Question

Find a valid tax court case to match the fact pattern evident in the case presented below:

CPA Joe reimburses a client for a $75,000 tax liability that is traceable to Joe’s ineffective tax advice. For fear of increasing his already steep malpractice-insurance premiums, Joe does not file a claim with the insurer. Can Joe deduct the $75,000 loss?

Facts in this case:

Joe reimburses a client $75,000 due to his ineffective tax advice and he does not file a claim with the insurer

When finding a case that aligns with the one above, be sure to use a reputable database (i.e. Bloomberg Tax, CCH AnswerConnect, Thomson Reuters RIA Checkpoint). The case you find should have a similar fact pattern (i.e. a case where a CPA reimburses a client $$ for ineffective tax advice and does not file an insurance claim. Use code section 165(h)(4)(E) as guidance.)

Answer 1

Yes. He can deduct the loss. Joe is not required to make a claim under his malpractice insurance policy in order to take a tax deduction for his loss; this treatment is supported by a 1981 court case (Hill vs. CIR) which reversed an earlier (1068) decision in Kentucky Utilities vs CIR that disallowed a deduction where the loss was covered but not claimed.

The Hills court rejected Kentucky and held that Section 165(a) allows a deduction for an economic detriment that (1) is a loss, and (2) is not compensated for by insurance or otherwise. Hills also recognized that "compensated" is distinct from "covered." The Hills court recognized that "All losses compensated by insurance are also… covered by insurance; nonetheless, it should be equally obvious that… all losses covered by insurance are also compensated for, is not necessarily true."

The court in the present case followed the reasoning in Hills and adopted a plain English interpretation of 26 U.S.C. § 165(a) that allows a deduction for an economic detriment that is a loss and (2) is not compensated for by insurance or otherwise.

The court is avoiding two undesirable consequences of the Kentucky Utilities rule. First, it allows insured taxpayers to decline insurance indemnification without the penalty of not being able to deduct the loss as if they did not have insurance. There are many valid reasons for not involving insurance companies and the tax law should not work against them. Second, taxpayers who carry no insurance or are under-insured are not rewarded with an additional deduction not available to their colleagues who carry the proper amount of insurance coverage