October 19, 2011
Joe, CPA reimburses a client for a $75,000 tax liability that is traceable to Joe’s ineffective tax advice. For fear of increasing his malpractice premiums, Joe decides not to file a claim with his insurance company.
How much, if any, of the $75,000 paid to the client can Joe deduct using either causality loss or business expense?
Joe may not deduct the payment as a loss under Section 165 of the Code or as a business expense under Section 162 because Joe voluntarily elected not to file an insurance claim.
The IRS addresses this issue in Rev. Rul. 78-141, 1978-1 CB 58, where an attorney (who had malpractice insurance) paid a client for erroneous advice but did not file a claim against the insurer. The IRS found that the attorney could not deduct the payment as a loss under Section 165 or a business expense under Section 162.
Under Reg 1.165-1, only a bona fide loss is allowed. “Substance not mere form shall govern in determining a deductible loss.”
The IRS allows a deduction for any loss sustained during a year that was not compensated for by insurance. IRC § 165(a). Joe never allowed the insurance company an opportunity to cover this expense. In Bartlett v. United States, 397 F.Supp. 216 (D. Md.1975), the court disallowed a casualty loss deduction for damage to a personal automobile where the taxpayer declined to file an insurance claim although the taxpayer had a valid collision insurance policy. The court stated that the “economic loss the taxpayer sought to deduct did not arise from the causality, but rather arose from the taxpayer’s voluntary election not to claim or receive insurance proceeds to which the taxpayer was entitled.”
Also, the IRS allows for a deduction for ordinary and necessary expenses paid or incurred during the taxable year that relate to any trade or business. IRC...