The Benefit Rule: A Defense for Accountants after Failing to Timely File or Pay Taxes

Although liability defenses will depend on the circumstances leading to the imposition of interest, some consistencies exist in contesting damages. The benefit rule may be the best bet to reduce exposure in a subsequent claim by the client.

The Benefit Rule and Its Many Forms

The benefit rule is memorialized within the Restatement (Second) of Torts: “When the defendant’s tortious conduct has caused harm to the plaintiff . . . and in so doing has conferred a special benefit to the interest of the plaintiff that was harmed, the value of the benefit conferred is considered in mitigation of damages, to the extent that this is equitable.” Stated differently, damages flowing from interfering with a particular interest must be reduced by the amount the same interest is benefited by the defendant’s conduct.

“Interest” is used in the rule in its general sense, rather than referring to money paid for the use of money. For example, the Restatement illustrates how the rule would work when the interest is intangible—a plaintiff’s pain and suffering damages arising from an unprivileged surgery should be reduced by any diminution of future pain caused by the operation. Regardless of the type of interest injured, the rule is based on the tort recovery policy of placing an injured person in the position they would have been had the injury not occurred. Had an injury not occurred, the injured party would not have realized a benefit and, therefore, to place the injured party in their pre-injury position, the benefit must be considered in the overall damages calculation.

In the accounting malpractice context, the benefit rule is a damages defense that can prevent or limit a plaintiff from recovering the interest due taxing authorities in an action against the accountant because the plaintiff had the benefit of the funds while interest accrued. At the outset, it is important to distinguish between penalties and interest. It is nearly universally held, and not the subject of much controversy, that the penalties taxing authorities impose for late payment or filing are an element of recoverable damages in an action against the accountant. The benefit rule does not directly apply to penalties.

The benefit rule as applied to accounting malpractice has at least two forms depending on the jurisdiction. In a minority of jurisdictions, the benefit rule is an absolute bar to recovering interest. The more modern, and majority, trend is to permit recovery of interest if the interest due the taxing authority exceeds the value to the plaintiff of having use of the money in the meantime. Some sources refer to the benefit rule as having three versions, explaining that jurisdictions finding it is an “allowable recovery” are further divided into jurisdictions holding that (a) interest is recoverable just as any other damage, and (b) interest is recoverable only if the damage exceeds the interest actually earned by the plaintiff using the money. However, analysis of this purported division suggests that it may be unwarranted. It seems to suggest that all interest is recoverable under (a) even if the plaintiff earned interest while having use of the money. But the jurisdictions identified as following the former approach still consider whether the plaintiff earned interest while in possession of the money and factor that into the recoverable damages. Regardless, in both scenarios the interest is recoverable. Favoring the “keep it simple” method, we divide the jurisdictions into two classes: not recoverable and recoverable.

The Blanket Bar—Interest Never Recoverable

A minority of states hold that the benefit rule absolutely prevents an accountant’s client from recovering from the accountant interest owed to the taxing authority tied to the underpayment or failure to pay taxes. The states most often cited for following the minority approach include Alaska, California, New York, and Washington.

The blanket bar’s primary policy is one of equity—to prevent a windfall. The interest represents the time value of the money. Interest paid to the IRS is not necessarily considered damages. Permitting the plaintiff to have use of the money and to collect interest as damages would result in a windfall. The other courts adopting the blanket bar reach the same result by different terminology, finding that the blanket bar prevents a double recovery or unjust enrichment.

Courts do not appear to focus on whether the plaintiff actually earned interest while having use of the money, and mention that the plaintiff is not damaged to the extent the taxing authority charges market rate interest. Not examining a plaintiff’s use of the funds and references to the market rate suggest that courts are implicitly considering a failure to mitigate within the context of the benefit rule. In other words, a plaintiff, while possessing funds owed a taxing authority, could presumably earn the market rate of interest just as the taxing authority charges while the funds are unpaid.

If the plaintiff invests the money, however, it supports the blanket bar on causation grounds. For example, the Washington Court of Appeals in Leendertsen v. Price Waterhouse acknowledged that an accountant’s miscalculation of a tax liability led to larger refunds than the client was entitled to. But the client invested the money in another business and earned a profit. The court held that investment represented independent judgment, breaking the chain of causation and making the interest damages too speculative to recover. In this context, if the court considers the profit a plaintiff earned on funds owed the taxing authority as an offset to the interest the taxing authority charges, it could implicate the collateral source rule, which bars offsetting a tortfeasor’s liability by payment from an independent source. While it depends on the terminology of each jurisdiction’s collateral source rule, the Leendertsen court summarily dismissed collateral source arguments by reasoning that the profit or interest a plaintiff earned is not an independent source compensating for the same injury.

In sum, the blanket bar version of the benefit rule is followed by a minority of jurisdictions, but the rationale is straightforward and does not require analyzing how the plaintiff used the funds while the funds were in the plaintiff’s possession. The more modern trend, in contrast, requires examining how the plaintiff used the funds.

The Majority Approach—Interest Recoverable under Certain Circumstances

Most jurisdictions that have considered the benefit rule in the context of accounting malpractice hold that it is not an absolute bar to recovery of interest. These jurisdictions include Arizona, Illinois, Massachusetts, Nebraska, New Jersey, North Carolina, Oklahoma, Oregon, Pennsylvania, and South Dakota.

These courts are unpersuaded by reasoning from jurisdictions with an absolute bar, specifically noting that the windfall concern and speculation regarding the causation of interest damages are addressed by other functions of the judicial system. They reason that taking interest damages claims on a “case by case” approach, rather than an absolute bar, will adequately address windfall concerns because it allows courts and juries to analyze whether the plaintiff actually received a benefit from using the funds owed the taxing authority. Further, the courts reason the potential speculative nature of interest damages does not support adopting the absolute bar because damages issues are typically for the jury to decide, but courts can rule as a matter of law if the plaintiff does not meet the burden of proof and the evidence is clearly insufficient.

Instead, these courts find that the competing public policies for tort recovery warrant allowing plaintiffs to recover interest if they can prove they were actually damaged by the interest the taxing authority charged, but the recovery should be reduced by any benefit caused by a defendant’s actions. On the one hand, there is an overriding policy of making the plaintiff whole, i.e., placing the plaintiff in the position the plaintiff would have been but for the defendant’s actions. The policy that defendants should not escape liability for their tortious conduct also supports the modern benefit rule. In this line of reasoning, the plaintiff would not have had to pay interest had the defendant not failed to timely pay taxes. Therefore, the defendant paying the interest places the plaintiff in the position the plaintiff would have been absent the defendant’s conduct and prevents the defendant from escaping liability.

On the other hand, the law disfavors double recoveries or windfalls and recognizes that plaintiffs should not profit from their injuries. If the plaintiff invests the money due the taxing authority and earns any interest, reducing the plaintiff’s recovery by the amount of the benefit obtained prevents a windfall and the plaintiff from profiting from the injury. Further, defendants are still free to argue that the plaintiff failed to mitigate damages if the plaintiff did nothing to invest or safeguard the funds due the taxing authority.

On a related note, claims for prejudgment interest may also implicate a windfall concern in jurisdictions that permit recovery of interest owed the IRS. Some plaintiffs may argue that interest accrues on the amount of interest owed the IRS before a judgment is entered. To the extent a plaintiff seeks prejudgment interest on the amount owed the IRS before the plaintiff paid the IRS, prejudgment interest should not be awarded because that would result in a double recovery if the plaintiff also collects the interest the IRS charged. If, however, the plaintiff seeks prejudgment interest for the period of time after they paid the IRS its interest, awarding prejudgment interest would not result in a double recovery because the IRS was no longer charging interest and, therefore, recovery should be permitted.

Considering the various approaches and the issues implicated by each, the majority approach is likely the better policy because it considers the circumstances of each case and is based on a balancing of equities and competing tort recovery public policies. Indeed, the text from which the rule springs—Restatement (Second) of Torts—explicitly states that the benefit rule should be applied “to the extent [it] is equitable.” The blanket bar, although a much easier and straightforward approach, has the effect of penalizing unsophisticated plaintiffs who are not savvy enough to invest funds or otherwise put the money to use to obtain a benefit. On the bright side, under the majority’s case-by-case approach, there is a possibility the benefit the plaintiff obtains far exceeds the amount of interest the taxing authority charges and, by extension, the reduction the defendant is entitled to from the ultimate award will be greater.

Guidance for Practitioners in the Majority or Undecided Jurisdictions

The lucky defense attorneys (and their accountant clients) practice in a jurisdiction with the blanket bar. But if your jurisdiction is undecided, or you have the misfortune of practicing in a jurisdiction that permits recovery, there are steps you can take to determine and reduce your client’s exposure to interest damages arising from a failure to timely file or pay taxes.

As an initial matter, even if you do practice in a jurisdiction that appears to have adopted a specific approach, review carefully the relevant case law and favor more recent cases before advising clients because the actual status of the law may not be clear. Nebraska, for example, illustrates the importance of carefully reviewing case law. The Nebraska Supreme Court in 2002 appeared to adopt the blanket bar in J.D. Warehouse v. Lutz & Co. when it affirmed a lower court’s decision that found interest paid to the IRS was not a damage at all because interest represented a return to the IRS of what otherwise would have been a windfall. Yet in 2008, the Nebraska Supreme Court thoroughly analyzed interest recovery in Frank v. Lockwood and refused to adopt the blanket bar, opting to permit recovery of interest as long as the plaintiffs could meet their burden to establish that they were damaged by the imposition of interest. At first blush these cases seem to be in conflict, and the Frank court did not address the apparent conflict despite referencing the J.D. Warehouse case. Although the J.D. Warehouse court affirmed the lower court, a closer inspection of the opinion indicates that it did not address whether interest was a proper element of damages under the facts of that case because the parties did not present evidence of interest damages beyond a general reference to interest damages. Technically, the issue was undecided by the J.D. Warehouse court, but caution is still warranted because J.D. Warehouse has been cited in the scholarly context as support for the state following the blanket bar.

Returning to guidance for attorneys in undecided jurisdictions, there are a couple of steps you can take to determine what version of the benefit rule your jurisdiction might follow. First, given the modern trend and that the majority permit recovery, it is likely that undecided jurisdictions will permit recovery if asked to decide the issue. Permitting interest damages accounts for the competing public policies of tort recovery—making the plaintiff whole but preventing a windfall. However, it is likely that each undecided jurisdiction has, in other contexts, addressed “making the plaintiff whole,” windfalls, or double recoveries. The courts’ impressions of these policies in other contexts will inform how they decide in which form to adopt the benefit rule. If your jurisdiction is undecided, and the amount of interest claimed is significant enough, for obvious reasons it will be worth pursuing a ruling that the jurisdiction should adopt the blanket bar.

In addition, the decided jurisdictions have found persuasive how their jurisprudence treats causation, speculative damages, and the collateral source rule. The plaintiff’s burden of proof on causation and damages, and the court’s ability to decide those issues as a matter of law in certain scenarios, are universal principles across jurisdictions that favor the majority approach. However, the majority’s reliance on the collateral source rule appears misplaced and in fact relies on a tangential public policy. Stated simply, the collateral source rule should not bar consideration of how the plaintiff used the money owed the taxing authority because any benefit received would not be an independent payment to compensate the plaintiff for injuries the defendant’s conduct caused. The primary case in the majority addressing the collateral source rule recognized that a tortfeasor should not benefit from a third party’s generosity, or the plaintiff’s ingenuity—“plaintiff’s ingenuity” being the tangential public policy. In our opinion, this reasoning fails to recognize the flip side of the failure to mitigate defense, i.e., the plaintiff has an obligation to mitigate damages, and when the plaintiff does so, the defendant theoretically gets credit for that mitigation through a reduced damages demand. Ultimately, the collateral source rule’s impact on a jurisdiction adopting one form of the benefit rule over another is likely inconsequential.

Second, even if your jurisdiction is undecided, there are a few methods to reduce your client’s exposure through the tools available to you in litigation, including early written discovery to determine how the plaintiff utilized the funds owed the taxing authority. You can also obtain admissions that the plaintiff had the use of the funds owed the taxing authority, and question whether the plaintiff invested or safeguarded the funds, and whether the plaintiff realized a benefit from retaining the funds. Along the same lines, investigate how the plaintiff invested other funds, and the returns realized. Even if the plaintiff did nothing with the funds at issue, you may be able to prove that they could have or should have done something based on other investments. Also, determine the plaintiff’s sophistication. Common sense indicates that a more sophisticated plaintiff either did obtain, or should have obtained, a benefit from the funds considering their education or experience. Further, the plaintiff’s ability to recover interest damages should be affected by how long the plaintiff allowed interest owed to the taxing authority to accrue after becoming aware of the failure to pay taxes.

Conclusion

Because an accountant’s liability for the failure to file or pay taxes can be difficult to defend and is case specific, defense strategy often focuses on defenses reducing damages and overall exposure. Thus, it is critical to evaluate how your jurisdiction applies the benefit rule and the extent to which it will impact the specific facts of your case when the plaintiff did or could have obtained a benefit from not paying taxes. A complete or significant reduction of interest claimed can leave a seemingly large exposure case with only penalties as the recoverable damages.