PLR 9833007
Dear ***
This letter is in reply to a letter dated December 19, 1997, submitted on your behalf by your authorized representative, requesting a ruling that your receipt of an indemnity payment will not be includible in your gross income.
FACTS
After winning $x in the State lottery in Year, you consulted attorneys for tax preparation advice. You were not advised to maximize your deductible expenses for federal income tax purposes by paying State income tax in Year on your winnings. This resulted in your paying $y more federal income tax than you otherwise would have been required to pay. You have computed your economic detriment to be somewhat less, $z, and you are negotiating with your attorneys' malpractice insurer for an indemnification payment that will reimburse you for this amount.
LAW AND ANALYSIS
Section 61(a) of the Internal Revenue Code provides that gross income means all income from whatever source derived. Section 1.6114(a) of the Income Tax Regulations provides that another person's payment of the taxpayer's income tax constitutes gross income to the taxpayer unless excluded by law.
In Clark v. Commissioner, 40 B.T.A. 333 (1939), acq., 19571 C.B. 4, the taxpayers, husband and wife, made an irrevocable election to file a joint federal income tax return rather than separate returns on the advice of their return preparer. Subsequently, the Service examined the return and assessed a deficiency against the taxpayers. The deficiency existed because the return preparer took a larger deduction from income for longterm capital losses than was allowed by law. If the taxpayers had filed separate returns employing the proper deduction for longterm capital losses, their combined tax liability would have been $19,941.10 less than the amount of tax assessed and paid by them. As recompense for his error, the return preparer indemnified the taxpayers in that amount. The Service included the indemnification payment in the taxpayers' income as an amount attributable to the return preparer's payment of the taxpayers' income tax liability. The Board, however, viewed the excess of the taxpayers' tax liability on their joint return over what their liability would have been on separate returns as a loss caused by the return preparer's negligence and the reimbursement of this excess amount as compensation for a loss that impaired their capital. Thus, the Board held that the indemnification payment received by the taxpayers was a nontaxable recovery of capital rather than income.
In Rev. Rul. 5747, 19571 C.B. 23, a tax consultant made an error in preparing and filing a taxpayer's individual income tax return. This error caused the taxpayer to pay more tax than she would have paid had the correct method been used. By the time the error was discovered the period of limitation for recovery of overpayment of tax had expired. The tax consultant, as recompense for the error, paid the taxpayer a sum of money that included a reimbursement of the additional tax. Rev. Rul. 5747, citing Clark, concludes that the reimbursement of the additional tax is not includible in the taxpayer's gross income.
The indemnity payment that you will receive as reimbursement for the economic detriment you sustained is distinguishable from the indemnity payments in Clark and Rev. Rul. 5747. In Clark, and Rev. Rul. 5747, the preparers' errors in filing returns or failing to claim refunds caused the taxpayers to pay more than their minimum proper federal income tax liabilities based on the underlying transactions for the years in question. However, your payment of additional federal income tax was not due to an error made by the attorneys on the return itself but on an omission to provide advice that would have reduced your federal income tax liability. Thus, unlike the situations in Clark and Rev. Rul. 5747, you are not paying more than your minimum proper federal income tax liability based on the transaction for the tax year to which the tax reimbursement relates. Therefore, under § 1.6114(a) the indemnity payment that you receive for the additional federal income tax you paid represents a gain that is includible in your gross income.
HOLDING
Accordingly, we conclude that you must include in gross income the indemnity payment you will receive to reimburse you for the additional federal income tax paid arising from your attorneys' omission to advise you to pay your State income tax in Year on your lottery winnings.
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PLR 9833007