Comparative negligence defense in tax return preparation malpractice actions.
The following is an overview of this legal defense and its evolution in the field of accounting malpractice. It also examines how the comparative negligence defense can apply in the context of tax return preparation and tax planning in general. CPAs should familiarize themselves with the strategies below in order to enhance the effectiveness of this line of defense.
When a client sues an accountant for malpractice, there are generally two different theories that may underlie the client's cause of action. The more common theory rests in negligence. Most courts will characterize malpractice claims as asserting a negligence claim, unless the defendant has undertaken to achieve a specific result; accordingly, most claims are subject to the comparative negligence defense. To establish negligence, an aggrieved client must demonstrate satisfaction of the following four elements (George Spellmire and Debra Winiarski, Accounting, Auditing, and Financial Malpractice, ch.1, section 1.03, 1998):
* The accountant owed a duty to the client.
* In carrying out that duty, the accountant breached the standard of care.
* This breach of the standard of care was the proximate cause of the injury.
* The client suffered damages.
Alternatively, some states permit clients to sue their accountants for breach of contract To establish a breach of contract, an aggrieved client must demonstrate satisfaction of the following four elements (Spellmire and Winiarski, ch. 1, section 1.05):
* A contract existed.
* The plaintiff complied with its own obligation under the contract.
* The defendant breached the terms of the contract.
* Damages resulted from the breach, and those damages were foreseeable at the time the contract was made.
The cause of action that the client seeks to advance, or that is available in the state in which the malpractice incident allegedly occurred, can have important repercussions. Among other things, negligence and breach of contract actions can carry different statutes of limitations, issues of privity, and measures of damage. A plaintiffs choice of action might also limit accountants' available lines of defense; in a contract action, for example, the invocation of comparative negligence is typically unavailable.
The historical antecedent to comparative negligence is contributory negligence, which is defined as follows: "A plaintiff's own negligence that played a part in causing the plaintiff's injury and that is significant enough (in a few jurisdictions) to bar the plaintiff from recovering damages" (Black's Law Dictionary, 8th ed., 2004). By way of comparison, that same edition of Black's Law Dictionary defines comparative negligence as follows: "A plaintiff's own negligence that proportionally reduces the damages recoverable from a defendant." For reasons of equity, most states have passed legislation endorsing the use of the comparative negligence defense, supplanting the contributory negligence defense (see http://www.mwl-law.com/PracticeAreas/Contributory-Neglegence.asp).
When contributory negligence dominated the legal landscape, courts attempted to ameliorate the all-or-nothing nature of this legal doctrine. This was particularly true when it came to accounting malpractice cases that involved auditing, epitomized in National Surety Corp. v. Lybrand (9 N.Y.S.2d 553 [19391), under which a contributory negligence defense was deemed viable only in those limited instances when a plaintiff's negligence directly interfered with a professional's ability to perform assigned duties (e.g., the plaintiff's refusal to allow an auditor to review critical books and records). Absent direct interference, negligent auditors could not escape malpractice liability simply by invoking the contributory negligence doctrine and pointing to some minor dereliction on the plaintiff's part (e.g., an inventory miscount).
For many decades, National Surety was the law of the land. But National Surety has ebbed in importance because the comparative negligence doctrine has gradually supplanted the contributory negligence doctrine--indeed, only the District of Columbia and the states of Alabama, Maryland, North Carolina, and Virginia still subscribe to the latter doctrine. In the context of tax return malpractice, National Surety has played almost no part in the resolution of such matters; its absence might signify its overall declining role in accounting malpractice cases--or, alternatively, the very different roles that accountants perform as auditors of their clients' financial records versus preparers of their clients' tax returns. The following section explores the application of the comparative negligence doctrine in the tax return preparation context.
Application of Comparative Negligence
The preparation of tax returns is not a one-sided endeavor. Ideally, there is a constant flow of information between a taxpayer and a preparer in such a manner that the product is a tax return that accurately portrays the taxpayer's income, deductions, credits, and ultimately tax liability.
But this exchange of information is often less than ideal. On the one hand, it is sometimes the accountant who is at fault. For example, the accountant might fail to solicit accurate information from the client (e.g., actual number of annual hours worked on a job), and the reporting of this inaccurate information might prove to be financially detrimental to the client (e.g., resulting in a loss disallowance under the passive activity rules). On the other hand, sometimes it is the taxpayer who is at fault. For example, a married couple might not divulge to their accountant that they have a hidden Swiss bank account, the existence of which must be reported and the income taken into account on their income tax return.
Fault might not lie entirely with either the client or the accountant; instead, both parties might have played a contributing role in the production of an inaccurate tax return. It is these instances when a comparative negligence defense can potentially come into play. Two cases help illustrate those instances when fault may lie with both parties.
In the first case, Bartlett v. Jacobs Jr. (477 S.E.2d 693 ), a client commenced a malpractice action against his accountant for faulty tax return preparation that failed to report income. The accountant's defense--which both the presiding lower court and the appeals court ruled had merit--was that the client never reviewed the tax returns before signing them. The accountant observed that if the client had done so, he would have undoubtedly noticed substantial omissions of income.
In the second case, King v. Neal (19 P.3d 899 ), the IRS disallowed two deductions, and a taxpayer sued his attorney/tax preparer for failing to prepare the taxpayer's return in an accurate fashion. Using a comparative negligence defense, the attorney/tax preparer argued that he reported the deductions based upon incorrect and incomplete information--information that was supplied by the client. Ultimately, after the attorney/tax preparer utilized this defense, a jury found him 70% at fault and the client 30% at fault.
To date, there are no reported accounting malpractice cases that examine the commonplace scenario in which a taxpayer claims tax deductions (e.g., for meals or entertainment expenses) that are unsubstantiated and, therefore, not deductible under Internal Revenue Code (MC) section 274 (d). Although it's easy to envision that clients might blame their accountants for failing to demand adequate substantiation documentation, accountants will likely point out that they are not surrogates for the IRS. While tax professionals have a responsibility to inquire whether such adequate documentation exists, they are not obligated to explore whether it demonstrates the deductible nature of the purported expense. These two opposing positions illustrate when a comparative negligence defense in an accounting malpractice setting might readily come into play.
Aside from reducing the financial damage award accorded plaintiffs, a comparative negligence defense can produce a secondary benefit. Insurance malpractice carriers typically underwrite their coverage policies by examining "run totals" that is, the aggregate costs incurred in covering a practitioner during the course of a malpractice suit. To the extent that a comparative negligence defense speeds settlements, mitigates damages, or brings about successful litigation outcomes, the run totals of an accountant being sued can be minimized. By maintaining a tight lid on litigation run totals, accountants can keep their future malpractice premiums under control.
Strengthening the Defense
Individuals who retain tax professionals to prepare their tax returns expect that the advice they receive will be accurate and timely. To be safe, accountants should assume that their clients are versed in neither tax law nor the tax return submission process.
Consider a simple example: A client retains an accounting firm to perform tax preparation services and, in February of a given year, supplies the firm with all of the tax information returns that she has received. By April 15, if the accounting firm has not forwarded a completed tax return to her to be filed, the firm cannot point an accusatory finger at the client or claim that the client was de facto on notice to file an extension because everyone, including the client, knows when income tax returns are due.
To avoid these situations, tax professionals should engage their clients in the tax return completion process. From the outset, communication is crucial. Engagement letters, for example, should specify in detail the scope of the accountant's responsibilities, as well as those of the client. Filing deadlines, substantiation requirements, the need for accurate appraisals, or anything else requiring the client's attention should be spelled out in a clear, concise, and timely manner and should be memorialized in writing. Furthermore, accountants must ask their clients to read and review the prepared tax returns for accuracy; having clients simply sign tax returns that they have not reviewed significantly undermines the viability of a comparative negligence defense.
Clearly communicating clients' responsibilities also extends to tax planning. Tax professionals must delineate those responsibilities that they are willing and able to shoulder, as well as those areas where they lack the necessary expertise. If a client is considering making an investment in a tax shelter, for example, the client's accountant should document that whether a particular investment has sufficient economic substance to be considered bona fide under the IRC rests entirely with the client.
In a recent case, an accounting firm that was being sued for malpractice countered with a comparative negligence defense; however, the presiding court chastised the defendant firm with the following cautionary advice:
Had the [accounting firm] provided a retention agreement, outlined the specific tasks they agreed to undertake, the relevant deadlines or obligations either party was to meet, prepared estimated taxes for [the client] to sign, prepared an application of extension of time for [the client] to sign, or explicitly notified [the client] the deadline by which to file the estates taxes was April 13, 2003, this matter may not have come to this point. (Stiles v. Lilly, 2011 WL 5299295 Mel. Sun. Ct. 20111)
Foresight will go a long way to ensuring the viability of a comparative negligence defense; if accountants hope to invoke this defense and hold their clients partially responsible for the resulting damages, they must put the clients on explicit notice regarding the clients' responsibilities and the scope of their obligations early in the relationship.
Being named in a professional malpractice suit is one of the singularly worst aspects of conducting an accounting practice; however, accountants need not simply wave a white flag every time they are sued and function as underwriters for the damages that their clients sustain as a result of the tax return submission process. When clients are responsible--in whole or in part--for the tax consequences they have brought upon themselves, they should have to bear or share culpability and the resulting financial burden. This is exactly when the comparative negligence defense comes into play.
The comparative negligence defense can potentially play a significant role in reducing a tax professional's malpractice exposure during the tax return preparation process. For this defense to be viable, however, CPAs must take steps to ensure that clients understand that they, too, have responsibilities that they must be willing to honor and adhere to.
Jay A. Soled, JD, LLM, is a professor of accounting and information systems at Rutgers University, Newark, N.J.
|Printer friendly Cite/link Email Feedback|
|Title Annotation:||accountant's liability|
|Author:||Soled, Jay A.|
|Publication:||The CPA Journal|
|Date:||Nov 1, 2012|
|Previous Article:||Fiduciary financial management in Nonprofit Organizations.|
|Next Article:||A Uniform CPA exam, but not-so-uniform requirements: education and licensure rules vary among states.|