Title: Managing a tax practice to avoid malpractice claims.(Cover Story) Authors: Yancey, William F. Citation: The CPA Journal, Feb 1996 v66 n2 p12(6) ------------------------------------------------------------------------ Subjects: Accountants_Malpractice Tax accounting_Cases Tax planning_Cases Reference #: A18122094 ======================================================================== Abstract: Tax engagements account for about 50% of all malpractice claims against public accounting firms. Nearly half of the 3,295 new malpractice claims received by AICPA Professional Liability Insurance Plan between 1987 to 1993 were generated. According to another accounting malpractice insurer, the Accountants' Professional Liability System, tax engagements create 55% of all malpractice claims against its members. Studies on tax malpractice claims are reviewed and eight specific cases of tax malpractice are examined to better understand why such claims are made and to gain insights that can serve as a basis for tax practice policies to minimize such suits. Tips for avoiding malpractice claims are offered in the areas of client acceptance, scope of engagement, client communications, application of law, work scheduling and billing. ======================================================================== Full Text COPYRIGHT New York State Society of Certified Public Accountants 1996 Preparing tax returns and giving tax advice carries liability risk - at higher rates than audits. Tax engagements give rise to approximately half of all malpractice claims against public accounting firms. Tax-malpractice claims studies and eight specific cases involving malpractice tell us why practitioners were sued and provide a basis for establishing policies to avoid such suits in the future. Approximately half of all malpractice claims against public accounting firms arise from tax engagements. Although audit-related claims receive more publicity and are more costly to settle, tax claims occur more frequently. During 1987 to 1993, the AICPA Professional Liability Insurance Plan received 3,295 new malpractice claims, of which 48% were from tax engagements, 17% from audits, and 35% from other accounting and consulting engagements. The Accountants' Professional Liability System, another large accounting malpractice insurer, reports tax engagements generate 38% of members' fee income, but create 55% of all malpractice claims. Malpractice Insurance Claim Studies The most frequently quoted statistics on tax malpractice by public accounting firms are based on insurance claims submitted to the AICPA Professional Liability Insurance Plan. The relative frequency of new tax claims jumped from 22% in 1986 to 51% in 1987, and then varied between 42% and 51% between 1988 and 1992. IRS persistence in attacking tax shelters resulted in the large jump in tax malpractice claims in 1987. When the tax and economic benefits of tax shelters failed to meet clients' expectations, many sued their tax accountants. About one-third of the plan's tax claims result from procedural errors, including late returns and omitted or incorrect elections. Similar to most other civil suits in the U.S., approximately 95% of the claims submitted to the AICPA plan are resolved without a court trial. Another study showed that the decline in tax shelter related claims was offset in part by an increase in claims for estate tax returns. Many of the estate tax return problems arose from late filings and failure to make tax-reducing elections. State tax returns, particularly in California, resulted in a number of claims where the accountant failed to identify different treatments between Federal and state tax laws. Other problem areas include qualified plans, S corporation elections, late filings, partnerships, and divorces. Claims appear to be more likely with nonroutine than routine events. The largest published classification study of tax-related malpractice claims against attorneys is derived from legal malpractice claims filed in 1983 to 1985 collected by the American Bar Association (ABA). The ABA study classified claims in several different ways. In the classification by type of alleged error, there were 537 claims alleging an attorney's failure to understand or anticipate a tax, of which 30.5% were a consequence of document preparation and 29.8% for tax reporting. In the classification by area of law, there were 458 claims arising from tax engagements of which 31.7% alleged the attorney failed to understand and anticipate a tax and 29.9% for late or missed filings. Inexperience with the law does not appear to be a major cause since 69.4% of the tax engagement claims were against attorneys with ten or more years in legal practice and 96.7% with four or more years experience. The general conclusion from these insurance claim studies is that no area of tax practice is immune from alleged malpractice. Claims are caused by both incorrect tax planning, such as tax shelter advice, and compliance failures, such as late filings. Judicial Decisions in Tax Malpractice Cases Although the conclusion of the insurance claim studies is that preventing malpractice should be a significant strategic issue for practice management, they do not reveal enough details for modifying tactics on particular tax engagements. The following case histories identify specific practice errors that caused clients to file malpractice lawsuits. Eight cases were selected from published Federal or state Appellate Court opinions that had extensive descriptions of professional engagements. Legal scholars have examined these opinions for judicial precedents on tax practice standards and legal defenses to malpractice suits. In contrast, the purpose here is to identify specific practices that caused the suit to be filed. CPA firms are the defendants in most of the examples below. The examples with other professional advisers are included because they have close analogies with engagements of CPAs in tax practice. Asset Sale. In Lewin v. Miller Wagner & Co., the tax accountant failed to incorporate the client's tax goal into the tax planning process. Miller Wagner & Co., a CPA firm, had been advising Burton Lewin on his personal and business taxes since 1976. In February 1980, Lewin sought advice about how to minimize the tax consequences of selling a large block of corporate stock. Carl Dornan, the tax department head who advised Lewin on this issue, was a new member of Miller Wagner & Co. Lewin maintains he attempted to communicate to Dornan his goal of limiting his 1980 income tax liability to no more than $32,000, the amount of his income tax withholding. Dornan testified he had no recollection of Lewin's goal. Dornan advised Lewin he could sell all of his stock for cash and decrease his 1980 income taxes through charitable donations, stock option straddles, and oil and gas ventures. Unfortunately, Dornan did not estimate Lewin's alternative minimum tax liability. Lewin did not invest in enough tax shelters to reduce his tax liability. On April 13, 1981, two days before the 1980 tax returns were due, Lewin learned from the CPA firm that his 1980 liability, including the alternative minimum tax, was $333,921 rather than the planned $32,000. Lewin had to borrow substantial sums to pay the 1980 liability. The expert witnesses at the trial testified that Dornan's advice fell below the accepted standard of accounting practice for overlooking the alternative minimum tax and failing to adequately consider the tax deferral advantages of an installment sale. The defendant's own expert witness acknowledged a tax planner has an affirmative obligation to discover his client's goals, and that failure to make that inquiry indicated the tax planner was not acting in a competent manner. Lewin won $261,806 in claims and attorney fees from the trial court, but the Appeals Court reduced the award. The Lewin case illustrates the importance of understanding client goals and constraints. Dornan maintained inadequate records and correspondence to document his understanding of Lewin's goals. If Dornan had adequately understood the importance of minimizing the 1980 balance due, he might have recommended delaying the sale of some stock. Even after the stock was sold, if Dornan had promptly and accurately updated the tax estimate, he could have given Lewin more timely warning of the balance due. Divorce. In Bronstein v. Kalchiem & Kalchiem, an attorney gave erroneous tax advice about the tax consequences of a divorce settlement and was repeatedly sued by the client. In 1976, Michael Kalchiem, a divorce attorney, advised his client, Leonard Bronstein, that a particular $14,000 payment to Bronstein's ex-wife would qualify as deductible alimony. Subsequently, the IRS denied the deduction and Kalchiem unsuccessfully appealed the denial. The IRS issued a notice of deficiency for $7,252 that was ultimately sustained by the Tax Court. Bronstein filed three successive malpractice suits against Kalchiem, and pursued each case to the Illinois Appeals Court. Bronstein requested damages of $150,000 - over 20 times the size of the original deficiency notice. Fortunately, the courts denied Bronstein's claims; but the final appeal was not completed until 1986. Although the defendant in the Bronstein case was not a tax practitioner, the case illustrates the intense reactions that result from erroneous tax advice to parties to a divorce. Bronstein incurred more legal fees on the malpractice case than the amount of the tax deficiency. Lawyers and accountants should be exceptionally careful in documenting and researching advice given in connection with divorces. If a client is unwilling to pay for the added service, the practitioner should consider declining the engagement. Declining to Enter an Engagement. Togstad v. Vesely, Otto, Miller & Keefe demonstrates the importance of a clear disengagement letter to a client if the practitioner has declined an engagement. Although Togstad was about legal malpractice, a reference text on tax malpractice cites this case as a warning to tax practitioners. In October 1972, Joan Togstad met with attorney Jerre Miller regarding the hospitalization of her husband John Togstad 14 months earlier. Mr. Togstad had become severely paralyzed as a result of the hospital's failure to adjust a blood clamp. During a 45-minute meeting with Miller, Mrs. Togstad described what had happened, but she brought no written records with her. At the conclusion of the meeting she testified that Miller stated the Togstads did not have a valid medical malpractice case but that he would discuss the case with another attorney and get back to her if he changed his mind. No fee arrangements were discussed, no medical authorizations were requested, and the Togstads were not billed for the interview. One year later Mrs. Togstad contacted another attorney who told her they did have a valid malpractice case. Unfortunately for her, the two-year statute of limitations for medical malpractice claims expired shortly before the consultation with the second attorney. Mr. and Mrs. Togstad sued Miller and his law firm for legal malpractice. At the malpractice trial, Mrs. Togstad proved she had sought legal advice from Miller and detrimentally relied on his advice. Miller testified he had told her that his firm did not have expertise in medical malpractice and would not be interested in her case. Miller, however, never wrote a letter to Mrs. Togstad documenting why he declined the engagement. The plaintiffs expert witness testified that when a lawyer is asked for his legal opinion on the merits of a medical malpractice case, community standards required that he review hospital records and consult with an expert before rendering his opinion. Furthermore, due care and diligence would require him to inform the party of the two-year statute of limitations applicable to medical malpractice. The jury awarded damages of $649,500 to the Togstads as a consequence of legal malpractice. The Minnesota Supreme Court affirmed the verdict. The court held Miller responsible for negligence even though the Togstads never paid for his advice. The significance of this case to tax practitioners is the need to write disengagement letters to existing or prospective clients if an engagement is declined. The letter should explicitly state the practitioner is offering no opinion and recommend the party seek advice from another expert. Tax Shelters. Burdett v. Miller illustrates an investment advice malpractice suit that resulted when a tax accountant recommended particular tax shelters to a client. In this case, Patricia Burdett was a successful sales representative who met Robert Miller, a CPA and Northwestern University professor, when she enrolled in his course. Burdett hired Miller to prepare her tax returns and sought his advice on minimizing her taxes. Beginning in 1983, Miller recommended she invest in a series of tax shelters controlled by three acquaintances. He did not tell her that one of these ventures was the group's first project. In another venture Miller sold Burdett his own shares without disclosing he was the owner. In 1986, the ventures collapsed and the three promoters fled to Canada. Burdett lost a total of $200,000 and she sued Miller on a variety of Federal and state charges. The Federal District Court awarded Burdett $725,000 in damages and attorney fees, but the Appeals Court ordered the amount reduced. The courts held that, as an investment adviser, Miller had a fiduciary duty to his client. Miller presented himself as an investment expert and knew that Burdett was not sophisticated. The Appeals Court noted the following: Miller could have protected himself from being deemed a fiduciary by explaining the character and circumstances of the investments to Burdett, disclosing his stake in them to her, seeing to it she received prospectuses and other documents describing the risks of the investments, and, if need be, advising her to seek additional investment counsel before staking large sums on the these risky ventures. He did none of these things. Clients may sue the tax practitioner if either the tax or economic benefits of the tax shelter are less than expected. If a tax adviser is acting as an investment adviser, he or she can be sued under a wide variety of security statutes and common law causes of action. Qualified Plan Distributions. In Oddi v. Ayco Corporation, an individual received erroneous advice from an investment counseling firm on the after-tax benefits of various qualified plan distribution alternatives. A corporation hired Ayco Corporation, an investment counseling firm, to provide financial planning to Raymond Oddi and other executives considering early retirement. Oddi initially preferred to roll over his profit-sharing plan proceeds to an IRA. Ayco's representative, Cynthia Garrett, tried repeatedly to convince Oddi that a lump-sum withdrawal and 10-year averaging would be the better alternative. In February 1987, Garrett prepared an analysis intending to assume a 9% return on taxable securities and a 6% return on non-taxable securities. Garrett incorrectly reversed the 9% and 6% figures, and assumed the higher return was on non-taxable securities. Based on her incorrect advice, Oddi took the lump-sum distribution she recommended. Oddi discovered Garrett's error on May 2, 1987, and informed Garrett. After the error was discovered, neither Garrett nor anyone else at Ayco Corporation advised Oddi that the 60-day window for rolling the withdrawn amount into an IRA would not expire until mid-May. Oddi filed suit against Ayco Corporation for the present value of the difference in projected return between the lump-sum and IRA rollover alternatives. The District Court awarded Oddi $483,088 in damages plus the amount of income tax on the award. The Appeals Court affirmed the verdict. Oddi illustrates the malpractice exposure when calculations are insufficiently reviewed before presentation to a client. After the error was discovered, the adviser failed to consider the potential impact of the error and methods of mitigation. Proper advice on distributions from qualified plans can be particularly sensitive to small changes in tax law or planning assumptions. Errors in this area can represent a significant portion of an individual client's wealth. State Taxes. Gantt v. Boone illustrates what can happen when practitioners do not consider important differences between state and Federal tax law. In Gantt, the Turner Lumber Company agreed to sell its extensive land holdings in Mississippi, South Carolina, and Louisiana to Omni Capital Lumber Company for $11,750,000, and required Omni to defray all state and Federal income taxes accrued by Turner. Turner's attorney, Donald Pemberton, structured the sale of Turner's assets and subsequent liquidation to comply with IRC Sec. 337 to avoid Federal income taxes. Pemberton, however, failed to consider that none of the three states where the property was located had a similar tax-free liquidation statute. Ten days before the sale was to close, Pemberton met Robert Wales, a CPA who had audited Turner and prepared the corporate tax returns for the prior three years. Pemberton instructed Wales that within the next nine days he should calculate the state and Federal income taxes from Turner's operations for 1976. Pemberton instructed Wales not to analyze the sale and liquidation because that would be handled by Pemberton's law firm. Wales admits he thought of the state income tax liability from the sales transaction, but he did not tell Pemberton about the state taxes before or during the closing on December 20, 1976. Wales was paid a fee of $1,500 for his work on the closing. In January 1977, Wales told Turner's principal shareholder that the corporation owed approximately $500,000 in state income taxes. The shareholder was surprised because that amount had not been accrued at the closing. Wales and Pemberton each said they thought the other would accrue the state income taxes from the asset sale and corporate liquidation. Turner's shareholders sued Pemberton and Wales for negligence. Pemberton reached a pretrial settlement agreement with the plaintiffs. At trial the District Court found Wales and his accounting firm not liable. Evidence cited by the court included handwritten notes by Wales' associate that reflected Pemberton's instructions to limit the tax work to income from operations. Neither Wales himself nor Pemberton had a written agreement precisely specifying the accounting firm's responsibilities on the engagement. Although the accountant, Wales, won a favorable verdict, he could have avoided many problems for himself and his client if he had raised his concerns about state income taxes prior to the closing. The costs of malpractice defense and trial preparation were undoubtedly much higher than the $1,500 fee earned. A contributing factor in the malpractice complaint was the accountant's acceptance of a limited services engagement without a clear written engagement letter explicitly specifying the scope limitations. S Corporation Election. Feldman v. Granger was an accounting malpractice case that resulted from the failure to timely file a subchapter S election. Joseph Feldman was the sole shareholder of his corporation and decided he wanted to elect subchapter S treatment for the tax year beginning October 1, 1960. Harrell Granger's accounting firm prepared the required IRS Form 2553, but did not mail it until after 7:00 p.m. on the evening of October 31, 1960. The local post office gave all evening mail the following day's postmark, and this Form 2553 was postmarked November 1, 1960, 3:00 a.m. On November 12, 1960, Feldman received notice that his S election was denied because the November 1 postmark was not within the one-month statutory filing period. Feldman claimed he notified Granger's accounting firm, but Granger denied this assertion. Granger prepared Feldman's 1961 and 1962 individual income tax returns as if the S election were valid. On July 22, 1964, Feldman received an IRS statutory notice of deficiency totaling $25,428. After an unsuccessful Tax Court case, Feldman filed suit against Granger on July 18, 1968. On October 16, 1969, the state Appeals Court dismissed Feldman's malpractice suit on the grounds the statute of limitations for malpractice expired no later than July 22, 1967, three years after Feldman received the statutory notice of deficiency. Feldman v. Granger demonstrates a long time may pass between the tax practice error and the filing of a malpractice case. Feldman filed suit more than seven years after the error occurred. If the suit had been filed a year earlier, Granger's statute of limitations defense might not have been successful. SUMMARY OF MALPRACTICE CASES Lewin v. Miller Wagner & Co., Tax accountant failed to incorporate 151 Ariz 29 (Ariz. Ct. App. client's tax goal into tax planning 1986) process. Bronstein v. Kalchiem & Attorney gave erroneous tax advice Kalchiem, 90 Ill. App. 3d 957 about tax consequences of divorce (1980), 126 Ill. App. 3d 643 settlement. (1984), 146 Ill. App. 3d 1160 (1986) Togstad v. Vesely, Otto, Practitioner declined an engagement Miller & Keefe, 291 NW 2d 686 but did not write an disengagement (Minn. Sup. Ct. 1980) letter. Burdett v. Miller, 957 F. 2d Tax accountant recommended 1375 (7th Cir. 1992) particular tax shelters to client. Oddi v. Ayco Corporation, 947 Investment counseling firm gave F. 2d 257 (7th Cir. 1992) erroneous advice on the after-tax benefits of various qualified plan distribution alternatives. Gantt v. Boone, 559 F. Supp Practitioner did not consider 1219 (M.D. La. 1983) important differences between Federal and state tax law. Feldman v. Granger, 255 Md. Practitioner failed to file a timely 288 (Md. App. 1969) subchapter S election. Moonie v. Lynch, 256 Cal. Practitioner filed a collection App. 2d 361 (1967) action for work performed in previous years. Although the accountant, Granger, was victorious in this case, he could have prevented years of litigation by filing the S election on time. He brought the suit on himself by waiting until the last possible evening to file the election and receiving a postmark three hours past the deadline. Billing Disputes. Moonie v. Lynch illustrates the undesirable consequences of billing disputes. David Moonie, CPA, prepared income tax returns for Frank Lynch during the period 1956 to 1960. On May 15, 1963, Moonie filed a collection action in Municipal Court for $1,300 in fees due for work performed in 1959 and 1960. Lynch counterclaimed, alleging Moonie had negligently prepared Lynch's 1956 Federal income tax return resulting in IRS penalties. In 1967, the state Appeals Court determined the statute of limitations for malpractice claims started running on the date Lynch discovered the alleged negligence, and the case was remanded to the District Court for further proceedings. Moonie was involved in malpractice litigation a decade after he performed the tax services. If he had insisted on complete payment for prior year's work before renewing a tax engagement, he may have lost a client but avoided a malpractice suit. If tax practitioners allow clients to fall far behind in their payments for services rendered and the practitioner sues the client for collection, the client may file a cross-complaint alleging professional negligence. The practitioner may face larger legal costs in the ensuing malpractice litigation than the original amount of unpaid fees. Prevention The lessons from the above examples are summarized in the accompanying tax malpractice prevention checklist. Practitioners can adapt this checklist and other published guidelines into their own firm operating procedures. Although malpractice risk always exists, it can be reduced by implementing prevention procedures. As this article has shown, malpractice claims can arise from any aspect of tax practice. The cost of resolving these claims can far exceed the revenue from the engagement, even if the verdict or settlement is favorable to the practitioner. Therefore, tax practitioners should utilize the lessons drawn from others' misfortunes to limit their malpractice exposure. RELATED ARTICLE: TAX MALPRACTICE PREVENTION CHECKLIST Client Acceptance * Discuss and document client goals on each engagement. * Inquire about prior disputes with accountants, attorneys, or tax collectors. * Exercise caution when clients express callous disregard for law and deadlines. * Consider the potential for outrageous reactions when clients are involved in divorce or disputes with family members. * Avoid representing parties on opposite sides of a transaction. Scope of Engagement * Write engagement letters for each project or year of work. * If an engagement is declined, write a disengagement letter and state that no opinion is offered. * Specify professional services to be performed by other advisers. * Identify taxes not covered by engagement, such as state, payroll, or property taxes. * Do not recommend a specific investment unless you are a registered investment adviser under Federal and state law and have thoroughly analyzed the propectus and sponsors. Communications with Clients * Document all client meetings and phone calls. * Obtain client's consent to file extensions and elections. * Inquire about the existence of nonroutine transactions. * Request copies of executed documents after large asset sales or transfers. * When deductions or elections have a significant chance of being disallowed, inform the client of potential consequences in writing. Make the client responsible for making a final decision on these high-risk issues. * Provide written instructions to clients on filing deadlines. Application of Law * If engagement involve an unfamiliar area, consider consultation with a specialist. * When large dollars are at stake, computations should be checked by a second reviewer. Scheduling Work * Maintain systematic calendars of filing and planning deadlines for all clients. * Consider using engagement tracking software. * Request client information sufficiently far ahead of deadlines. If the information is late, write client another letter warning of deadline. Billing * Collect delinquent bills before renewing client engagements * Do not sue clients for nonpayment. William F. Yancey, PhD, CPA, is an assistant professor of accounting at Texas Christian University.