Advisers beware: the cost of being sued is going up: courts in South Dakota and Pennsylvania held in favor of the taxpayers/plaintiffs on the recovery of interest paid on a tax liability in an accounting malpractice lawsuit. This article discusses these new cases and the existing case law from other jurisdictions on the issue.

• Author: Lynch, Michael

EXECUTIVE SUMMARY

* 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.

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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 professional 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...