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Is Accountant Malpractice Compensation Taxable?
If a taxpayer suffers a loss by reason of errors made by a tax advisor, and the tax advisor makes a payment to compensate the taxpayer for the loss. May the payment be excluded from the taxpayer's income subject to tax? The courts and the IRS have, in some circumstances, found such payments to be non-taxable returns of capital. In McKenny v. United States, a recent decision of the U.S. Court of Appeals for the Eleventh Circuit (126 AFTR 2d 2020-5943), however, the court concluded that the taxpayers could not exclude the payment at issue from income.
Background
McKenny was an independent consultant providing advice to car dealerships. He engaged an accounting firm (the Accountant) to advise him on matters including tax strategy.
The Accountant recommended that McKenny conduct his advisory business through an S corporation wholly owned by an employee stock ownership plan (ESOP), of which McKenny would be the sole beneficiary. McKenny implemented that strategy in 2000 and, also at the recommendation of the Accountant, caused another S corporation owned by the ESOP to acquire an interest in a car dealership.
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