The number of malpractice cases brought against tax advisers for negligent tax advice has increased greatly in recent years. In most of these cases, the plaintiffs attempt to recover interest charged by the IRS on the tax liability that is a result of the adviser’s negligence.
There is no national rule regarding the recovery of interest, and the issue has been decided in the courts on a state-by-state basis, with some states yet to address the issue. Traditionally, recovery of interest is not allowed as a matter of law; however, in an increasing number of states, courts have held that the issue is a matter of fact and allow recovery if a plaintiff can prove damages.
Courts in South Dakota and Pennsylvania held in 2006 that the recovery of interest is possible and is a matter of fact to be decided on a case-by-case basis.
Negligent tax advice leads to most malpractice claims filed against CPAs. When a taxpayer relies on this erroneous advice and is harmed, the courts will attempt to compensate the taxpayer. In assessing damages, most courts agree that the tax deficiency itself is seldom recoverable; however, in cases of accounting malpractice, courts split on whether or not interest assessed by the IRS on the deficiency is recoverable.
In 2005, at a Tax Executives Institute conference, IRS Chief Counsel Donald Korb commented that he anticipates a “marketplace response” to tax shelters in the form of malpractice lawsuits. He called the lawsuits the “100,000-pound gorilla that’s overlooking all of the tax professionals today.” Korb said that the suits could provide a “new tool to keep people under control.” Korb further predicted that the law will develop so that tax advisers will be held accountable in some way.1
Recent case law is proving Korb right. There has been an avalanche of new suits, and new law is developing. Courts have been changing direction on IRS assessments of interest on unpaid tax liabilities in malpractice cases and have begun to award damages for interest. In such cases, that interest often doubles or triples the amount awarded to the taxpayer/plaintiff.
This article explores the circumstances surrounding the awarding of such interest. It analyzes the prior case law, discusses the decisions in two recent cases, and considers the future treatment of interest in accounting malpractice suits.
Treatment of Accrued Interest: A Two-Sided Issue
Currently no national legislative standard exists for allowing a taxpayer to recover interest charged by the IRS on an unpaid tax liability from a negligent defendant in an accounting malpractice suit. Rather, various federal and state courts have established case law in their jurisdictions.2 In some jurisdictions, the issue is treated as a question of law under which taxpayers can never recover interest, while in others it is treated as a question of fact under which taxpayers can recover interest if they can prove that they suffered damages due to the negligence of the defendant tax adviser.
Question of Law—No Recovery Allowed
Alaska, California, New York, and Washington treat interest recovery as an issue of law and follow a rule (called the blanket rule) that prohibits the recovery of such interest. Their position rests on two pillars: (1) the “windfall effect” theory and (2) the speculative nature of the causation of the damage.
The windfall-effect theory refers to a taxpayer’s ability to realize a profitable return on the monies that would have otherwise been applied to the tax liability and to recover damages for interest owed to the IRS. This scenario is equivalent to the taxpayer’s receiving an interest-free loan. Under this theory, the taxpayer is not economically damaged by having to pay interest to the IRS and is therefore not entitled to recover such payment from the negligent adviser.
The second pillar states that damages realized due to a poor investment (or lack thereof) of the unpaid tax liability are too speculative to blame on the negligent adviser. This argument is strongest if the interest rate charged by the IRS is at or near the market interest rate; then the Service is merely charging the taxpayer a nominal rate of interest for the use of its monies over an extended period of time. Of course, this is not always the case.
In Orsini v. Bratten, 3 a lawyer/CPA (Orsini) was sued by the taxpayer (Bratten) for negligence in a prior pro-fessional malpractice suit. The trial court granted the taxpayer damages, including accrued interest on the tax liability related to an investment that, on IRS audit, was deemed not to qualify for investment tax credits. Orsini appealed, among other things, the court’s award of the interest paid to both federal and state governments on the deficient tax liability. The Supreme Court of Alaska cited a presumed windfall effect to the taxpayer and ruled that since the taxpayer had prolonged use of the money beyond the due date to the government, the money presumably earned interest during that time. Therefore, the taxpayer’s payment of interest to the IRS did not substantially worsen his condition.
A similar verdict was rendered in Alpert v. Shea Gould Climencko & Casey. 4 In this case, the interest was due to the disallowance of deductions claimed by the taxpayers on their investment in a tax shelter caused by negligent advice. The Supreme Court of New York ruled that the recovery of interest by the taxpayers would constitute a windfall and therefore barred the recovery of such interest in an accounting malpractice suit.
In Eckert Cold Storage, Inc. v. Behl, 5 the taxpayer argued that Grant Thornton LLP was negligent in confirming the taxpayer’s representations of certain tax deductions related to a tax shelter. Regarding interest recovery on the tax liability attributable to the disallowed deductions, a California district court held that the market rate of interest charged by the IRS did not damage the taxpayer due to a presumed windfall effect. Although the taxpayer argued that it could not invest the money and earn interest on it because the money was tied up in the shelter, the court held that the investment in the shelter itself constituted “use” of the money.
Similarly, in Leendertsen v. Price Water- house, 6 the IRS imposed penalties on a taxpayer for an excessive tax refund, including payment of interest on the refund. The taxpayer sued both a local accounting firm and Price Waterhouse, citing negligence on the part of the tax preparers.The local accounting firm settled out of court, but Price Waterhouse took the case to trial, where it introduced evidence indicating that the taxpayer had benefited from an investment that the excessive refund had helped finance. However, the jury sided with Leendertsen, awarding the taxpayer compensatory damages, including interest. On appeal, the Washington Court of Appeals barred the award of interest to the taxpayer, holding that the taxpayer had use of the money and would be “unjustly enriched” by obtaining payment from the defendants for the use of the money.7
Question of Fact—Recovery Possible
Several jurisdictions discern an error in an absolute presumption against interest recovery on a tax liability, noting that many taxpayers have neither the foresight nor the ability to invest the delinquent funds. Under these circumstances, a taxpayer’s payment of the interest to the IRS may be directly due to the defendant/adviser’s negligence; therefore, the payment should not be perceived as a cost for the extended use of someone else’s money. Jurisdictions taking this position include Arizona, Illinois, New Jersey, Oklahoma, and Oregon. In cases argued in these jurisdictions, each party can present its position regarding the recovery of such interest, but the ultimate burden of proof is on the taxpayer. Historically, such decisions have focused on a comparison of the taxpayer’s current position with his or her probable position absent the negligent advice.
In Wynn v. Estate of Holmes, 8 the estateof a deceased accountant who negligently prepared a return was ordered to pay interest on a tax liability related to an excessive loss taken on the return. The taxpayers were originally awardedthe full amount of the interest they had paid to the IRS. On appeal, the defendant cited a windfall effect, presenting evidence showing the interest income that the taxpayers could have received had they invested the outstanding tax liability in certificates of deposit while the interest charge had accrued.
The Oklahoma Court of Civil Appeals held in favor of the taxpayers for two reasons. First, it found that the defendant could not argue for a setoff of the value of the use of the outstanding tax liability against the interest paid due to the collateral source rule. The collateral source rule states that payments to an injured party from a collateral source (here, the earnings from investing the outstanding tax liability) cannot benefit a wrongdoer by lessening the damages recoverable from him or her.9 Second, the court ruled that although such an investment presumably could have existed, there was no evidence indicating that such an investment did exist. The court therefore affirmed the ruling awarding interest in full to the taxpayers as a portion of the total damages assessed.
In Dail v. Adamson, 10 the taxpayer appealed a trial court decision barring the recovery of accrued interest paid to the IRS for the improper filing of sales tax returns due to the negligence of the taxpayer’s accountant. The trial court cited the speculative nature of the value of such interest to the taxpayer. The Appellate Court of Illinois stated that “the appropriate measure of damages is the difference between what the [taxpayers] would have owed in any event if the tax returns were properly prepared, and what they owe now because of their accountants’ negligence, plus incidental damages.”11 The court recognized that the payment of interest was directly due to the accountant’s negligence and awarded the taxpayer full recovery of the accrued interest paid to the IRS. An Arizona court in Jobe v. International Insurance Co., 12 following a similar line of reasoning, ruled that the interest recovery was allowable as a portion of the damages paid to the taxpayer in an accounting malpractice suit.
In McCulloch v. Price Waterhouse LLP, 13 the taxpayer argued that accrued interest assessed by the IRS relating to the taxpayer’s mother’s estate was due to accounting negligence, a breach of fiduciary duty, and unlawful trade practices by the accounting firm. Therefore, the taxpayer sought to recover the interest as part of the overall damages awarded. The defendants cited the blanket rule adopted by other jurisdictions as reasoning against such a reward. Neither of the rationales of the blanket rule (the windfall effect and the speculative nature of the causation of the damage) persuaded the court to bar the award of such interest. The court stated that under certain circumstances the taxpayer may not have received a windfall, such as when the taxpayer is unable to invest the money from the tax liability, and that although causation of damages is speculative, it is a question of fact that can be decided by a jury. Therefore, rather than establishing an inflexible rule, the court held that awards for accrued interest should be determined on a case-by-case basis, with the burden of proof placed on the taxpayer/plaintiff.
In Ronson v. Talesnick, 14 the taxpayers sought to recover as damages the accrued interest resulting from disqualified loss deductions related to tax shelters claimed on a corporate return. On the advice of their accountant, the taxpayers posted a bond in order to stop the interest accrual. However, the advice proved to be negligent, and the amount of interest due to the IRS skyrocketed. The defendant argued that such an award was contrary to established law.
Citing the collateral source rule and the benefits rule,15 a federal district court applying New Jersey law awarded the taxpayers accrued interest damages as part of the total damages in the accounting malpractice suit. In accordance with the benefits rule, the court further held that the value of any benefits realized by the taxpayer resulting from the extended use of monies due to the IRS should reduce the total amount of damages awarded, contingent on the defendant’s ability to prove the existence of such benefit. This outcome not only prevents a windfall but also holds the defendant accountable for any damages that he or she may have caused through negligent behavior.
As the cases discussed above show, the treatment of interest due or paid to the IRS in an accounting malpractice suit has spurred much debate within courts nationwide. Many jurisdictions have yet to establish their positions about whether the recovery of such interest can be considered a part of the damages awarded to the taxpayer/plaintiff. In 2006, courts in Pennsylvania and South Dakota addressed the issue for the first time.
O’Bryan v. Ashland
The Supreme Court of South Dakota addressed the recovery of interest in O’Bryan v. Ashland. 16 In O’Bryan, Doug O’Bryan, Joni O’Bryan, and Doug O’Bryan Contracting, Inc. (O’Bryan) sued Bruce Ashland (an accountant) for filing improper federal income tax returns related to the contracting business. O’Bryan sought recovery of the additional expenses incurred to correct the faulty returns and of the accrued interest assessed on the outstanding tax liability.
The O’Bryan business, which had previously been treated as a sole proprietorship, was incorporated effective April 1, 1995, based on the professional advice of Ashland. However, Ashland failed to report O’Bryan’s income for the first quarter of 1995 on the cash basis of accounting and instead erroneously used the accrual basis. As a result, O’Bryan’s tax liability for 1995 was understated, and the IRS ordered it to pay $239,933 of tax liability and $50,000 of accrued interest. Furthermore, Ashland failed to use an Indian Employment Tax Credit on O’Bryan’s 1994 return. At trial, Ashland conceded to negligent behavior. Although the circuit court ruled that as a matter of settled law the $239,933 outstanding tax liability could not be included in damages because it was solely O’Bryan’s obligation, the court left the decision to award damages for the accrued interest to the jury’s discretion.
Each party offered expert testimony on the accrued interest. Ashland argued that O’Bryan was not damaged by paying the interest because it would have had to borrow funds in order to pay the tax liability had the return been correctly filed. The interest rate on such borrowing (10.5%) would have been higher than that being charged by the IRS (4–9%). Furthermore, O’Bryan’s prolonged control over the $239,933 beyond its tax due date would be equivalent to an interest-free loan if the company was reimbursed for the interest.
O’Bryan argued that the interest charged by the IRS directly damaged the business. Ashland should have incorporated the business at the beginning of the tax year so that O’Bryan could take advantage of the three-year rule of Regs. Sec. 1.481-2(a),which would have allowed it to make tax payments on the $790,000 of accounts receivable taxed in 1995 over a three-year period rather than in one year. Under this scenario, O’Bryan claimed that it would not have had to borrow money to cover the payments and therefore would not have incurred an interest expense.
The jury decided that O’Bryan had been directly damaged by Ashland’s negligent behavior and included $39,038.03 of accrued interest as part of the damages awarded. This amount represented the time period from October 10, 1996, the date that the faulty return was filed with the IRS, to June 23, 1998. Ashland appealed the decision, arguing that under the blanket rule, such payment could not be awarded in an accounting malpractice suit.
After considering its own precedent and case law from other jurisdictions, the Supreme Court of South Dakota held that interest is recoverable in an accounting malpractice suit. In particular, the court relied on its holding in Lien v. McGladrey & Pullen. 17 In that case, the court ruled that the appropriate award of damages in an accounting malpractice suit is the difference between what the taxpayer would have paid absent any negligent behavior and what was actually paid as a result of the accounting negligence, plus any incidental damages. Although the ruling did not explicitly call for the award of accrued interest in an accounting malpractice case, the court stated that it effectively laid the foundation for such a rule.
The court further emphasized that the purpose behind awarding compensatory damages in a malpractice suit is to “make the injured party whole.”18 Recognizing that there are circumstances in which the taxpayer is directly damaged by interest payments on tax liabilities arising from a tax preparer’s negligence, the court refused to adopt the blanket rule as called for by the defendant. Rather, it held that such a determination should be made on a case-by-case basis, with both parties having an equal opportunity to argue their positions. The court also indicated that it agreed with the general principle that the ascertainable value of any benefits realized by the taxpayer as a result of the continued use of monies that should have been paid to the IRS should reduce the total damage assessment to an equitable extent.
After establishing the recoverability of interest in an accounting malpractice suit, the court addressed the facts in the case. O’Bryan argued that incorporating its business at the beginning of the tax year would have invoked the three-year rule, under which O’Bryan could have paid its tax liability without borrowing any money. O’Bryan also contended that in the absence of the three-year rule, it could have borrowed the necessary funds from family members in order to pay any taxes due to the IRS, as it had done in the past. Ashland responded that the use or nonuse of the three-year rule was irrelevant to the case at hand and that, barring any negligent behavior, O’Bryan would have had to borrow monies at an interest rate higher than that charged by the IRS in order to pay off its tax liability.
The court ruled in favor of O’Bryan, finding that the trial court did not err in determining that the business did not use the monies related to the tax liability to benefit financially and that, rather than borrowing from a lender to pay the taxes absent the invocation of the three-year rule, O’Bryan could have borrowed from the family at an interest-free rate. However, the court declined to decide whether in South Dakota any benefits a plaintiff may have obtained from a defendant’s negligence should be offset against the accrued interest because neither party raised the issue.
Amato v. KPMG LLP
In Amato v. KPMG LLP 19 (Amato I), a group of wealthy investors filed a complaint in the Court of Common Pleas of Luzerne County, Pennsylvania, relating to their participation in an investment strategy known as an offshore portfolio investment strategy (OPIS). The IRS and the Common-wealth of Pennsylvania had disallowed substantial tax losses taken by the investors as a result of the OPIS transaction. The investors brought suit against all the parties involved in the marketing and sale of the abusive tax shelter, seeking the return of lost profits, restitution of fees, and recovery of accrued interest paid to the IRS. In 2006, a Pennsylvania district court ruled in favor of the plaintiffs and awarded them lost profits and restitution of fees. However, the court dismissed the claim for the recovery of interest.
The decision rendered by the Supreme Court of South Dakota in O’Bryan v. Ashland initiated the filing of a motion for reconsideration by the plaintiffs in Amato I on the treatment of the interest paid to the IRS on the tax liability (Amato II).20 Historically, motions of reconsideration are granted sparingly because federal courts believe in the finality of past judgments, but after reviewing the submissions by the parties and the applicable case law, the district court determined that the issue was substantial and granted the motion for reconsideration. Finding that no Pennsylvania case law directly addressed the issue, the court analyzed the case law from other jurisdictions on the issue. Pointing primarily to discussion of the issues in the Ronson and O’Bryan opinions, the court rejected the blanket rule and held that interest recovery as a part of the total damages in an ac-counting malpractice suit is an issue of fact to be decided on a case-by-case basis, with the burden of proof on the taxpayer.
The recoverability of interest charged by the IRS on an unpaid tax liability arising from an adviser’s negligence in an accounting malpractice suit is an issue that has “divided the courts around the country.”21 The O’Bryan and Amato II decisions have continued the trend toward applying a flexible, facts-based approach to the issue. Both decisions favored the taxpayer in allowing the accrued interest paid to the IRS on an outstanding tax liability to be included in the award of total damages paid to the plaintiff in an accounting malpractice suit. These rulings are of increasing interest to taxpayers and practitioners alike because the line of reasoning involved seems likely to be followed by many more jurisdictions in the near future.
The old argument favoring a blanket rule under which accrued interest should not be included as part of the damages awarded an innocent plaintiff in an accounting malpractice suit is quickly losing adherents. Courts are finding the rationales supporting the blanket rule—the windfall effect and the speculative nature of the causation of the damage—to be overly presumptuous. Specifically, cases such as O’Bryan and Amato II reflect courts’ reluctance to assume that the taxpayer could have and should have invested deferred tax monies in such a manner as to generate interest income comparable to the interest payments charged by the IRS. However, these courts are not claiming that such interest must be recovered in order to restore the taxpayer/plaintiff to his or her original position when negligent behavior is proven. Rather, the holdings in these recent cases are opting for a middle path between two extremes.
In both O’Bryan and Amato II, the courts ruled that the recovery of such interest is allowable in an accounting malpractice suit. However, the burden of proof has been placed on the taxpayer to show that he or she was directly damaged by having to pay the accrued interest. Furthermore, the defendant may argue that the taxpayer received an incremental benefit from the extended use of the tax money and can move to have such a benefit reduce the damages awarded to the plaintiff. In other words, the question of allowing interest on a tax liability as a part of the damages awarded to a taxpayer/plaintiff in an accounting malpractice suit is changing from one of law to one of fact, where the specific circumstances of each case and the testimonies of both parties will play the major roles in determining the amount of interest awarded.
With the number of accounting-related malpractice lawsuits on the rise, the issue of how to treat accrued interest is bound to appear in jurisdictions where the issue has not yet been decided. The argument for its potential inclusion in the total amount of damages awarded favors the innocent taxpayer and, in many cases, it is not unusual for the amount of accrued interest to double or triple the amount awarded to the plaintiff. As judicial reasoning evolves, taxpayers and practitioners alike must take notice, because the next case could be in their own jurisdiction.
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1 Kenney and Sheppard, “Korb Predicts Shelter Malpractice Suits,” 2005 TNT 216-2, November 9, 2005.
2 State tort law governs most malpractice actions. Federal courts become involved when there is a diversity of residences among the parties.
3 Orsini v. Bratten, 713 P2d 791 (Alaska 1986).
4 Alpert v. Shea Gould Climencko & Casey, 559 NYS2d 312 (N.Y. App. Div. 1990).
5 Eckert Cold Storage, Inc. v. Behl, 943 FSupp 1230 (E.D. Cal. 1996).
6 Leendertsen v. Price Waterhouse, 916 P2d 449 (Wash. Ct. App. 1996).
7 Id. at 451.
8 Wynn v. Estate of Holmes, 815 P2d 1231 (Okla. Ct. App. 1991), overruled in part by Stroud v. Arther Andersen & Co., 37 P3d 783 (Okla. 2001).
9 Id. See also Ronson v. Talesnick, 33 FSupp2d 347 (D. N.J. 1999).
10 Dail v. Adamson, 570 NE2d 1167 (Ill. App. Ct. 1991).
11 Id. at 1169, quoting Thomas v. Cleary, 768 P2d 1090, 1091–1092, n.5 (Alaska 1989).
12 Jobe v. International Ins. Co., 933 FSupp 844 (D. Ariz. 1995), opinion withdrawn as part of settlement agreement, 1 FSupp2d 1403 (D. Ariz. 1997).
13 McCulloch v. Price Waterhouse LLP, 971 P2d 414 (Or. Ct. App. 1998).
14 Ronson v. Talesnick, 33 FSupp2d 347 (D. N.J. 1999).
15 The benefits rule states that “[w]hen the [d]efendants’ tortious conduct has caused harm to the plaintiff or to his property and in doing so has conferred a special benefit to the interest of the plaintiff that was harmed, the value of the benefit conferred is considered in mitigation of damages, to the extent that this is equitable.” Id. at 354 (quoting Restatement (Second) of Torts §920 (1979)).
16 O’Bryan v. Ashland, 717 NW2d 632 (S.D. 2006).
17 Lien v. McGladrey & Pullen, 509 NW2d 421 (S.D. 1993).
18 O’Bryan, 717 NW2d at 639, citing Hulstein v. Meilman Food Indus., Inc., 293 NW2d 889, 891 (S.D. 1980) (citing Ralston Purina Co. v. Jungers, 199 NW2d 600 (S.D. 1972)).
19 Amato v. KPMG LLP, 433 FSupp2d 460 (M.D. Pa. 2006), vacated in part for reconsideration, 2006 U.S. Dist. LEXIS 57091 (M.D. Pa. 2006). The initial state case was removed to federal district court.
20 Amato v. KPMG LLP, 2006 U.S. Dist. LEXIS 57091 (M.D. Pa. 2006).
21 O’Bryan, 717 NW2d at 636.