There has been a recent uptick in lawsuits brought by taxpayers claiming that their tax preparer rendered negligent tax advice or caused tax reporting errors that resulted in an audit by the tax authorities or, worse yet, the issuance of tax assessments. Oftentimes, the taxpayer blames the tax preparer and seeks compensation for a variety of damages that the taxpayer claims were proximately caused by the tax preparer’s misconduct.
The taxpayer’s alleged damages claim against the tax preparer usually consists of four damages theories. First, the parties dispute the unpaid taxes that are due and owing to the tax authorities. Second, the parties dispute the penalties assessed by the tax authorities. Third, the parties dispute the corrective costs incurred by the taxpayer to respond to the audits and cure the deficiencies. Fourth, the parties dispute the interest charges incurred on the unpaid taxes. Some of these damages theories are seldom recoverable by the taxpayer, while others fuel the litigation. This client alert focuses on the interest charges incurred because it is subject to an important yet oftentimes overlooked jurisdictional split.
The view adopted by a majority of states is that interest incurred on unpaid taxes is recoverable from the negligent tax preparer. The leading cases follow the logic that the interest paid by the taxpayer flows directly from the tax preparer’s misconduct and would not have been owed had the tax returns been properly prepared. See Dail v. Adamson, 570 N.E.2d 1167, 1169 (Ill. App. Ct. 1991), King v. Neal, 19 P.3d 899, 902 (Okla. Civ. App. 2001). Other states have simply awarded interest to a taxpayer without discussing the underlying merits. See Warmbrodt v. Blanchard, 692 P.2d 1282, 1284 n.2 (Nev. 1984); Hall v. Gill, 670 N.E.2d 503, 506 (Ohio Ct. App. 1995).
The State of California adopted the minority viewpoint holding that interest incurred on unpaid taxes is not recoverable from a negligent tax preparer. See Eckert Cold Storage, Inc. v. Behl, 943 F. Supp. 1230, 1235 (E.D. Cal. 1996). The Eckert case held that interest “…represents a payment for the plaintiffs’ use of the tax money during the period after the taxes came due and before they were paid…to the extent that the IRS charges the market rate, interest is not a proper element of damages.” Id. at 1235. This view is analogous to federal securities fraud claims (under Rule 10b-5), where interest paid to taxing authorities is also viewed as compensation for the taxpayer’s “use of the money” and is not recoverable for identical reasons. See DCD Programs v. Leighton, 90 F.3d 1442, 1451 (9th Cir. 1996). California’s jurisprudence presumes that a taxpayer has benefited from the use of the money, receiving what amounts to an interest-free loan for the period during which the taxes were owed. Whether the taxpayer subjectively benefited from the use of the money is not considered. The State of Washington, another minority viewpoint jurisdiction, reasons that the taxpayer’s rate of return from the unpaid taxes results from his independent judgment, and “damages from poor investing are too speculative to blame” on the tax preparer. Leendertsen v. Price Waterhouse, 916 P.2d 449, 451-452 (Wash. Ct. App. 1996).
There exists a third, intermediate viewpoint that some states adopted as a compromise between the majority viewpoint and the minority viewpoint. The intermediate viewpoint allows parties to introduce admissible evidence to demonstrate whether or not the taxpayer subjectively benefited from the use of the tax money. The State of New Jersey introduced the intermediate viewpoint in Ronson v. Talesnick, 33 F. Supp. 2d 347 (D.N.J. 1999). The Ronson court, citing Eckert as the leading example of the minority viewpoint, rejected the minority viewpoint reasoning that it is irreconcilable with the theory that “…a tortfeasor should not benefit from the ingenuity of a harmed plaintiff.” Id. at 355. The Ronson court also rejected the majority viewpoint reasoning that the law does not entitle a taxpayer to receive a double-recovery due to the tax preparer’s negligence. Id. At least four states (including Nebraska, Pennsylvania, South Dakota and Texas) have adopted the Ronson approach in varying degrees. The key distinction among the states rests upon which party must bear the burden of proof, i.e. to substantiate that the plaintiff benefited from the use of the tax money, or to demonstrate that no material benefit was realized from the use of the tax money.
Despite the emergence of Ronson and its progeny, the minority viewpoint controls taxpayer versus tax preparer disputes in California. Eckert was followed in Fallon v. Locke, Liddell & Sapp, LLP, Case No. C-04-03210, 2008 U.S. Dist. Lexis 67708 (N.D. Cal. Sept. 1, 2008). It is worth noting that the Eckert and Fallon decisions are federal district court opinions. The California state court judiciary has not rendered a published opinion on this narrow issue, which makes the federal district court opinions all the more persuasive. Plus, the Eckert rationale comports with well-established California tort principles, namely that a plaintiff’s damages award must not place the plaintiff in a better position than had the misconduct not occurred.
While Eckert’s value to California’s jurisprudence cannot be overstated, California attorneys representing tax preparers must actively cultivate wider acceptance of the minority viewpoint and prevent the taxpayers from introducing change toward Ronson’s intermediate viewpoint.
Sometimes the trier of fact will be charged with rendering a verdict on the issue of interest charges. It is prudent to engage an expert witness to run simulations to substantiate that the taxpayer actually used (or had the opportunity to use) the tax money to their financial advantage. The more comprehensive simulations source the taxpayer’s funds and then trace them to reveal the actual returns received by the taxpayer. It is also prudent to compare the actual returns with the prevailing market rates, as well as the interest rates charged by the IRS and California Franchise Tax Board. Oftentimes the simulations reveal that the taxpayer actually benefited (or could have benefited financially) more handsomely because the government assesses interest at rates typically lower than prevailing market rates.
As a final comment, tax preparers should be mindful to not make representations to any client with an active or expected audit. One Louisiana court found that a tax preparer “unconditionally guaranteed” to his taxpayer client that he would pay all interest assessed in the event of an audit. Slaughter v. Roddie, 249 So. 2d 584, 586 (La. Ct. App. 1971). The court ruled that the tax preparer’s statement that he would indemnify the taxpayer following an audit gave rise to an agreement.