his businesses. The court found that the basis of the lawsuit was not that the accounting firm "failed to adequately support the businesses' income-producing activities," but rather that the accounting firm "failed to help the McKennys reduce their personal tax liability."

Loss deduction: The IRS disallowed the deduction because in their audit closing agreement, the McKennys agreed to pay tax attributable to the disallowance of any of the couple's ESOP transactions. The McKennys argued on appeal that their $1.4 million claimed loss was not related to the ESOP transactions. They instead contended that the loss was due to the accounting firm's "failure to fully reimburse" them in the lawsuit.

The Eleventh Circuit stated that this was "a distinction without a difference." The court, observing that the payment was made to settle the tax liability resulting from those transactions, found that the McKennys did not, and could not, dispute that their $2.2 million tax payment to the IRS was related to the ESOP transactions. Thus, their settlement agreement with the IRS barred them from claiming any deduction based on this payment.

Exclusion of malpractice settlement payment: The McKennys argued that the settlement payment was a return of capital that they had lost due to the accounting firm's malpractice and therefore was excluded from their income. To support their position, the couple relied primarily on the Tax Court case Clark, 40 B.T.A. 333 (1939), in which the court held that gross income does not include a payment made as compensation for damages or loss that was caused by a third party's negligence in the preparation of a tax return. The IRS acquiesced to Clark (Rev. Rul. 57-47), and the Tax Court has followed it in a number of cases.

The IRS argued that Clark was distinguishable and that the payment was taxable under Old Colony Trust Co., 279 U.S. 716 (1929), in which the Supreme Court held that a third party's payment of a taxpayer's tax liability is generally included in gross income, regardless of the form of that payment. The IRS further argued that the rule from Clark is limited to situations in which an accountant makes a mistake in preparing a tax return or in advising the taxpayer on how to prepare the return and does not apply to settlements based on claims that an accountant committed malpractice in giving advice about, structuring, or implementing a transaction.

The Eleventh Circuit noted that whether Clark was correctly decided and whether it applied in a situation like the McKennys' were difficult questions. However, it did not address them because it concluded that, even if Clark was correctly decided and it applied to the McKennys' case, the couple had failed to prove that they were entitled to exclude the settlement payment from income.

In the district court, the IRS argued that the McKennys could not establish, based on the facts, that they were entitled to exclude the malpractice settlement from income. The IRS maintained that the harm the McKennys claimed was entirely speculative and that nothing in the record showed that they would have been entitled to the ESOP or its tax benefits. Consequently, they had not proved that they were entitled to the exclusion or the amount of the exclusion. The district court rejected this argument, explaining that the ESOP strategy was legal at the time that the accounting firm proposed it to the McKennys and the IRS "offered no legal authority for its argument that it might have denied approval" for the ESOP strategy the accounting firm recommended.

On appeal, the IRS continued to argue that the McKennys failed to carry their burden with respect to the exclusion and, additionally, that the district court had erred by assuming critical facts in the couple's favor. The Eleventh Circuit, contrary to the district court, found that the general legality of the S corporation/ESOP strategy at the time in question, by itself, was insufficient for the McKennys to satisfy their burden of proof on their entitlement to the exclusion. The court stated that there is no strict rule for what taxpayers must do to establish their entitlement to an exclusion or to establish its amount. However, given that taxpayers must prove a refund claim by a preponderance of the evidence, it was not enough for the McKennys "simply to make a bald assertion, devoid of specifics, that they overpaid taxes or would not have incurred any federal taxes (or penalties)" had the accounting firm correctly implemented the S corporation/ESOP strategy.

The Eleventh Circuit averred that it had no evidence in front of it, other than the McKennys' self-serving statements, regarding what the results of the ESOP strategy would have been if the accounting firm had implemented it correctly. Thus, the court concluded that the McKennys had not proved that the $800,000 malpractice settlement payment was a return of capital that they were entitled to exclude from income.


Although the McKennys may have been wronged, they were not wronged by the IRS, and the Eleventh Circuit correctly thwarts the couple's attempt to ameliorate their losses from their relationship with the accounting firm through income tax deductions and exclusions. If their accounting firm actually caused their tax problems, their recourse for any extra tax, penalties, and interest they paid was against the accounting firm.

McKenny, No. 18-10810 (11th Cir. 9/1/20)

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