GPSOLO September 2009
Tax Malpractice Damages
This article explores the proper measure of damages in tax malpractice litigation. Assuming a plaintiff establishes negligence by a tax advisor and the other requisite elements of the cause of action, exactly what damages may be recovered? This article focuses on damages caused by attorneys and accountants interchangeably.
Usually, the malpractice tort asserted against an attorney "is a specific application of the ordinary" tort of negli-gence (unless noted, all quotes from Bernard Wolfman et al., Standards of Tax Practice, 6th ed., Arlington, Vir-ginia: Tax Analysts, 2004). The attorney must "act as a reasonably competent and careful [professional] would . . . [act] under similar circumstances." Because tax law is generally perceived as a specialty, the standard of care may be higher than in other attorney malpractice situations. To establish a prima facie cause of action, a plaintiff must show "(1) a duty owed by the attorney to the plaintiff . . . ; (2) breach of that duty . . . ; (3) injur[ies] suffered by the plaintiff; and (4) a ‘proximate cause’ relationship between the injury suffered and the attorney’s breach of duty." The standards for accountants are similar to those for attorneys.
Damages: General background. In tax malpractice, as in other types of professional malpractice, the plaintiff generally is "entitled to recover for all injuries proximately caused by the defendant’s [negligence]." The plaintiff is entitled to recover for the loss of any expected benefit that competent performance would have yielded.
This basic measure of damages is the same regardless of the context of the tax malpractice. There are three broad areas in which tax representation, and consequently malpractice, may arise: tax planning, tax return preparation, and subsequent representation. Tax planning occurs before a transaction occurs. It involves professional advice as to how to structure a transaction or how to plan gifts or an estate. Return preparation has the obvious meaning relating to the process of reporting to the appropriate authorities a transaction or events that have already occurred. Subse-quent representation refers to all post-return filing services, such as representation during an audit, at administrative hearings, in response to administrative communications, or in litigation. Damages that may be recovered are only for those injuries that have actually occurred. No recovery is permissible for injuries that "may occur at some future point in time," that is, for speculative damages.
Damages are usually divided into two categories: direct and consequential. "Direct damages are those damages . . . that are immediate, natural and anticipated consequences of the wrong. Consequential damages are compensation for those injuries that flow, because of the direct damages and, therefore, depend on special circumstances that are not necessarily anticipated" (Ronald E. Mallen and Jeffrey M. Smith, Legal Malpractice, Eagan, Minnesota: Thom-son West, 2008).
One other aspect of recoverable damages needs to be focused on, and that is the general requirement imposed on an injured party to mitigate damages. Under normal tort principles, damages that may be minimized or reduced through reasonable efforts are not recoverable. In the tax context, this would be illustrated if, for instance, a return preparer made a simple mechanical error, such as reporting $10,000 of income as $100,000 or neglecting to claim a valid deduction. The recoverable damages would not normally include the full amount of the additional tax because an amended return easily could be filed to correct the error so long as the statute of limitations were still open. As a concomitant to not being able to recover the avoidable additional tax, the plaintiff may recover his or her mitigation expenditures (here, the cost of filing the amended return). Such mitigation or corrective costs, whether or not ulti-mately successful, are ordinarily an important element of recoverable tax malpractice damages.
Elements of damages. In tax malpractice situations, the most direct types of damages encountered consist of ad-ditional taxes resulting from the malpractice, interest and penalties imposed on the additional taxes, and corrective costs incurred in attempting to eliminate or mitigate all or some of the foregoing damages.
Because the determination of recoverable damages is a matter of state law, differences among the states are to be expected and do in fact exist. Thus, although there seems to be general agreement that penalties and corrective costs are recoverable, the situation concerning taxes and interest is different. As to taxes, although the language encoun-tered would seem to suggest a more fundamental disagreement, it appears that most states allow recovery of the ad-ditional taxes caused by the malpractice. What is not recoverable are other taxes incurred by the plaintiff, that is, taxes that would have been incurred even in the absence of the malpractice. With respect to the interest imposed on a tax underpayment, three distinct approaches are evident: One approach permits the recovery of such interest from the defendant; one approach denies any recovery of such interest; and a third approach stands between these two extremes and permits recovery of some interest, but only to the extent that the interest paid by the plaintiff to the government exceeds the interest earned by the plaintiff on the tax underpayment.
There are a number of provisions in the Code that impose penalties on taxpayers in various circumstances. For instance, penalties are imposed for late filing of required tax returns and for underpayments of tax for accuracy-related reasons. States have a similar panoply of penalty provisions. Thus, when a tax advisor is negligent, a tax penalty often is suffered by the taxpayer. If the injured taxpayer is to be made whole, such penalties need to be re-covered. By and large, the decided cases have shown no reluctance to include such penalty amounts in recoverable damages.
Corrective costs are the costs incurred to mitigate, or attempt to mitigate, the damages incurred. When tax malpractice occurs either in return preparation or tax planning, there normally will be a need to file late or amended tax returns. If an audit occurs as a result of the negligence, representation at the audit by either an attorney or an accountant will be necessary. Often, subsequent representation at administrative or legal proceedings also will be necessary to either attempt to salvage the desired tax treatment or to attempt to eliminate or minimize interest, penalties, or other negative tax consequences caused by the malpractice. All these and any other similar mitigation costs are corrective costs. If the malpractice occurs in a litigation situation, the corrective costs normally would be costs incurred to hire counsel to attempt to undo the mistakes of the negligent counsel. Although there do not seem to be many reported cases involving litigation-related errors, it is well established that corrective costs are recoverable as damages.
Generally, no recovery is available for any emotional distress or mental anguish that might result from a tax professional’s negligence. The reason for this is usually articulated in one of two ways: either that distress is not a foreseeable result, or any monetary recovery for the underlying negligence will adequately compensate the aggrieved party. In especially egregious circumstances, such damages may be recoverable.
Whether punitive or exemplary damages may be recovered will depend on the laws of the state that has jurisdiction over the cause of action. There are a number of cases in which punitive or exemplary damages were awarded, or at least considered, in tax malpractice situations.
The recoverability of attorney fees depends on the nature and type of attorney fees involved. Where the fees are incurred to correct the damages flowing from the defendant’s negligence, these are corrective costs and are recoverably as core damages. However, attorney fees incurred to prosecute the malpractice action against the negligent tax advisor are, generally, not recoverable as damages.
- This article is an abridged and edited version of one that originally appeared on page 705 of The Tax Lawyer, Spring 2008 (61:3). - For more information or to obtain a copy of the periodical in which the full article appears, please call the ABA Service Center at 800/285-2221.
- Website: www.abanet.org/tax.
- Periodicals: NewsQuarterly, quarterly newsletter; The Tax Lawyer, quarterly journal; monthly e-Newsletter; The Practical Tax Lawyer (published by ALI-ABA in cooperation with the Section), subscription available to Section members at a significant discount.
- Books and Other Recent Publications: Careers in Tax Law; Effectively Representing Your Client Before the IRS: A Practical Manual for the Tax Practitioner with Sample Correspondence and Forms; Property Tax Deskbook; Sales and Use Tax Deskbook; The State and Local Tax Lawyer, Symposium ed.; A Comprehensive Analysis of Current Consumption Tax Proposals; Value Added Tax: A Model Statute and Commentary.
Jacob L. Todres is a professor of law at St. John’s University School of Law in Jamaica, New York. He may be reached at firstname.lastname@example.org.