III. The Clark Doctrine
When a taxpayer’s property is damaged or destroyed, payments received by the taxpayer to compensate for the loss suffered are excluded from income to the extent of the taxpayer’s basis in the damaged property. Consider the following examples.
Example (1). Helen has an adjusted basis of $300,000 in her home. Helen’s home is damaged by a fire caused by the negligence of Ralph. As a consequence of the damage caused by the fire, the value of Helen’s home is reduced by $25,000. Ralph pays Helen $25,000 to compensate her for the loss he caused. Helen’s receipt of the $25,000 is treated as a return of the capital she had invested in the home and so is excluded from income. Helen reduces her basis in the home to $275,000.
Example (2). In Year 1, Paula had adjusted gross income of $50,000. Paula also had an automobile with a fair market value of $4,000 and an adjusted basis of $10,000 that she used for personal purposes. In Year 1, the automobile was destroyed when a tree fell on it during a storm. Paula had no other personal casualty losses or personal casualty gains in Year 1. While Paula suffered a loss of $4,000 (the lesser of her basis and the car’s fair market value), she was not allowed to deduct that loss because a net personal casualty loss is deductible only to the extent that the loss exceeds ten percent of the taxpayer’s adjusted gross income. Since ten percent of Paula’s adjusted gross income was $5,000, she did not qualify for a deduction. Paula had, however, insured the automobile, and the insurer paid her $4,000 for her loss. Since the $4,000 she received did not exceed her adjusted basis in the car, it was excluded from her gross income.
Clark v. Commissioner is the landmark case involving the tax treatment of the reimbursement of a taxpayer for the additional amount of tax paid because of an error of the payor. In 1932, Clark, the taxpayer, was married and living with his wife. On the advice of tax counsel, the taxpayer and his wife filed a joint federal income tax return for that year. In 1934, the taxpayer was audited by the government, which imposed a deficiency for the taxes paid for 1932. The taxpayer’s tax counsel then realized that if he had advised the taxpayer and his wife to file separate returns, their tax liability would have been $19,441.10 less than the amount they actually had to pay. The tax counsel had advised the parties to file a joint return because of a mistake the tax counsel made in claiming a deduction to which they were not entitled. Recognizing that his error caused the taxpayer to pay a larger tax, the tax counsel paid the taxpayer $19,441.10 to compensate him for the excess amount of tax he caused the taxpayer to pay. The government then contended that the amount paid to the taxpayer was includible in his gross income, and the taxpayer chose to litigate that issue before the Board of Tax Appeals (now the Tax Court). (For convenience, hereafter we will refer to that body as the Tax Court.)
The Tax Court held that the payment to the taxpayer was a return of capital and so excluded from his gross income. The tax counsel’s negligence caused the taxpayer to pay a larger tax than he would have paid if he had been advised correctly. The tax counsel was liable to the taxpayer for the amount of damage caused by his negligence. The payment to the taxpayer was compensation for the extra amount of dollars he paid to the government. Just as a payment for causing damage to property is treated as a return of the capital invested in the property, the reimbursement of dollars lost is a return of those dollars. Basis in property is just a reflection of the dollars deemed to be invested in the property, and the damages received for an injury to property is a replacement of the dollars deemed to be invested in the property. In the Clark situation, the recovery of actual dollars that were lost is no different from the recovery of dollars invested in property that were lost.
While the government initially nonacquiesced in the Clark decision, it subsequently acquiesced and published a revenue ruling adopting the Clark approach. Nevertheless, the Clark case has been subjected to a significant amount of discussion by tax experts, some of whom disagree with the result and some of whom are uneasy with the result. We will discuss the issues raised involving the Clark decision and will show that they are without merit.
One issue raised is that the Tax Court in Clark mentioned that the amount received by the taxpayer was not gain derived from capital or from labor or from both combined. That language was used by the Supreme Court in its 1920 decision in Eisner v. Macomber as a definition of gross income for federal income tax purposes. That definition became the standard used by the courts from that date until the Supreme Court repudiated it in 1955 in Commissioner v. Glenshaw Glass. After Glenshaw Glass was decided, that definition was no longer used. Any criticism of Clark for using a definition of income that was subsequently repudiated misses the mark because the basis of the decision in Clark does not rest on that now defunct definition. Instead, the decision rests on the normal tax treatment of compensatory damages, and that treatment is as valid today as it was in 1939. The reference to the Eisner v. Macomber definition was understandable since it was in good standing at that time, but the decision would be the same if that definition had been ignored.
Three more significant issues have been raised in questioning the validity of the Clark decision. We will examine each of them.
A. Old Colony Trust
In Old Colony Trust Co. v. Commissioner, the taxpayer had an arrangement with his employer under which the employer paid the income tax liability the taxpayer incurred for the taxes on his salary. Accordingly, the employer paid the taxpayer’s taxes. The government contended that the payment of those taxes was additional compensation to the taxpayer and included in the taxpayer’s gross income. The Supreme Court agreed with the government and held that the payments were taxable income to the taxpayer. The Court reasoned that the payment to a third party of a debt of a taxpayer is the same as a payment made directly to that taxpayer. The Court held that the payment was not a gift but was additional compensation for the taxpayer’s services.
Some tax commentators have contended that the case stands for the proposition that if someone pays the tax liability of a taxpayer, the payment is always income to the taxpayer. Since the tax counsel in Clark effectively reimbursed the taxpayer for part of the income tax he paid, that has been said to be equivalent to the counsel’s paying his tax; and the contention is made that therefore the payment is income to the taxpayer under Old Colony. Indeed, the government relied on Old Colony in asserting that the taxpayer in Clark recognized income.
That contention reads Old Colony far too broadly. The case does not hold that any payment of a taxpayer’s tax liability is income to the taxpayer. Rather, it holds that a payment of a taxpayer’s tax liability (or indeed of any other liability of the taxpayer) is treated as a payment made directly to the taxpayer and characterized the same as a direct payment would have been. In its opinion, the Court held that the payment was not a gift to the taxpayer, thereby implying that had it been a gift, it would not have been included in the taxpayer’s income. Surely, that is correct. If a father makes a gift to his son by paying the son’s income taxes, that would not be taxable income to the son. In Old Colony, the payment of the taxes was made as compensation for services and therefore was properly included in the taxpayer’s income.
Consider the situation in which Robert, a business consultant, advised Alice to incur certain nondeductible expenses that Robert assured her would prove profitable. Alice incurred the expenses, and they turned out to be of no benefit to her business at all. Robert subsequently acknowledges that he gave bad advice and reimburses Alice for the expenses she incurred. That reimbursement should be excluded from income as a return of Alice’s capital. Alice’s situation is identical to that of the taxpayer in Clark except that the expenditures in the Clark case were tax payments. There is no reason to treat a tax expenditure differently from any other expenditure that was not deducted.
Regulation section 1.61-14(a) states that another person’s payment of a taxpayer’s income tax is income to the taxpayer “unless excluded by law.” The regulation explicitly acknowledges that the payment of a taxpayer’s income tax is not income to the taxpayer when exclusionary tax principles or provisions are applicable.
B. Annual Accounting
Another issue that has been raised is whether the Supreme Court’s decision in Burnet v. Sanford & Brooks Co. requires the inclusion of the reimbursement in Clark’s income. The contention is that the annual accounting concept prevents the examination of past events to characterize the recovery that the taxpayer received in Clark. The short answer to that question is that the Sanford & Brooks case was badly decided and clearly would not be decided that way if it arose today. The case misapplied the annual accounting concept.
In Sanford & Brooks, the taxpayer carried out a contract for the United States government from the years 1913 to 1915. In conducting that contract, the taxpayer incurred and deducted expenses that exceeded its income for those years by $176,271.88. In 1916, the taxpayer sued the government for breach of warranty and obtained a judgment for $192,577.59 compensatory damages that included an amount for the $176,271.88 of its excess expenses over its income. The taxpayer also received interest on its award. The Supreme Court held that all of the amounts received by the taxpayer were included in gross income. The Court relied on the annual accounting requirement that income be reported on an annual basis. The Court stressed that if income instead were reported on a transactional basis, the tax law would be difficult to administer in that the characterization of current events could not be made until a transaction was completed perhaps some years in the future. The case is often cited for the general proposition that income is reported annually, but it is not cited for the holding on the facts that were present in that case. The annual accounting concept means that a taxpayer cannot take into account events that occur in the future to characterize the treatment of events in the current year. It does not mean that events in the past cannot be taken into account in characterizing current events. There is no administrative difficulty in looking to the past. It is only the problems that would be caused by having to wait for future events to occur that is prevented by annual accounting.
It is quite common for the tax law to look at past events to characterize current events. The use of basis in determining gain or loss or depreciation deductions is an example of examining past events to characterize what occurs in the present. The tax benefit rule is another example of referring to past events. Section 108(e)(5) is another example. Section 111(a) excludes from income a recovery of past expenses that had been deducted without providing a tax benefit. That provision is a codification of what came to be the common law rule. It is noteworthy that if the facts of the Sanford & Brooks case arose today, section 111(a) would exclude the recovery of the prior expenses that were deducted without a tax benefit.
C. Nonparallel Treatment
If no compensation had been obtained in Clark, the taxpayer would not have been allowed a deduction for the additional tax paid. Yet, the reimbursement of that additional tax is excluded from income. We refer to this situation as a nonparallel treatment. Excluding a receipt from income has the same tax consequence as including it in income and allowing a full deduction for the amount. The apparent inconsistency in disallowing a deduction for a “loss” while excluding a reimbursement of that loss from income might seem to violate the principle of horizontal equity and has troubled some commentators. To the contrary, however, several commentators have demonstrated that there is no inconsistency in having nonparallel treatment. In some situations, nonparallel treatment would be inappropriate, and in some it would be correct.
While a nontaxed reimbursement of an expenditure bears some similarity to allowing a deduction for the expenditure, they are not the same. A reimbursement provides the taxpayer with the same net worth that he would have had if he had not made the reimbursed expenditure. Granting a deduction for an unreimbursed expenditure does not provide the same net worth position for the taxpayer. The benefit derived from the deduction depends upon the taxpayer’s marginal tax rate; but regardless of the rate, the benefit will be less than 100% of the expenditure. While the two situations are not identical, the question remains as to whether different tax treatments are warranted. As explained below, we conclude that different treatment is appropriate in some circumstances including the events of the Clark case.
The fact that some commentators have been troubled by the nonparallel aspect of the Clark situation is difficult to understand. There is nothing unusual about that treatment. Numerous provisions in the tax law provide for that treatment, especially in the case of a recovery of damages; it is odd for there to be angst over the situation in which the reimbursement is for tax payments and not over situations in which the reimbursement is for something else. For example, if John is injured by Mildred’s negligence and loses his arm as a result of the accident, and if he does not recover damages for his injury, John is not allowed any deduction for his loss. But, if John recovers $1,000,000 from Mildred as compensatory damages for personal physical injury, the amount received is excluded from gross income by section 104(a)(2).
Another example involves damage to or destruction of property held for personal use. An uncompensated personal casualty loss is deductible only to the extent that the taxpayer’s net casualty loss exceeds ten percent of the taxpayer’s adjusted gross income. If the casualty loss is less than that floor, none of it is deductible. If, however, the taxpayer is reimbursed for that loss by the tortfeasor or by an insurance company, the reimbursement is excluded from income to the extent of the basis in the property, and the payment merely reduces the basis of the damaged property. In that regard, consider Example (2) set forth at the beginning of this Part.
A similar example involves a taxpayer with medical expenses that do not exceed the minimum adjusted gross income floor for that deduction and so are not deductible. A reimbursement of those expenses by a medical insurer is excluded from gross income by section 104(a)(3).
In an article written in 1991, Professor Zelenak stated that the question of whether the reimbursement of a nondeductible expenditure (or the payment of a taxpayer’s liability the payment of which would not be deductible) should be excluded from the taxpayer’s income depends upon the reason that Congress made the expenditure (or the payment of the liability) nondeductible. Professor Zelenak suggested that if an exclusion from income would contravene the purpose of denying a deduction, the item should be included in income. If an exclusion from income does not contravene the purpose of not allowing a deduction, the item can be excluded from income. Professor Zelenak set forth two examples to illustrate reimbursements that do not contravene the purpose of nondeductibility, and one of those examples was the Clark case itself. Those examples are instructive, and we have set them forth below.
Example (3). In Year 1, Hilda paid a fine of $4,000 to a government. Hilda was not allowed a deduction for the payment of the fine under section 162(f) which denies a tax deduction for the payment of a fine. In Year 3, Hilda is found innocent of the violation, and the government returns the $4,000 to her. The purpose of prohibiting a deduction for the payment of a fine is that allowing the deduction would mitigate the sanction sought to be imposed; no deduction is allowed in order to maintain the level of sanction chosen for the violation. Returning the fine to the taxpayer when it is determined that there was no violation does not contravene the purpose of the nondeductibility provision since there was no reason to penalize the taxpayer who was innocent.
Example (4). Consider the facts of the Clark case. Professor Zelenak gave the following argument for allowing the exclusion. The reason that the payment of a federal income tax is not deductible is because Congress chose to have the income tax be tax inclusive, and to allow a deduction would make it tax-exclusive. The exclusion of the reimbursement does not affect the tax-inclusive characterization of the amount that the taxpayer would have paid if all had been done properly. The only effect of excluding the reimbursement from income is to relieve the taxpayer of the burden of an overpayment of his taxes.
But, the fact is that because the taxpayer chose to file a joint return he consequently owed the larger tax amount to the government. While it is far from clear, excluding the reimbursement could be deemed to conflict with the congressional goal that the income tax be tax inclusive. If so, can the exclusion still be justified? We explain below that it can.
While we agree with Professor Zelenak that a reimbursement can be excluded from income if it does not contravene the purposes for which the expenditure was made nondeductible, we do not agree that contravening the purposes of nondeductiblity necessarily requires that the reimbursement be included in income. In the latter circumstance, there can be a separate and independent purpose for excluding the reimbursement, and the question then becomes which purpose should be given priority—the purpose for exclusion or the purpose for denying a deduction. In some cases, the purpose for excluding the reimbursement may well be more reasonable and thus be given priority.
Consider the Clark case as illustrated in Example (4) above. The exclusion of the reimbursement allows the taxpayer to be made whole—that is, he effectively bears no more tax liability than the amount that he would have paid if he had not suffered from the negligence of the tax counsel. Excluding the compensatory payment from income facilitates the effort to keep him from suffering harm from the tax counsel’s negligence. That humane and equitable goal is entitled to considerable weight. Comparing the goal of eliminating the harm that the taxpayer suffered with the goal of having a tax-inclusive tax system, it is not unreasonable to give priority to facilitating the former. Even if the exclusion of the reimbursement were deemed to conflict with the purpose for nondeductibility, there still is a good reason to exclude the reimbursement from income.
Another objection that has been made to nonparallel treatment is that it violates horizontal and vertical equity. A number of commentators have made that point. The nature of the situation and the reason that it is not actually a problem is illustrated in the following example.
Example (5). A, B, and C are three individuals each of whom has $100,000 of actual taxable income if their taxable incomes were determined correctly. All three individuals have their returns prepared by an accountant. A’s accountant correctly determines his income, and so A pays tax on $100,000 of taxable income. B’s accountant negligently errs in determining B’s taxable income, and so B pays tax on $120,000 of reported income. On discovery of the error, B’s accountant reimburses B for the additional tax that B paid. The reimbursement is excluded from B’s gross income. C’s accountant also makes an error, and causes C to pay tax on $120,000 of taxable income. C’s accountant is judgment proof, and so C does not recover any of the additional tax he paid. C cannot deduct the additional tax he paid as a loss.
As a result of the recovery and exclusion, B has the identical increase in net worth as A whose taxable income was determined properly, and A and B pay the same amount of tax. That treatment conforms with horizontal equity. As a result of no recovery and no deduction, C has the identical increase in net worth as A and B, but C pays a greater tax than either A or B. That difference of tax treatment would seem to violate the principle of horizontal equity.
Moreover, taxing B on the receipt of damages from the accountant would still result in a violation of horizontal equity. B would pay a greater tax than A even though they had the same net income. Indeed, B would have less of an increase in net worth than A because of the tax B would pay on the receipt of the reimbursement. C would pay a larger tax than either B or A even though all three had the same net income.
The reason that there is a violation of horizontal equity in the above situation is not because of the exclusion of B’s recovery but rather because of the denial of a deduction to C. The denial of a deduction for a loss will create an inequity in the tax treatment of that taxpayer when compared to the treatment of a taxpayer who had the same income but did not suffer a loss. For example, F and G each earned $100,000 net income. G lost $10,000 when it was stolen from him, and G could not deduct that loss because of the ten percent of adjusted gross income floor. While G’s increase in net worth is less than F’s, G pays the same amount of tax that F pays. That is contrary to the vertical equity principle, but it is an inevitable aspect of denying the deduction.
The result is that once a deduction is denied for the excess payment, a violation of horizontal or vertical equity will occur regardless of how the reimbursement is treated by the tax law. Consequently, equity considerations have no role to play in determining how the reimbursement should be treated.
Horizontal and vertical equity are one general goal of the tax law, but there are many other goals that are often given priority. Moreover, the determination of what constitutes a departure from equity is murky at best. The tax laws are replete with provisions that conflict with horizontal and vertical equity, and equity principles have been ignored more than followed.
IV. Purported Distinction of Clark
Even if the principle of the Clark case is correct as we have concluded, the case for the taxpayer in McKenny has another hurdle to overcome. In Clark, the error made by the tax counsel was the advice provided regarding the taxpayer’s filing status. The accountant’s error in McKenny did not involve the taxpayer’s tax return. Rather, the accountant failed to take the required steps to qualify the ESOP so that the taxpayer would obtain the tax deferral benefits sought. Does the Clark doctrine apply only to reimbursements for errors made in preparing or filing the return?
After accepting the validity of the Clark decision, the Service had to rule on a number of situations in which the reimbursement was made for external errors that failed to qualify the taxpayers for tax relief rather than on the preparation of a tax return. Initially, the Service concluded that the Clark doctrine applied in those situations as well. After a few years, however, the Service changed its position and ruled that the doctrine was limited to return errors and did not apply to remedies for payment of a larger tax because of external errors. The rationale for making that distinction is that when a return error is made, the taxpayer paid a greater tax than the correct amount. In contrast, when an external error failed to qualify a taxpayer for tax relief, the tax paid was equal to the tax actually owed. Since the reimbursement of the taxpayer’s larger payment is a reimbursement of a tax actually owed, the Service maintains that the reimbursement is included in income under Regulation section 1.61-14(a). As will be shown below, we contend that the current position of the Service is incorrect and that no principled basis exists for not applying Clark to external errors. Before discussing the merits of the Service’s position, we will note several of the rulings on this issue.
In Private Letter Ruling 8447076, the taxpayer wished to make a gift to his son of the maximum amount he could give without incurring any gift tax liability. He sought advice from his attorney as to that amount. The attorney erred in arriving at a figure that was larger than the minimum amount. Consequently, the taxpayer incurred a gift tax liability. The taxpayer claimed that the attorney should reimburse him for the gift tax. A negotiated settlement provided a recovery for the taxpayer. The Service ruled that the payment to the taxpayer was excluded from income under the Clark doctrine.
Similarly, in Private Letter Ruling 9211029, the Service again applied the Clark doctrine to exclude from income an accountant’s reimbursement of a client’s payment of a larger tax because of the accountant’s failure to qualify the client as a regulated investment company (RIC). Because of the accountant’s error, the client did not qualify as an RIC; thus, the tax paid was equal to the tax owed. Five years later, the Service revoked the ruling and held instead that the reimbursement was included in the client’s taxable income.
In 1997, the Service ruled on this issue and showed that it had changed its position. In Private Letter Ruling 9728052, the taxpayer had agreed to pay alimony to his divorced wife for a period of years with the payments to be made to her estate if she died within that time frame. The taxpayer agreed to this arrangement on the advice of his lawyer that the payments would be deductible. The lawyer erred, and the payments were not deductible thereby causing the taxpayer to pay a larger income tax than expected. The taxpayer then entered into negotiations with the attorney for additional taxes paid, plus interest and penalties incurred. The Service ruled that any damages he received would be included in his gross income because the error that the attorney made was external. The Service did not apply Clark because the amount of tax paid was the amount that was owed.
In 1998, the Service again ruled on this issue in Private Letter Ruling 9833007. After winning a state lottery, a taxpayer consulted an attorney for advice as to how to treat his winnings. The taxpayer could have reduced his federal income tax liability for that year by paying his state income tax in the year in which he received his winnings so that he could deduct that amount from income that would otherwise be taxed at a higher rate. If he had done so, the taxpayer’s federal income tax liability would have been significantly lower. Because the lawyer failed to advise the taxpayer to take that step, the taxpayer bore a higher tax liability than he would have had the attorney not erred. The taxpayer requested a ruling as to how any recovery he might obtain from the lawyer for the failure to provide accurate advice would be taxed. The recovery sought would be the difference between the amount of federal income tax paid and the amount that would have been owed had the taxpayer been advised to pay the state tax early. The Service ruled that because the taxpayer actually owed the tax paid, any recovery received would be a payment of part of his correct tax liability by a third party and therefore taxable to him.
In our view, the Service’s current position is incorrect. In those rulings and in McKenny, the advisor’s negligence caused the taxpayer to incur a greater liability than would have been incurred if the advisor had not erred. The advisor’s negligence required him to replace the funds that he caused the client to spend in order to place the client in the same position that he would have occupied if all had been done properly. In determining the net amount of additional cost that the client incurred, the difference in tax liabilities should be offset by any additional costs the client would have incurred to achieve the reduced tax. When the advisor’s liability is settled, as was the case in McKenny, the amount of the settlement at which the parties arrived will reflect any mitigating costs that reduce the client’s actual loss.
The Service does not dispute that when a person’s negligence causes a taxpayer to expend more dollars than would have been expended if no error had been made, the replacement of those dollars is a return of capital and is excluded from income. That concession is reflected in the Service’s approval of the Clark decision. But the Service seeks to treat the taxpayer differently when the dollars expended were used to pay federal income taxes. The loss of dollars is the same to the taxpayer regardless of whether they were expended on taxes or on some other liability. Consider the following example.
Example (6). Mildred has an idea for a profit motivated venture that does not constitute a trade or business. Consequently, the expenses of producing income from that venture are miscellaneous itemized deductions that currently are not deductible. She seeks the advice of a lawyer as to how best to handle the expenditures to conduct the venture. The lawyer proposes a plan that will reduce her expenditures, and she approves it. The lawyer then negligently fails to implement the plan correctly so that Mildred incurs greater expenditures than she would have had under the plan. The lawyer pays Mildred an amount equal to the additional expenditures that his negligence caused. Because the plan was not implemented correctly, Mildred did in fact owe the amount of expenditures paid. Nevertheless, there is no dispute that the payment Mildred received is a return of her capital and is excluded from her income. There is no reason to treat the replacement of those dollars differently when the expenditure is the payment of a tax. The payment to Mildred is designed to make her whole from the excess costs she incurred because of the lawyer’s malpractice. Similarly, in McKenny, the settlement was designed to make the taxpayer whole from the injury suffered from the accountant’s negligence.
The Service seeks to distinguish Clark on the ground that the amount of tax the taxpayers paid in those other situations was equal to the actual amount of tax owed whereas the Service claims that the taxpayer in Clark paid more than the actual tax liability. But, that is not true. Clark filed a joint income tax return, and he was not permitted to change that election. Consequently, the taxpayer in Clark did actually owe the tax that he paid. The payment that he received from the counsel was to replace the additional tax he actually incurred over what would have been incurred had he received proper advice.
The Service’s attempt to treat tax payments differently from other expenditures is unwarranted. It is true that an error in preparing a tax return is different factually from an external error. But there are always factual differences between a precedent and a new case. For example, the names of the taxpayers will be different. A factual difference is not sufficient to justify a difference in treatment; a principled justification is necessary to treat parties differently because of a factual difference. The Service’s claimed justification that the compensatory payment is effectively a payment of the taxpayer’s actual tax liability taxable under Old Colony and Regulation section 1.61-14 ignores the fact that Old Colony and Regulation section 1.61-14 characterize a payment of another’s tax liability as income unless the law provides otherwise. The payment satisfied a liability of the taxpayer; whether that liability was a tax obligation or some other obligation should not matter. The point of the case and the regulation is that the payment of another person’s debt is equivalent to making a direct payment to the debtor and should be treated the same. The Service’s effort to treat a tax debt differently than other debts makes the tax a kind of shibboleth.
There are several cases in which damages received for paying higher taxes due to external errors by an advisor have been excluded from income. The courts did not accept the Service’s contention that the external distinction from the facts of Clark requires a different result.
In Cosentino v. Commissioner, the Tax Court rejected the claim that an external error is distinguishable from Clark. In that case, an accountant advised the taxpayer to adopt a plan for the disposition of realty. The plan carried out by the taxpayer was subsequently held to be an abusive tax shelter. The taxpayer incurred a large amount of tax, interest, and penalties. Had the taxpayer known that the plan was abusive, he would have exchanged the realty for realty of like kind in a section 1031 nonrecognition exchange. The taxpayer sued the accountant, and they settled. The accountant paid the taxpayer $375,000. The settlement did not allocate that amount among the several losses that the taxpayer claimed. Some of the items claimed by the taxpayer were expenses that the taxpayer had deducted and for which he had received a tax benefit. One of the items was a claim for a loss in an amount that was greater than the actual amount of the loss. The court held that the settlement had to be apportioned among the several items claimed. The amount apportioned to the payment of higher taxes was excluded from the taxpayer’s income. The court held that the Clark doctrine applied to external errors. The amount apportioned to the deducted expenses was included in income under the tax benefit doctrine. The amount apportioned to the claim for a loss that did not exist was also included in income.
We discussed Concord Instruments Corp. v. Commissioner in Part II. In that case, the taxpayer’s lawyer failed to file a timely appeal from an adverse judgment on a tax issue. The taxpayer sued the lawyer for malpractice claiming damages for the taxes paid that would not have been due had he won the appeal plus interest that he paid to the Service and to a bank. The taxpayer had deducted the interest payments. The suit was settled, and the attorney paid the taxpayer $125,000. The settlement did not apportion the amount among the several claims that the taxpayer made. The Tax Court held that the settlement had to be apportioned among the several claims, and the court made that apportionment according to the percentage of each item in the taxpayer’s complaint. The amount allocated to the payment of taxes was excluded from the taxpayer’s gross income under the Clark doctrine. The court did not treat an external error differently from a return error. The amount allocated to interest payments was included in income under the tax benefit rule.
We have made significant references to an excellent article by Professor Zelenak on this topic. In that article, Professor Zelenak concluded that the Clark case was correctly decided. He also concluded, however, that the Service’s distinction between external errors and errors in preparing a tax return is correct. As noted above, we have come to the opposite conclusion. And the several courts that have passed on that issue have rejected that distinction. In support of his conclusion, Professor Zelenak set forth an example that he believed demonstrated that the Service’s distinction is appropriate. At first blush, it might appear that his example demonstrates that he is correct, but a careful examination shows that he is not. The substance of his example is set forth below.
Example (7). X Corporation issues a bond to Joan for $100. The bond pays 10% interest ($10 per year). X falsely represents to Joan that the interest payable on the bond is exempt from federal income tax under section 103. Upon discovering that she had been misled, Joan complains, and X is required to pay Joan the amount necessary to put her in the same position she would occupy if the bond’s interest were tax exempt. Assuming that Joan is in the 20% marginal tax bracket, the tax on the $10 of interest she receives each year would be $2, and Joan would retain $8 per year after tax. X will pay Joan an amount each year to provide her with $10. If the payment made to Joan is excluded from income, X will pay her $2 each year. If, however, the payment to Joan is subject to tax (at a 20% marginal rate), X will have to pay her $2.50 for her to have $10 after tax. In effect, if the payment to Joan is not taxable, X can be seen as paying interest at a 12% rate, but if it is taxable, X will be paying interest at a 12.5% rate. The result is that X would have had to pay Joan 12.5% interest to give her the promised 10% after-tax return, but if the compensatory payment is excluded form income, X will have to pay only 12% interest.
We should note that the problem raised by the example does not exist in the McKenny case. First, in the example, there was not an error that prevented Joan from having a desired tax benefit that she would have enjoyed if the error had not been made as was the case in McKenny. Joan would not have been entitled to tax-exempt interest in any event. Joan’s complaint is that she was misled regarding the tax consequences of the arrangement, not that she was prevented by negligence from obtaining those benefits. Second, because the compensatory payment in McKenny was not made by the obligor of the debt in question, the arrangement between the debtor (the taxpayer) and the obligor (the government) was unaffected. Third, no risk of collusion or fraud existed in McKenny since neither party benefitted from the error.
The accountant’s payment in McKenny did not reduce the revenue the government received from the taxpayer for the income the taxpayer earned. If, as we maintain, the accountant’s payment is excluded from income, the government will not collect any additional revenue from that payment. The reason is that the government has chosen generally not to tax compensatory payments. Congress could tax compensatory payments if it chose to do so, but it has not. There is nothing unusual about not taxing the compensatory payments that were made in McKenny or in similar cases.
As to the factual situation posed in Example (7), the payments made by X to Joan are not actually interest payments. They are compensation for an injury she suffered, and the amount of her injury is measured by the amount of tax she incurred. Instead of the proposed characterization of the payments as additional interest on the bond, they might better be characterized as a reduction of Joan’s cost in purchasing the bond. As such, they would reduce her basis in the bond. In that regard, consider the comparable treatment involving the cancellation of debt under section 108(e)(5), codifying the common law treatment of such cancellations, under which the cancellation of purchase money debt that would normally be treated as income to the debtor is instead treated as a reduction of the cost of the purchased item.
In any event, as noted above, the principal concerns that Professor Zelenak has are the possibility of collusion and the obtaining of unauthorized tax treatment by arranging for compensatory payments to be made. As noted above, there is no prospect for collusion in the McKenny situation or in comparable cases. Even in the situation described in Example (7), the requirement that the arrangement be bona fide and that a settlement be bona fide, in good faith, and having the color of merit would seem to be sufficient to prevent abuse.
V. Allocation
If a claim for damages for malpractice includes a claim for expenses incurred in addition to a claim for compensation for payment of higher taxes and if the claims are settled by payment of a lump sum amount which is not apportioned in the settlement agreement, the courts will apportion the settlement amount among the several claimed items. There is no established manner for making that allocation, but typically the courts and the Service have allocated according to the percentage each item represents in the complaint or claim.
If a settlement includes an allocation, the courts generally will accept it if the “agreement is entered into by the parties in an adversarial context at arm’s length and in good faith.” It is surprising that so many settlements fail to make such an apportionment.
VI. Conclusion
The decision of the Eleventh Circuit in McKenny failed to take into account the Lyeth v. Hoey doctrine that a bona fide, arm’s length settlement is conclusive of the matters settled by that agreement. The court’s decision for the government rested on its determination that the taxpayer failed to provide proof of items that were settled in the written agreement between the taxpayer and the accountant. We have shown that the Lyeth v. Hoey doctrine does apply to the case and should have been treated as conclusive of those issues.
Because the court determined that the taxpayer had failed to prove crucial elements of the case, the court expressly declined to examine the question of whether a payment to compensate a taxpayer for paying a larger tax because of an external error of the payor should be excluded from income. This issue raises the questions whether the Tax Court’s decision in Clark is valid and, if so, the scope of that doctrine. We have examined the Clark doctrine in the light of objections raised by some commentators and found that the doctrine is valid. We have discussed the issues whether the decisions in Old Colony and Sanford & Brooks invalidate the Clark doctrine and concluded that they do not. We examined the issue whether nonparallel treatment violates horizontal and vertical equity principles and have shown that equity cannot be obtained in the Clark situation because whether the compensatory payment is excluded or taxed a violation of horizontal or vertical equity will occur. Consequently, the principle of horizontal and vertical equity has no role to play in determining how to treat those compensatory payments.
While the Service has accepted the validity of the Clark decision, it maintains that the decision is limited to errors made concerning the preparation of a tax return and does not apply to external errors that caused a taxpayer to incur a larger tax obligation. We have shown that there is no justification for treating compensatory payments to an injured party because of external errors differently from compensatory payments for errors in preparing a tax return. The purpose of generally not taxing compensatory payments is to ensure that an injured party is made whole; any injury caused by increasing a victim’s tax liability is as harmful as any other pecuniary injury and should be treated the same.