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How to treat income?

Taxpayer's investment advisor convinces them to sell the IBM and to buy an annuity. State Office of Investment Regulation finds that the investment guy gave improper advice. (Like how often you see THAT happen?) Demands taxpayer be reimburses for the out- of-pocket tax and related effects of the sale.

I calculate that if the taxpapayer was reimbursed, and if that reimbursement was treated as ordinary income, they should get a payment of, say $50,000.

Investment campany agrees to pay, but they also cite the Arrowsmith case, and suggest that the taxpayer may want to consider treating the proceeds of the settlement as capital gains.

I'm not crazy about that. Something about it seems a little off- point.

What do you guys think?

Reply to
Tom C
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Consistent with the Arrowsmith Doctrine (Arrowsmith v. Commissioner, 344 U.S.

6), I believe the portion of the settlement that is to reimburse capital losses (potential or realized) should be reported as capital gain. The portion of the settlement that is to reimburse items that are deductions against ordinary income should be reported as ordinary income.

If the above doesn't absorb all of the $50,000 then I suspect the rest is ordinary income.

Reply to
Bill Brown

6), I believe the portion of the settlement that is to reimburse capital losses >(potential or realized) should be reported as capital gain. The portion of the settlement that is to reimburse items that are deductions against ordinary income

There were no capital losses. The IBM was sold at a terrific gain.

However, because taxpayer has a big tax bill due to bad investment advice, the settlement with the Department of Regulation required them to be reimbursed for those taxes. Taxpayer makes out alright, they effectively get a step-up in basis in their portfolio due to the recognized capital gain, plus they get reimbursed for the tax bill.

The investment company lawyer is making the suggestion that taxpayer might want to treat it as capital gain. They and their accountants are $500 an hour type guys.

That doesn't scare me, but then I didn't want to dismiss the idea, nor do I want my client to pay too much in taxes.

Reply to
Tom C

If the reimbursement is for an over payment of federal income taxes due to bad advice, then see Clark v. Comm?r, 40 B.T.A. 333 (1939), acq.

1957-2 C.B. 4, and Rev. Rul. 57-47, 1957-1 C.B. 3 where the reimbursement was determined to be not taxable. If the amount received goes beyond the excess taxes paid, then you will need to determine the reason for the excess in order to characterize it. E.g., if there's an amount that represents additional gain on the stock sold had the t/p held on to it: = LT Capital Gain.
Reply to
Alan

Thanks, but te situation wasn't an "overpayment of taxes," the taxes that will be paid are the correct amount. The taxpayers also benefit from the step-up in basis in the portfolio.

In Clark, the taxpayer was merely brought back to his original position where he would be had the return been prepared competently.

Reply to
Tom C

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