IRS Announces Disagreement With Case That Allowed Exclusion of Tax Advice Damage Award That Caused Taxpayer to Deviate from Lifetime Plan

The issue of the taxable status of awards received by a taxpayer from his tax adviser was addressed in the case of Cosentino v. Commissioner, TC Memo 2014-186.  While the Tax Court granted the taxpayer a victory, the IRS has announced nonacquiesence with regard to this case (AOD 2016-01).

A key issue when a taxpayer receives a damage award related to negligent tax advice is whether the amounts received will be taxable income to the taxpayer or not.  Generally when a taxpayer receives questionable tax advice, the taxpayer will file a claim against the adviser and argue for damages for taxes, interest and penalties.  The argument for the tax payment generally is based on the claim that if the taxpayer had known the action the adviser was suggesting would not have led to the claimed tax savings, the taxpayer would have taken other actions to reduce his taxes.

The question of whether or not the payment is taxable is important to the tax adviser against whom damages are sought since the client, to be made whole, will likely seek a higher damage payment in order to cover the tax likely to be due on the settlement, in effect “grossing up” the damages so that after taxes the client is “made whole” in the situation.

That also can pose risk to the parties advising the aggrieved taxpayer in arriving at a settlement of the issue if the potential taxable nature of the settlement isn’t considered.

Cosentino Case

The fact pattern in this case involved a claim of “bad advice” that caused the taxpayer to pay income taxes which the taxpayer now believes should not have been paid.  The taxpayer had entered into a variant of a basis inflation shelter to offset a gain the taxpayer would be incurring from the sale of real estate.  When the taxpayer discovered that the IRS had listed this type of arrangement as a potentially abusive one, the taxpayer filed immediate amended tax returns and paid the tax due.

The taxpayer asked for damages from the adviser who suggested the basis inflation shelter arguing that if the taxpayer had not entered into a basis inflation shelter the taxpayer would have entered into a §1031 exchange.

In CCA 201307005 the IRS had considered a similar “I would have done something differently” claim related to receipt of a damage award from a tax adviser and decided the taxpayer would not be able to exclude the amount from income.  The IRS distinguished that situation from the holding in the case of Clark v. Commissioner, 40 BTA 333 (1939), acq. 

In the Clark case the taxpayer received damages when the adviser gave bad advice causing the taxpayer to file a joint return.  Later the error was uncovered and it was found that had the taxpayers filed separate returns there would have been significantly less tax paid.  Since the taxpayer’s election to file a joint return could not corrected after the fact, the adviser paid an amount equal to the excess tax.  In that case, the Court found that the payment was clearly for taxes that never needed to be paid, thus simply restoring the taxpayer to the state they should have been in—thus, the award was not taxable.

However, in the case in the CCA the IRS pointed out that there was no evidence the taxpayer had abandoned an alternative that would have had the same effect nor any evidence any such arrangement was under consideration.  While it was clear in Clark that the taxpayer had relied on the adviser for a simple binary choice (file joint or separate), there was no such binary issue here.

Not surprisingly, the IRS argued the same thing in this case.

But this case had a few unique facts.  While the case in the CCA involved a taxpayer who was suggesting they certainly could have found something they could have done, the taxpayer here had previously entered into §1031 exchanges multiple times in the past to avoid taxes. 

The IRS objected that this was all fine, but §1031 is simply a deferral mechanism, not ultimately a mechanism that would remove the tax.  So the taxpayers were in a better position having avoided ever having to pay this tax.

However, the taxpayer had a clearly outlined plan to continue to enter into §1031 exchanges until the real property passed through an estate, at which point the basis would be stepped up. As the Court noted, this would mean that, if the plan was executed, no tax would ever be paid on the appreciation.

Thus, in this case the Court found the amount of damages related to the tax paid was not includable in the taxpayers’ income.

The IRS Warns It Will Not Follow This Case

In April of 2016 the IRS announced that it was issuing a formal notice of nonacquiesence in the result arrived at in the Cosentino case (AOD 2016-01).

In justifying its position with regard to this decision the IRS noted:

…[T]he taxpayers in this case paid the correct amount of Federal income tax based on the transaction they entered into. In this transaction, the taxpayers received taxable boot as part of their consideration upon the disposition of the rental property. When the artificially inflated basis was disregarded, the boot resulted in gain recognition from the exchange and the imposition of tax on that gain. Once this transaction was completed, no choices were available to the taxpayers to reduce this taxable gain. It was the facts of the transaction, and not a failure to make an election or a failure to timely file an appeal, that caused the taxpayers to incur additional tax.

In light of the underlying gain recognition transaction, the amount of tax imposed was not more than what they properly owed on that transaction and, consequently, the taxpayers did not sustain a loss. To the contrary, because the taxpayers received the boot, and because they continued to receive the benefit of both the boot and the basis in the newly acquired real property even after the abusive tax shelter transaction was disregarded, taxpayers financially were in a better (not merely restored) position after the settlement than they were in before entering the transaction.

The above analysis did not look at the “lifetime plan” theory, but in a footnote the IRS dismissed reliance on that:

In reaching its holding, the court considered the taxpayers’ plan to use a lifetime series of tax-free exchanges, followed by a step up in basis at death, to permanently avoid paying taxes on the gain from these transactions. We disagree with the court’s reliance on these facts. The taxpayers’ ability to execute that tax planning strategy was purely speculative, and a change in the taxpayers circumstances, or even a change to the provisions of the Internal Revenue Code, could have altered the strategy at any time.

This can be viewed of a form “burying the lead” by the IRS in this case since this very factor (the lifetime plan) was the key fact the Court relied upon.  It’s also important to note that this footnote analysis never actually cites to any supporting authorities justifying this view, rather representing the IRS’s commentary on this way of viewing the situation—a method of viewing the situation the Court clearly accepted.

Nevertheless, the publication of this document puts taxpayers and their advisers on notice that the IRS has announced it is not going to accept the Cosentino case as representing valid authority.  Advisers should expect agents to balk at accepting a “lifetime plan” defense to exclusion of negligent tax advice damages based on a supposed alternative that would have been undertaken.