Steve Hamilton is a Tampa native and a graduate of the University of South Florida and the University of Missouri. He now lives in northern Kentucky. A career CPA, Steve has extensive experience involving all aspects of tax practice, including sophisticated income tax planning and handling of tax controversy matters for closely-held businesses and high-income individuals.
Friday, December 5, 2014
Is Suing Your Tax Advisor Taxable?
who know me or occasionally read my blog, you know that I am not a “high wire”
type of tax practitioner. Pushing the edges of tax law is for the very wealthy
and largest of taxpayers: think Apple or Donald Trump. This is – generally
speaking - not an exercise for the average person.
the frustration. A number of years ago I was called upon to research the tax
consequence for an ownership structure involving an S corporation with four
trusts for two daughters. This structure predated me and had worked well in
profitable years, but I (unfortunately) got called upon for a year when the
company was unprofitable. The issue was straightforward: were the losses
“active” or “passive” to the trusts and, by extension, to the daughters behind
the trusts. There was some serious money here in the way of tax refunds – if
the trusts/daughters could use the losses. This active/passive law change
happened in 1986, and here I was researching during the aughts – approximately
20 years later. The IRS had refused to provide direction in this area, although
there were off record comments by IRS officials that were against our clients’
interests. I strongly disagreed with those comments, by the way.
What do you
the client that a decision to claim the losses would be a simultaneous decision
to hire a tax attorney if the returns got audited and the losses disallowed. I believed there was a reasonable chance we would eventually win, but I also believed we would have to be committed to litigation. I thought the IRS was unlikely to roll on the matter, but our willingness to go to Tax Court might give them pause.
I was not a popular guy.
But to say otherwise
would be to invite a malpractice lawsuit should the whole thing go south.
And this was
a fairly prosaic area of tax law, far and remote from any tax shelter. There
was no “shelter” there. There was, rather, the unwillingness of the IRS to
clarify a tax law that was old enough to go to college.
I am reading
about a CPA firm that decided to advise a tax shelter. It went south. They got
sued. It cost them $375,000.
Here is a
question that we have not discussed before: is the $375,000 taxable to the (former) client?
discuss the case.
Cosentinos and their controlled entities (G.A.C. Investments, LLC and Consentino
Estates, LLC) had a track record of Section 1031 exchanges and real estate.
COMMENT: A Section 1031 is also known as a “like kind”
exchange, whereby one trades one piece of property for another. If done
correctly, there is no tax on the exchange.
Consentinos played a conservative game, as they had an adult disabled daughter
who would always need assistance. They accumulated real estate via Section 1031
transactions, with the intent that – upon their death – the daughter would
inherit. They were looking out for her.
looking at one more exchange when their CPA firm presented an alternative tax
strategy that would allow them to (a) receive cash from the deal and (b) defer
taxes. The Consentinos had been down this road before, and receiving cash was
not their understanding of a Section 1031. Nonetheless the advisors assured
them, and the Consentinos went ahead with the strategy.
OBSERVATION: It is very difficult to walk away from a Section
1031 with cash in hand and yet avoid tax.
know that the strategy was declared a tax shelter?
bounced the whole thing. There was almost $600,000 in federal and state taxes,
interest and penalties. Not to mention what they paid the CPA firm for structuring the transaction.
Consentinos did what you or I would do: they sued the CPA firm. They won and
received $375,000. They did not report or pay tax on said $375,000, reasoning that it was less than the tax they paid. The IRS
sent them a love letter noting the oversight and asking for the tax.
were Tax Court bound.
relied upon several cases, a key one being Clark
v Commissioner. The Clarks had filed a joint rather than a
married-filing-separately return on the advice of their tax advisor. It was a
bad decision, as filing-jointly cost them approximately $20,000 more than
filing-separately. They sued their advisor and won.
decided that the $20,000 was not income to the Clarks, as they were merely
being reimbursed for the $20,000 they overpaid in taxes. There was no net
increase in their wealth; rather they were just being made whole.
The Clark decision has been around since
1939, so it is “established” law as far as established can be.
decided that the same principle applied to the Cosentinos. To the extent that
they were being made whole, there was nothing to tax. This meant, for example:
extent that anything was taxable, it shall be a fraction (using the $375,000 as
the numerator and total losses as the denominator).
amount allocable to federal tax is nontaxable, as the Cosentinos are merely
amount allocable to state taxes however will be taxable, to the extent that the
Cosentinos had previously deducted state taxes and received a tax benefit from
same concept (as for state taxes) applied to the accounting fees. Accounting
fees would have been deducted –meaning there was a tax benefit. Now that they were
repaid, that tax benefit swings and becomes a tax detriment, resulting in tax.
some other expense categories which we won’t discuss.
By the way,
the Court’s reasoning is referred to as the “origin of the claim” doctrine, and
it is the foundation for the taxation of lawsuit and settlement proceeds.
So the IRS
won a bit, as the Cosentinos had excluded the whole amount, whereas the Court wanted
a ratio, meaning that some of the $375,000 was taxable.
curious what the CPA firm charged for this fiasco?