Joseph M. McKenney v. United States, 973 F.3d 1291

In 2000 Mr. McKenny (sole beneficiary) implemented a tax strategy advised by Grant Thornton: an S corporation wholly owned by an ESOP to defer taxation on business income.
The ESOP allegedly was never properly formed or administered; Grant Thornton later paid $800,000 to settle malpractice claims while expressly denying liability.
An IRS audit for 2000–2005 found underpaid taxes tied to the S/ESOP transactions and the dealership arrangement; the McKennys ultimately paid $2,235,429 to the IRS in taxes, interest, and penalties and executed a closing agreement barring certain related deductions.
The McKennys sued Grant Thornton (state court), settled for $800,000 (2009), and then claimed on their tax returns (2009–2011) (a) business deduction for legal fees, (b) an unreimbursed loss equal to the shortfall between IRS payment and Grant Thornton recovery, and (c) exclusion of the $800,000 settlement as a return of capital.
The IRS issued a notice of deficiency disallowing those positions; the district court granted partial summary judgment for both sides (disallowed fees and loss; allowed exclusion). The Eleventh Circuit reviewed de novo.

Issue	Plaintiff's Argument	Defendant's Argument	Held
Deductibility of legal fees under §162(a)	Costs of suing Grant Thornton are ordinary & necessary business expenses because suit related to Mr. McKenny’s business tax-structure advice	Fees are personal in origin; suit sought recovery of personal tax liability and was brought on Plaintiffs’ behalf, not the business	Fees are not deductible as business expenses; affirmed for government
Deductibility of unreimbursed loss (difference between IRS payment and Grant Thornton recovery)	Loss reflects Grant Thornton’s partial reimbursement and thus is deductible	Closed IRS settlement (26 U.S.C. §7121) bars claiming deductions/losses relating to the covered ESOP transactions	Deduction barred by IRS closing agreement; affirmed for government
Tax treatment of $800,000 settlement (income vs. return of capital)	Settlement compensates Plaintiffs for malpractice-caused loss of capital (Clark v. Comm’r line) and thus is excludable as return of capital	Under Old Colony Trust and related authorities, third‑party payment of tax liabilities is taxable income; Clark is distinguishable and/or limited	Plaintiffs failed to prove entitlement/amount of exclusion by preponderance; district court’s grant for Plaintiffs reversed and remanded for judgment for government

Welch v. Helvering, 290 U.S. 111 (1933) (taxpayer bears burden to prove IRS deficiency incorrect)
Janis v. United States, 428 U.S. 433 (1976) (taxpayer in refund action must prove amount of recovery)
United States v. Gilmore, 372 U.S. 39 (1963) (deductibility depends on origin and character of claim)
In re Collins, 26 F.3d 116 (11th Cir. 1994) (litigation costs arising from non-income-producing trust held nondeductible)
Old Colony Trust Co. v. Commissioner, 279 U.S. 716 (1929) (third party discharge of taxpayer’s tax obligation is equivalent to receipt)
Clark v. Commissioner, 40 B.T.A. 333 (1939) (Tax Court ruling that negligent tax adviser indemnity may be excludable as compensation for loss)
Ellinger v. United States, 470 F.3d 1325 (11th Cir. 2006) (IRS closing agreements interpreted under contract principles)