Texas Supreme Court rules on tax statute of limitations in malpractice case.

The Texas Supreme Court ruled that the statute of limitations in a plaintiff's cause of action against an accounting firm in a tax malpractice case had started running when the plaintiff received an IRS notice of deficiency. The plaintiff, Colonial Food Stores, Inc., which operated more than 125 convenience stores in Texas, had three major shareholders who wanted to sell the business if each could receive $2 million net of taxes or other obligations. The price offered by the most promising purchaser, National Convenience Stores, would not yield this amount unless Colonial's tax obligations were based on depreciated cost instead of fair market value. By this allocation of the purchase price, Colonial Food Stores could avoid recognizing any taxable gain on the sale of its equipment.

Colonial's accountant and auditor, Touche Ross & Co. (now Deloitte & Touche), discussed the sale at a meeting with the client on April 27, 1983. Colonial Food Stores alleged the firm said the proposed tax treatment was proper. On October 27, 1986, the Internal Revenue Service advised Colonial's stockholders that it had not approved the allocation of the sales proceeds to equipment and that additional taxes were due. It issued a formal deficiency notice on June 11, 1987. Colonial's shareholders filed suit in U.S. Tax Court on September 8, 1987, but settled with the IRS before trial. The Tax Court entered its final decision on November 16, 1989. On April 5, 1990, the IRS assessed $735,596 in taxes and interest, which Colonial Food Stores paid. Then, on June 11, 1991, Colonial's shareholders sued the accounting firm alleging negligent tax advice.

When accrual begins

The issue before the Texas Supreme Court was determining when the statute of limitations applies to accounting malpractice claims involving tax advice. The firm argued that such claims begin to accrue when the taxpayer knows or should have known that the advice received was faulty--certainly no later than the IRS's issuance of a formal deficiency notice triggering the taxpayer's right to sue in Tax Court. The plaintiffs argued that such claims do not begin to accrue until any litigation is completed and the IRS has issued an assessment of taxes.

In ruling for the accounting firm, the court applied the discovery rule, under which a claim occurs when the claimant knows or should have known of the wrongful act and resulting injury. In most discovery-rule cases, the date a person has knowledge of accounting malpractice depends on the circumstances of the case. In this case, in which the evidence does not establish when plaintiffs knew or should have known that the tax advice was flawed, the deficiency notice marks the latest date on which their malpractice action could have begun to accrue. (That is, at this point the plaintiffs should have known the advice was faulty.) As the deficiency notice arrived four years before the plaintiff; filed suit against the firm, their claims were barred by the two-year statute of limitations unless the running of limitations was "tolled," or stopped, by the Tax Court litigation.

The advice was right ... and wrong

The plaintiffs contended that such a tolling applied in this case. They argued that if they had been required to file their malpractice claim while the Tax Court case was pending, they would have been forced to take inconsistent positions: They would have had to argue to the Tax Court that the accounting firm was correct in its advice, while in the malpractice case they would have had to argue that the accounting firm was incorrect in its advice. The court rejected this argument, noting that although having both the tax and malpractice suits prosecuted at the same time would have required the plaintiffs to take inconsistent positions, they could have avoided this by requesting the court to "abate" the malpractice case pending resolution of the tax case.

Firms rest easy

This case is significant to the accounting profession because the highest court in a commercially significant state has placed definitive restrictions on how long a plaintiff can wait to bring an accounting malpractice action. This allows accountants some certainty that tax work they did several years ago cannot come back to haunt them indefinitely. (Thos. D. Murphy, Jr. et al. v. Robert Campbell et al., no. 96-0079, 41 Tex. Sup. Ct. Jour. 193)