Note: The following is an excerpt from the introduction to the article as published in The Tax Lawyer. Author citations have been omitted for brevity. Tax Section members may read the article in its entirety in Adobe Acrobat format.
Tax Malpractice Damages: A Comprehensive Review of the Elements and the Issues
Jacob L. Todres*
*Professor of Law, St. John’s University School of Law
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? May the plaintiff recover additional taxes owed? What about recovery of interest, penalties, and lawyer’s or accountant’s fees? What about recovery of consequential damages, such as those for emotional distress or mental anguish? What if, as a result of the tax advisor’s negligence, the plaintiff is audited and other, unrelated deficiencies are uncovered that likely never would have come to light but for the initial negligence?
At a very simplistic level, one would expect the contours of recoverable damages to be very well established by now. After all, a suit against a negligent tax advisor is likely to be either a relatively simple tort or breach of contract claim. Tort and contract law have been around seemingly forever. In any event, in more recent times, as society has become more litigious and as such cases have become more common, the law should have had ample opportunity to develop definitive answers.
In fact, while the basic elements and concepts concerning the proper measure of damages do seem to have been individually developed, a comprehensive overview of the area is difficult to glean. Also, many uncertainties and gaps in the law seem to remain. For instance, three views have developed as to whether interest incurred on a tax underpayment is recoverable as damages. Likewise, there does not seem to be any authority on whether recovery is available when, due to a tax advisor’s negligence, an audit is triggered and other, unrelated deficiencies are uncovered. Finally, I have observed a relatively recent instance in which a federal court has either misstated or vastly oversimplified a basic principle in this area.
The issue of the correct measure of damages is especially significant today in light of the crackdown during the past few years by both the Service and Congress on the abusive tax shelters of the 1990s and early 2000s. In addition to several publicized settlements by attorney and accountant defendants in a number of high-profile class actions and even criminal cases, many more suits against tax advisors involved in such investments may be expected in the future. In addition to these special situations, there is the “normal” flow of such litigation.
In this Article, I explore the damages area in detail. In addition to exploring the basic elements of recoverable versus non-recoverable damages, I highlight a number of lurking issues, including some that have no clear-cut answers, and offer suggested solutions for these.
I will focus on damages caused by attorneys and accountants interchangeably. While there might be some theoretical benefit in attempting to analyze these professions separately, the pragmatic truth is that the dividing line between the professions with respect to tax work has never been clear. That dividing line, as faint as it always was, may have eroded still more in 1998 when Congress extended the traditional attorney-client privilege to other tax practitioners. There are many instances in which attorneys and accountants share the defendant’s role. In many, if not most, situations (except, perhaps, purely litigation-related errors in a court other than the Tax Court), the defendant could just as easily be from one profession as from the other. In light of the interchangeability of the professions in tax practice, many courts simply hold both professions to the same malpractice standards.
It should be noted in passing that the reported tax malpractice cases occasionally involve defendants other than attorneys or accountants. Such defendants are typically financial planners or others serving this function, such as an insurance company or bank. Similarly, a “non-professional” may serve as a tax return preparer. While such cases may involve different standards concerning the duty of the defendant, where the court’s discussion of damages is relevant, it will be included in the discussion.
Normally, civil actions for tax malpractice are based on either traditional tort or traditional contract theories. Under traditional tort principles, a professional has a duty “to exercise the level of skill, care and diligence. . . [normally] exercised by other members of the profession under similar circumstances[,]” whereas traditional contract principles impose the obligation to perform the task undertaken diligently and competently. In practice, these two standards, though emanating from different areas of the law, are virtually identical. The professional, therefore, must exercise reasonable competence and diligence to avoid malpractice exposure.
While the basic standard of care is almost identical under tort and contract theories, other aspects of the causes of action and defenses thereto may differ depending on which theory is utilized. Differences are usually encountered in the statute of limitations (both how long and when it commences), the measure of damages, to whom liability extends ( i.e., privity), and evidentiary matters, such as the need for expert testimony. Several recent cases underscore that differences remain between the two theories and the need to comply carefully with the requirements of each theory.
Usually, the malpractice tort asserted against an attorney “is a specific application of the ordinary” tort of negligence. The attorney must “act as a reasonably competent and careful [professional] would . . . [act] under similar circumstances.” Since 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. Accounting is a learned profession, and practitioners must act as would a reasonably competent and careful member of the same profession under the same circumstances. The elements of the prima facie cause of action against the accountant are the same as those listed above against an attorney. Many cases simply equate the elements of the causes of action and the standard of care in accountant and attorney situations.
While the normal tax malpractice cause of action involves the tort of negligence, other torts are also encountered. In one case, in addition to negligence and breach of contract claims, there were also allegations of breach of fiduciary duty, professional malpractice, intentional or negligent infliction of emotional distress, breach of covenant of good faith and fair dealing, intentional or negligent misrepresentation, and false and deceptive trade practices under state law. Allegations of fraud, violations of federal securities laws, and RICO violations may also arise in tax malpractice situations.Since the tort of negligence is normally encountered in tax malpractice cases, unless specifically indicated otherwise, it will be assumed herein that this is the tort involved. This Article will not focus upon any other state or federal statutory basis for recovery.