## Facts

- Edward H. Clark, married and living with his wife, retained experienced tax counsel to prepare his 1932 federal income tax return(s).
- Counsel prepared and advised filing a joint return rather than separate returns; Clark followed that advice.
- Counsel erroneously deducted the full amount of long-term capital losses without applying the statutory limitation in § 101(b) of the Revenue Act of 1932.
- After audit, an additional assessment was made and reduced to $32,820.14, which Clark paid.
- If Clark and his wife had filed correct separate returns applying the capital-loss limitations, their combined tax would have been $19,941.10 less than the tax paid on the joint return.
- Because the error was discovered too late to recover the excess through a refund claim or amended return, counsel paid Clark $19,941.10 to compensate for the loss caused by the erroneous advice.
- The Commissioner treated the $19,941.10 payment as taxable income to Clark in 1934 and asserted a deficiency.

## Issues

1. Whether a $19,941.10 payment by a taxpayer’s tax counsel, made to compensate the taxpayer for excess federal income tax paid due to counsel’s erroneous advice, is includible in the taxpayer’s gross income for 1934.

## Decision

- The Board of Tax Appeals held the $19,941.10 payment was not taxable income to Clark and was not includible in gross income.
- The Board rejected the characterization of the payment as a third party’s payment of Clark’s tax liability; Clark had paid his own taxes.
- The Board redetermined the deficiency in Clark’s favor to the extent it was based on including the indemnity payment in income.

## Legal Principles

- A payment received as compensation for a loss caused by a professional’s error may be treated as a non-taxable restorative payment when it merely makes the taxpayer whole and produces no net economic gain.
- The tax character of the underlying loss (excess taxes paid) does not, by itself, convert a compensatory indemnity payment into taxable income.
- Old Colony Trust–type inclusion principles apply when a third party discharges a taxpayer’s legal obligation as a benefit to the taxpayer; they do not apply where the taxpayer already satisfied the obligation and later receives damages for malpractice or similar wrongdoing.

## Conclusion

The Board concluded that the tax counsel’s indemnity payment functioned as compensation for Clark’s out-of-pocket loss from erroneous advice, not as a payment of Clark’s tax, and therefore did not create taxable income in 1934.


Clark v. Comm’r, 40 B.T.A. 333 (B.T.A. 1939)