IRS Nonacquiescence in Cosentino: Settlement for Bad Tax Advice Should Be Taxable
In Cosentino v. Commissioner, T.C. Memo 2014-186, the Tax Court found that a couple’s settlement they received from an accounting firm to compensate them for bad tax advice was nontaxable. On April 18, 2016, IRS issued a nonacquiescence to the decision, arguing that the tax imposed was not more than what the taxpayers would have owed if they had filed the return properly. As such, IRS views such a settlement as compensation for the federal income tax owed and would require such a settlement to be taxed as income.
The Situation
The taxpayers received a settlement related to a position they took on their partnership tax return on advice from the firm they engaged. The advice was related to rental income from real estate rentals. The firm advised the couple to enter into the position in an attempt to artificially increase the partnership’s basis in the property. In 2003, the partners sold the property in a like-kind exchange that included boot. At disposal of the property, a small amount of gain was recognized with no deferred gain on the like-kind exchange, utilizing the increase in basis.
The taxpayers learned the tax position taken was an abusive tax shelter in 2005, and filed amended returns for 2002 and 2003 to report the correct gain of $2.4 million of which about $ 2 million was recognized in 2003.
In 2006, the couple filed suit against the accounting firm to cover fees, losses and income tax deficiencies. The case was settled in 2007 with an award of $375,000, which the couple did not declare as income on their tax return.
IRS issued a notice of deficiency declaring the $375,000 was income and reportable on the couple tax return.
Tax Court Ruled the Damages Were Nontaxable but IRS Disagrees
The Tax Court held that the settlement proceeds were excludible from gross income as they represented a return of loss capital. If the couple had not relied on the tax professional’s advice, they would not have paid penalties and interest or legal fees in correcting the position taken on the return.
In its April 18, 2016, Action on Decision, IRB No. 2016-16, IRS disagreed with the decision, citing several cases, and pointing out that the tax imposed was not more than what the taxpayers would have owed if they had filed the return properly. IRS also noted that no loss occurred on the original transaction. In fact, the taxpayer gained a better result. IRS views the settlement as compensation for the federal income tax owed and asserts that it should be included in the income.