Privity, statute of limitation in tax case.

The New York County Supreme Court ruled investors who are limited partners have standing to sue the limited partnership's accounting firm if the accountants' relationship to the partnership approaches privity.

The case began when the IRS disallowed certain interest deductions taken by the general partners for several limited partnerships. Price Waterhouse prepared the partnerships' tax returns and K-1s from the partnership's inception in 1980 through 1988.

During this period, Price applied the "rule of 78s," which allocates greater interest in the early years of a debt relative to later years. In 1983, an IRS revenue ruling disallowed the rule of 78s on any amount exceeding the economic accrual of interest.

The partnerships' tax counsel, consulted by Price, said the revenue ruling would more than likely fail if challenged in court. Based on this opinion, Price continued to apply the rule of 78s through 1988. That year, in an unrelated case, the Tax Court held the disallowance valid. The court said the rule had no legal or accounting authority to justify its use for computing long-term loans.

As a result, the limited partners were required to pay substantial added tax, penalty and interest to the IRS. A group of limited partners sued the partnerships and received a settlement of approximately $40 million. The limited partners then sued Price for negligence in calculating interest on the partnership debt.

The court ruled even if the accounting firm is engaged solely by a limited partnership, the limited partners may sue if there is a relationship so close as to approach privity. The court defined the client-accountant relationship as close to privity if the accountants were aware the financial reports were to be used for a particular purpose by a known party and the accountants' conduct showed understanding of that reliance.

The court noted the delivery of Price's letters and forms to the limited partners was an adequate allegation of a privity relationship between the parties.

The court also ruled the statute of limitations began to run when the limited partners received their respective 90-day letters from the IRS, since this was the date the legal obligation to pay the tax claim began. The court rejected the 30-day letters from the IRS, which the limited partners also received, as the date for commencement because no legal obligation to pay arose at that point.

An injury does not occur, the court said, and thus the statute of limitations period does not begin until the IRS challenges a tax return by issuing a final notice of proposed deficiency (in this case, the 90-day letters). (Ackerman v. Price Waterhouse, 591 N.Y.S.2d 936)