Court rules on statute of limitations.

In a ruling detrimental to accountants in California, the state's Supreme Court ruled that the statute of limitations in an accounting malpractice case does not commence until the tax deficiency is assessed by the Internal Revenue Service.

The plaintiff, International Engine Parts Inc. (IEP), had hired defendant Feddersen and Co., a CPA firm, to prepare the 1983 and 1984 income tax returns of its subsidiary, IEPO, an export company incorporated as a domestic international stock corporation (DISC). Among the requirements to maintain DISC status is the proper documentation of certain loans and intercompany pricing agreements. The firm failed to provide this documentation for the 1983 and 1984 tax returns.

In 1984 the IRS audited IEPO's tax returns and in 1986 advised IEPO that because the firm had failed to provide proper documentation for certain loans, it would disqualify the company as a DISC. Soon thereafter, the firm, which was representing IEPO before the IRS, informed IEPO that its federal tax liability for 1983 and 1984 could be approximately $300,000. This was an increase due to the IRS position in the case. At about the same time, in anticipation of the IRS assessment, IEPO's bank reduced its line of credit from $600,000 to $400,000.

After a June 1987 preliminary audit report to the accounting firm in which the IRS confirmed that it was disqualifying IEPO's DISC status and imposing additional tax, a penalty and interest, IEPO sued the firm for accounting malpractice on May 15, 1990.

The trial and appellate courts both granted summary judgment in the firm's favor. Although they separately ruled that IEPO suffered actual harm in 1986 when its line of credit was reduced or, at the latest, in June 1987, when the IRS issued a preliminary audit report, the plaintiff's suit was barred by the statute of limitations.

The plaintiff appealed to the California Supreme Court. The issue before the court was whether actual harm had occurred before June 1987, when IEPO had sufficient notice of the firm's negligence, or on May 16, 1988, when the IRS assessed the deficiency and penalties against the company.

The court ruled for the plaintiff, saying that the statute of limitations did not begin to run until the IRS assessed final notice of tax deficiency. Actual injury occurred when the IRS issued its penalty tax assessment on May 16, 1988, rather than when IEPO's line of credit was reduced by $200,000. Although the firm's alleged negligence may have been "discovered" during the audit, such potential liability could not amount to actual harm until the date of the final assessment. This ruling allows the client to wait until after the audit to sue the allegedly negligent accountant. (International Engine Parts, Inc. v. Feddersen and Co., 9 Cal. 4th 606.)