The question has arisen in numerous cases as to the extent to which a settlement between arms’ length parties is dispositive in tax cases of the claims on which the settlement is based. Another issue that often arises is whether the receipt of compensation for a tax payment that was incurred because of the negligence of the payor is excluded from gross income. While those two issues were central to the proper resolution of a recent case in the United States Court of Appeals for the Eleventh Circuit, McKenny v. United States, the court failed even to note one of those issues and did not resolve the other. The court’s failure to deal with those two issues led it to reach an incorrect result.
The two landmark cases establishing the doctrines that should have been applied in McKenny are the Supreme Court’s decision in Lyeth v, Hoey and the decision of the Board of Tax Appeals (now known as the Tax Court) in Clark v. Commissioner. Using McKenny as a springboard, this article reviews the continued misapplication and sometimes disparagement of the Lyeth v. Hoey and Clark v. Commissioner reasonings. Clark, in particular, has been criticized by both academics and the Service. The article reviews those criticisms and argues that they are unpersuasive. The article concludes that both doctrines are valid and should have applied to find for the taxpayer in the McKenny case.