Many taxpayers consult with their certified public accountant (CPA) before making significant financial transactions. Taxpayers consult with the expert so they can structure the transaction in a manner minimizing taxes.
But, what happens when the CPA underestimates the taxes due? What are the taxpayer claimant’s available damages? Is the taxpayer entitled to recover the difference between the taxes he expected to pay and the actual taxes due (i.e. “expectation damages”)? In this case, how does a taxpayer prove damages, and what defenses are available?
General Measure of Damages
Under California law, a taxpayer/claimant is only entitled to recover losses proximately caused by the alleged CPA misrepresentation. (Eckert Cold Storage v. Behl (1996) 943 F.Supp.1230, 1234 citing to, inter alia, Gray v. Don Miller & Associates (1984) 198 Cal. Rptr. 551, 554; and Kenly v. Ukegawa (1993) 19 Cal.Rptr.2d 771, 774.) In other words, the damages awarded should place claimant in the same position they would have been in absent the misrepresentation. (Id. at 1234.) A claimant is not allowed to recover taxes they are otherwise obligated to pay. (See generally Eckert, supra, at 1233-1237.)
Rather, in order to recover against a CPA for negligent tax advice, a claimant must: 1) show he made an investment decision based on the CPA’s misrepresentation, and 2) establish with reasonable certainty that he would have pursued an alternative favorable investment absent the misrepresentation. (Eckert, supra, at 1235 citing to Christiansen v. Roddy (1985) 186 Cal.App.3d 780, 789.) Under this scenario, the claimant is entitled recover the difference between the investment he made and the alternative, favorable investment. (Id.)
A Claimant May Not Recover Taxes Otherwise Due and Owing as an Item of Damages
When a CPA’s advice leads to underpayment of tax, the taxpayer is not allowed to recover the deficiency itself as damages. This is because the CPA’s advice did not create the taxpayer’s duty to pay taxes. Rather, the requirement to pay taxes arises from “the ineluctable requirements of the Internal Revenue Code.” (DCD Programs v. Leighton (9th Cir. 1996) 90 F.3d 1442, 1449 [barring investors from recovering back taxes as damages in securities fraud action regarding tax shelters developed by defendants since investors’ tax liabilities were created by the tax code, and not by defendants’ actions]; O’Bryan v. Ashland (2006) 717 N.W.2d 632, 633 [explaining, “when a tax advisor’s negligence leads to an underpayment of tax, the taxpayer cannot recover as damages the tax deficiency itself because the tax liability arose not from the negligence advice, but from the ongoing obligation to pay the tax]; Robert Fink, “What and When Can a Taxpayer Recover From a Negligent Tax Advisor” (2000) 92 J. Taxation 176; Jacob L. Todres, ”Tax Malpractice Damages” (2008) 61 Tax Law 705; Eckert Cold Storage v. Behl (9th Cir. 1996) 943 F.Supp. 1230 [applying California state law to disallow recovery of taxes otherwise owed in tax malpractice suit against accounting firm]; and see Cal. Civ. C. § 3333 [limiting tort recovery damages to those “proximately caused” by the defendant’s conduct – thereby prohibiting recovery of taxes otherwise owed].)
In Eckert Cold Storage v. Behl (9th Cir. 1996) 943 F.Supp. 1230, the plaintiff sued an accounting firm over alleged misrepresentations regarding the tax benefits of a particular investment. The plaintiff sought to recover the difference between the taxes actually paid and the taxes defendant negligently advised would be due. The court prohibited recovery of these “expectation damages” because the tax advisor’s advice did not create plaintiff’s tax liability. Awarding expectation damages would place plaintiff in a better position than she would have been in absent the misrepresentation, and so are not allowed. (Eckert, supra, at 1233-1234 in reliance on Cal. Civ. C. § 3333.)
Can the Taxpayer Recover Attorneys’ Fees?
Admittedly, there are circumstances under which a claimant may recover attorneys’ fees in a negligent tax advice claim. Where a claimant incurs fees to correct damage flowing from the CPA’s negligence (e.g. payment of a tax attorney to prepare amended returns, or fees paid to defend an IRS audit triggered by the CPA’s negligent underpayment of taxes), these are corrective costs and are recoverable as core damages. (See e.g. McKeown v. First Interstate Bank (1987) 194 Cal.App.3d 1225 [where plaintiff recovered attorneys’ fees related to retention of tax attorney to defend IRS notice of deficiency caused by defendant’s negligent tax advice; superseded on unrelated grounds.)
The law is clear however, that attorneys’ fees incurred to prosecute a malpractice action against a CPA are not recoverable. (Jacob L. Todres, “Tax Malpractice Damages” (2008) 61 Tax Law 705 [explaining the general U.S. rule does not allow recovery of attorneys’ fees incurred by a plaintiff in prosecution of a malpractice suit]; Eckert Cold Storage v. Behl (9th Cir. 1996) 943 F.Supp. 1230 [wherein attorneys’ fees generated in prosecution of an accounting malpractice action were not identified as an available item of damages]; see e.g. Sorenson v. Fio Rito (1980) 413 N.E.2d 47, 51-52 [applying general U.S. rule prohibiting recovery of attorneys’ fees generated in prosecution of a malpractice suit against a CPA]; and see e.g. Slaughter v. Roddie (1971) 249 So.2d 584, 586-587 [disallowing recovery of attorneys’ fees for prosecution of negligent tax preparation claim].) The law on this matter is uniform across jurisdictions – a claimant may not recover attorneys’ fees incurred prosecuting a negligent tax advice/preparation matter.
How Does the Claimant Establish Viable Investment Alternatives?
As discussed above, a claimant may not recover expectation damages. The claimant is however, entitled to recover the difference between the investment he made based on the CPA’s incorrect advice and the investment he would have made absent the negligent advice. In other words, a claimant must show viable and favorable investment alternatives.
Specifically, a claimant must show, with reasonable certainty, that she would have made alternate, favorable investments absent the inaccurate advice. (Eckert, supra, at 1235 citing to Christiansen v. Roddy (1985) 186 Cal.App.3d 780, 789.) The normal standard for a civil dispute is “by a preponderance of the evidence.” A claimant, however, may not recover simply by satisfying the normal civil standard.
“Reasonable certainty” requires a higher standard of proof than “preponderance of the evidence.” The “reasonable certainty” standard lies somewhere above “preponderance of the evidence,” but below “beyond a reasonable doubt.” (Bruck v. Adams (1968) 259 Cal.App.2d 585, 588.) Some California courts equate the “reasonable certainty” standard with the highest civil standard of “clear and convincing evidence.” (See e.g. Broadman v. Commission on Jud. Performance (1998) 18 Cal.4th 1079, 1090 [where judicial misconduct warranting discipline required showing of “clear and convincing” evidence to sustain charges to a “reasonable certainty”].)
While the definition is still somewhat open to interpretation, courts agree “reasonable certainty” is a significantly higher requirement than “preponderance of the evidence.” In short, a claimant has an uphill battle establish damages based on alternative investments made due to negligent tax advice.
The CPA defendant can attack claimant’s case a number of ways. For example, the CPA defendant can discredit: 1) the viability of alternative investments, 2) the propensity of the claimant to actually pursue the alternative investments, and 3) the value of the alternative investments.
For example, certain alternative investments, like 1031 exchanges, have strict “like kind” real property requirements. If no such “like kind” properties existed during the limited time frame claimant alleges he would have invested, then the alternative can be ruled out. Any investment with strict requirements is ripe for this type of defense.
Further, a claimant’s risk profile might also limit viable alternatives. If, for example, the claimant has a long history of low risk tolerance investing, the CPA could legitimately challenge high risk alternative investments. Based on the claimant’s history, such investments are arguably not “reasonably certain” alternatives.
Finally, claimants will often exaggerate the value of alternative investments. In this case, a financial planner, appraiser, or relevant investment specialist may be helpful to help collect all of the hidden costs in an alternative investment and help present a more reasonable actual value.
Taxpayer claimants may not recover “expectation damages.” While they may be entitled to attorneys’ fees related to corrective costs, they are not entitled to fees related to prosecution of the malpractice action.
Instead of “expectation damages,” a claimant is entitled to recover the difference between the investment he made based on the CPA’s advice, and the alternative investment he would have made absent the bad advice. The claimant, however, has the heightened requirement of establish alternative investments under the “reasonably certain” standard. The heightened standard provides significant opportunity to challenge, and potentially rule out, alleged alternative investments.