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Tax rate changes in malpractice cases.

In Oddi v. Ayco Corp., 947 F2d 257 (7th Cir. 1991), aff'g DC Ill., 1990, the Seventh Circuit held that the burden of proof on whether future tax rates will change fell on a tax adviser who made that assertion.

Oddi was a corporate executive with profit-sharing funds. He retired early and had to choose one of two alternatives for these funds: a lump-sum distribution or a rollover of the funds into an individual retirement account (IRA). Oddi initially favored the IRA, but his tax adviser (Ayco) advised selection of the lump-sum option that allowed 10-year averaging and a 20% capital gains rate during a limited window ending Mar. 15, 1987. (See Tax Reform Act of 1986 Section 1142(a).)

Oddi resisted this advice for several months, but in February 1987, Ayco presented Oddi with a calculation showing that the lump-sum strategy had a $3 million life-time advantage over the IRA. Stated assumptions included returns of 9% for taxable and 6% for nontaxable investments, as well as a maximum 28% tax rate and mandatory IRA withdrawals starting in 1998. Based on this advice, Oddi selected the lump-sum alternative.

Unfortunately, when making the decisive calculation, Ayco mistakenly reversed the taxable and nontaxable rates of return, resulting in nontaxable investments earning 9%. Three months later, Oddi discovered this error. Since corrected calculations now indicated a $2 million advantage for the IRA option, Oddi sued for the difference. The district court awarded Oddi $483,088 in damages and Ayco appealed.

The central issue was the effect of future tax rates on the amount of damages. Since the damages awarded by the district court were based on future tax rates remaining at 28% (a historically low rate), Ayco argued that a significant increase in rates by 1998 would eliminate the difference between the lump-sum and IRA strategies.

The question was whether Oddi had to prove that the tax rates would remain unchanged at 28% or Ayco had to prove that the rates would increase. The court ruled that the burden of proof was on the party who claimed that the rates would change; the current rate at the time of the trial was assumed to continue unless Ayco proved otherwise. The appeals court offered only limited support for its decision. I merely stated that "we are inclined to regard the laws of the United States as immutable, even when we know, as citizens, that they are not."

Since Ayco did not accomplish the difficult [if not impossible] task of proving that rates would increase, the damage award was affirmed. The court emphasized that its decision did not affect the requirement that the plaintiff must prove that the defendant's negligence caused the damages in the claimed amount . However, unless a plaintiff claims that the tax rates will change, he need not submit proof as to future rates.

Conclusion

In tax planning, future tax rates are usually relevant; if a malpractice suit results, they will affect the amount of damages. A CPA can be either a defendant or an expert witness in such a suit. Oddi is important because it is the first case to address the issue of possible tax rate changes. Tax rates have been increased to 31% since Oddi's 1990 trial, and many practitioners believe that rates will be increased again in the future. Nonetheless, given the ruling in Oddi, practitioners must realize that the law grants a presumption to the party who asserts no change. However, it is uncertain how Oddi would apply to engagements when a CPA's expertise in predicting future tax rates is specifically requested.

While Oddi is binding only in the Seventh Circuit (Wisconsin, Illinois and Indiana), courts in other jurisdictions will probably follow this decision.
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Author:Sager, Clayton R.
Publication:The Tax Adviser
Date:May 1, 1992
Words:617
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