In McKenney v. United States, No. 18-10810 (11th Cir. Sept. 1, 2020), in a matter of first impression, holds that the settlement of an accountant malpractice lawsuit is includable in gross income, even if the alleged damages concerned the payment of federal taxes. The panel gives no credence to several items in the record that the taxpayers filed in support of their refund action.
The accountant “recommended that [taxpayer] Mr. McKenny structure his consulting business as an S corporation for tax purposes …. [and] that the S corporation be wholly owned by an Employee Stock Ownership Plan (ESOP), whose sole beneficiary would be Mr. McKenny.” Unfortunately, the accountant supposedly “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.” The accountant also recommended that the taxpayer hold a stake in a car dealership in a separate S corporation.
After an audit, the IRS disapproved the structure set up by the accountant and assessed $2.2 million in income taxes, interest, and penalties. The taxpayers (a married couple) in turn sued the accountant, ultimately obtaining an $800,000 settlement. The IRS, thereafter, disallowed the taxpayers’ exclusion of this settlement from gross income in the year it was paid (as well as other items, not discussed here). In the refund action that followed, the district court granted summary judgment to the taxpayers, holding that “the settlement was a return of capital and therefore excludable from gross income.”
While generally affirming the district court, the Eleventh Circuit reverses and holds that the settlement was taxable as gross income. “In a refund suit like this one, the McKennys have the burden of proving both their entitlement to the exclusion and the amount of that exclusion by a preponderance of the evidence.” Although there is case law holding “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,” it is unresolved whether that principle stretches to damages from “malpractice in giving advice about, structuring, or implementing a transaction” designed to minimize tax liability.
Noting that the tax-law issue presents “very difficult questions” under the code, the panel sidesteps them by holding that the taxpayers did not meet “their burden of demonstrating that the $800,000 settlement was excludable” as a matter of fact. The panel holds that the taxpayers did not prove that they would have obtained the tax advantages sought had the accountant given them correct advice. “[G]iven the burden on taxpayers to prove their refund claim by a preponderance of the evidence, it is 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 accountant] followed through on the S/ESOP strategy.”
The panel discredited the record evidence offered in support of the losses. An argument that “if [the accountant] had properly performed its obligations, neither [Mr. McKenny], the S Corporation, . . . nor the ESOP would have incurred any [f]ederal income tax on the S Corporation’s taxable income” went unsubstantiated. “[A]bsent a stipulation or agreement, unsupported factual statements in a memorandum of law do not constitute evidence under Rule 56. McKenny’s own declaration “said nothing about whether [the accountant]’s advised S/ESOP strategy would have actually resulted in the McKennys paying no federal taxes had it been properly implemented.”
Finally, “[t]he record includes an interrogatory response from the McKennys with respect to the amounts they claim they would have paid in taxes had [the accountant] properly implemented the S/ESOP strategy. “Other circuits have explained that a sworn interrogatory response is treated like an affidavit on summary judgment,” yet here the interrogatory is also conclusory and “contains no explanation or details as to how the McKennys arrived at their respective tax liability numbers for the years in question.
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