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Couple Can Exclude Settlement Proceeds from Abusive Tax Shelter Scheme.
(Parker Tax Publishing October 3, 2014)

Most of the settlement proceeds received from a CPA firm and some of its accountants were excludible from the taxpayers' income because the payment compensated the taxpayers for additional taxes they paid as a result of incompetent advice from the CPA firm. Cosentino v. Comm'r, T.C. Memo. 2014-186 (9/11/14)

In an attempt to provide for their disabled daughter's future, a couple looked to a CPA firm for advice on how to maximize profits from their real estate holdings. Unbeknownst to the couple, the plan recommended by the firm, and acted upon by the couple, was really an abusive tax shelter which led to assessments by the IRS for additional taxes, interest and penalties. The IRS claimed that the resulting settlement was includible in the couple's income. However, in Cosentino v. Comm'r, T.C. Memo. 2014-186 (9/11/14), the Tax Court rejected the IRS's rationale for including the amounts in income and held that the majority of the settlement was excludible from income. Because the taxpayers settled for less than they sued for, the court ratably allocated the portion that was excludible from income. The excludible portions of the settlement related to (1) excess taxes paid, (2) losses incurred as part of the tax shelter which the IRS disallowed as a deduction, (3) fees paid for the bad advice, and (4) penalties paid to the IRS. The portion of the settlement relating to interest that the taxpayers deducted on their return was not excludible from income, however.


Garey Cosentino and his wife, Jo-Ann, had a plan to maximize and accumulate wealth during their lives in order to provide for their permanently disabled adult daughter both during their lives and after their deaths. The plan involved real estate they owned through two pass-through entities, G.A.C. Investments, LLC and Cosentino Estates, LLC. Pursuant to that plan, the couple engaged in several Code Sec. 1031 like-kind exchanges that did not involve boot and, thus, they never recognized gain.

Subsequently, the couple paid $45,000 to an accounting firm in return for its advice on building wealth. The firm, and some of its accountants, advised that the Cosentinos that G.A.C. Investments should enter into certain transactions in an attempt to increase G.A.C. Investments' basis in its rental property. Pursuant to the CPA firm's plan, in 2002, the Cosentinos and G.A.C. Investments engaged in various transactions involving the rental property. In 2003, G.A.C. Investments disposed of rental property in a Code Sec. 1031 like-kind exchange with boot. The gain that otherwise would have been recognized upon disposition of the rental property in return for like-kind property and boot was largely offset by an inflated basis that resulted from the implementation of the CPA firm's plan.

After engaging in the transaction, the Cosentinos learned that the tax-avoidance plan was an abusive tax shelter. The couple and their flow-through entities then filed amended returns disclaiming the benefits derived from implementing the tax-avoidance plan recommended by their CPAs. As a result, the Cosentinos were required to recognize additional gain of approximately $1.8 million. G.A.C. Investments amended its 2003 Form 4797 and reported additional Section 1231 gain from like-kind exchanges of approximately $1.8 million more than it had reported on the original Form 4797. In the resulting settlement with the CPA firm, the couple received $375,000, which they excluded from income. The IRS assessed a deficiency, saying the entire settlement was taxable income.

The Cosentinos argued that the $375,000 payment represented a replacement of capital that was, therefore, not taxable. In support of this position, they relied on Rev. Rul. 57-47, Clark v. Comm'r, 40 B.T.A. 333 (1939), and Concord Instruments Corp. v. Comm'r, T.C. Memo. 1994-248. The IRS countered that these authorities were materially distinguishable from the instant situation and were not controlling.

In Clark, a married taxpayer hired a lawyer to advise him on whether he and his spouse should file a joint return or separate returns. The lawyer advised the taxpayer to file a joint return, which the taxpayer did. After a subsequent audit, it was determined that separate returns would have been more beneficial and the lawyer paid the taxpayer $20,000. The court said the settlement was nontaxable.

In Concord, a taxpayer filed a malpractice suit against a lawyer who failed to timely file an appeal on the taxpayer's behalf. The IRS said the settlement was includible in income but the Tax Court rejected that position and held that, except for the portion of the malpractice payment representing interest reimbursement, the settlement was excludible from income.

The issue the IRS addressed in Rev. Rul. 57-47 was whether the taxpayer was required to include a settlement payment from her tax adviser in income. The IRS ruled that under Clark, no taxable income was derived from that part of the recovery that did not exceed the tax which the taxpayer was required to pay because of the error made by her tax consultant.

Tax Court's Opinion

The Tax Court held that the majority of the Cosentinos' settlement was excludible from income. The court found the authorities cited by the Cosentinos to be on point and said the IRS was ignoring the following material facts: (1) the Cosentinos paid more in federal income tax and state income tax than they would have paid if they had not taken the CPA firm's advice, and (2) the Cosentinos paid other expenses that they would not have paid if they had not followed the CPA firm's advice.

Thus, the court held that the $375,000 payment was not includible in the Cosentinos income except to the extent payments were received for (1) certain damages which they claimed in the complaint and for which they were compensated but for which they had claimed deductions that the IRS allowed, and (2) certain damages which they claimed in the complaint and for which they were compensated but which they in fact did not incur or incurred in amounts that were less than the amounts of those damages that they alleged in the complaint. (Staff Editor Parker Tax Publishing)

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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