How I Reduced a Member's Tax Bill from $200,000 to $78.00

Our member received a CP2000 notice showing he owed the IRS over $200,000! The member was quite distressed, but he was not surprised he’d received the notice. In 2013, he had received $500,000 as part of a lawsuit settlement from an insurance company. The member, through his partnership, had a disability insurance policy. When the insurance company failed to pay out, he was forced to sue them. Instead of taking the case to trial, our member accepted the $500,000 settlement from the company. The company did issue a 1099-Misc. form, reporting the income to the IRS as taxable; however, after consulting with some tax professionals, the member did not believe this income to be taxable and did not include it on his tax return. We responded to the IRS explaining this, but they did not want to accept our position that the settlement proceeds were not taxable, and by this point enough time had passed that a Notice of Deficiency was issued.

The Internal Revenue Code (IRC) states that amounts received by a taxpayer through accident or health insurance for personal injuries or sickness are excludable from gross income if the payments are made by the individual (IRC 105(a)). In our member’s case, his partnership Form K-1 showed that the member paid for these premiums through his own partnership distributions. We believed we could defend him based on this section of the IRC, so we filed a petition with the U.S. Tax Court.

We were assigned to an Appeals Officer who considered our arguments, but took the position that the $500,000 should be taxable because it was not received through a disability insurance policy, but rather as proceeds from a lawsuit ─ income that is typically taxable. She also argued that the settlement agreement did not specifically state the amounts were received for disability. Moreover, she stated that he did not pay for the disability policy: his partnership did.

I sent the Appeals Officer a letter explaining that, under IRC 104(a)(2), amounts from a lawsuit are excluded from income if the damages sought are for personal injury or sickness, which is what occurred in this member’s case. The Tax Court previously decided that if the origin of the suit is seeking damages for personal injury or sickness, it would be excluded from income. (Trez v. Commissioner 35 TCM 640, 1976). I also explained that, under IRC 707(c), disability payments are treated as being paid out of the partner’s after tax earnings; therefore, he paid for it himself.

Unfortunately, the Appeals Officer would not listen to any of our arguments. She continued to treat the amount our member received as taxable and forwarded his case to IRS counsel to prepare for trial. Since we do not generally represent our members in tax court, our member became extremely concerned about potentially having to hire a tax attorney to take the case to trial for him, in addition to possibly owing this large balance. I assured the member that we would continue to work with IRS counsel as his representative and try to obtain a favorable outcome before trial; however, if we were unable to resolve the issue, he would have to take the issue to trial.

The member told me that, prior to his disability, he had been an esteemed litigation lawyer and he was an expert at settling cases. He told me we should make an initial proposal to IRS counsel’s office to pay $25,000 to settle the case. I explained to our member that, while I was not an expert litigator like him, I consider myself a competent tax attorney. I explained to him that the IRS had not made any arguments in writing nor cited any case law or Internal Revenue Code Sections to support their position that the income was taxable. My advice to him was to continue to argue the case on the merits we had, and if we were unsuccessful, we would withdraw from representation, leaving him enough time prior to trial to make his $25,000 settlement proposal.

Luckily, the member listened to me. After I discussed the case with IRS Counsel, they conceded the issue entirely.

The amount of tax due on the decision documents was $78, based on some interest income the member had inadvertently not reported. Our member was beyond ecstatic with the result and promised to be a member for life.