Statute of Limitations: A Primer
Accountants frequently use statute of limitations defenses in professional liability litigation. Therefore, understanding the theory behind these statutes gives CPAs a powerful weapon in fending off such litigation.
Limitations, triggers and discovery dates
Depending on the circumstances of the case, the statute of limitations dates may be governed by one of several legal theories. Put simply, a lawsuit must be filed before the procedural statute-of-limitations period runs out. If too much time has elapsed, the claim is “time-barred.” State law determines the statute of limitations period if the contract does not stipulate an alternative time period. In addition, most states have default statutes of limitations that require suits for professional negligence to be brought within two or three years.
The “trigger” date of a suit is when the time period starts running. Determining a trigger date—particularly in a tax case—can be complicated.
For a reporting engagement, the date on which the defendant committed the negligent act or omission usually triggers the statute. The general rule is that the trigger occurs when the client suffers damages.
For client claims that are “inherently undiscoverable”—such as embezzlements—the date of discovery is the trigger date. Date of discovery is also used in cases in which uninterrupted professional representation may have hampered the client’s learning of the claim.
Tax cases add other wrinkles
The time period within which the client must file suit is complicated in tax cases; however, there are three default rules. CPAs should check with local counsel to determine which rule applies in their state.
- Work product date. Ackerman v. Price Waterhouse, 644 N.E. 2d 1009 (N.Y. 1994) held that the time period for the client, under the statute of limitations, to sue its accounting firm was triggered when the taxpayer received the tax return. This case involved limited partners who tried to sue six years after the firm had completed the work. The AICPA wrote an amicus brief in this case, arguing that a CPA’s liability should have a determinable time limit.
Final assessment date. Some states have held
that the statute commences only upon receipt of the final audit
assessment because that is the date the legal obligation to pay
arises. In International v. Feddersen, 38 Cal. 2d
150 (1995), for example, a final assessment date claim was filed
against a CPA more than three years after the work was done and the
return had been filed.
This line of reasoning leaves unclear when a malpractice claim is time-barred. The final date could be the conclusion of the tax audit, or it could include the IRS appeals division review, the adjudication in Tax Court, review by the Circuit Court of Appeals or even review by the Supreme Court.
- Discovery date. Many states have a date of discovery rule requiring an analysis of the audit process. Under the “discovery” rule, the statute is triggered when the taxpayer knows to a reasonable degree of certainty that the defendant’s tax error or omission will result in damages. (See Brown v. KPMG Peat Marwick, 856 S.W. 2d 742 [Tax APT 1993])
Putting standards into practice
There are always inherent uncertainties in applying the above standards. A judge may not understand the tax process, and juries are easily confused.
Discovery (and thus the trigger date) is a factual question. The trigger date becomes less important if the exposure period is shorter. Regardless of the state default provision, it normally applies only if the parties do not specify a different term in the contract.
A good example of the application of the discovery rule is Cotton v. Koenig & Eng, King County Superior Court 94-2-18663-9. Cotton was a Washington state tax malpractice case in which the plaintiff sought additional tax and consequential damages, claiming that his accounting firm had made a mistake in classifying an income item on a sales tax return.
The misclassification resulted in a $28,000 tax assessment against the taxpayer. The taxpayer claimed he was forced, therefore, to sell his business at a substantial loss. He sued the defendant for both the tax amount and consequential damages of the business bankruptcy.
The firm filed two summary judgment motions arguing that the consequential damages claim was too speculative. The second motion was successful, and the court dismissed most of the monetary claim. The issue remaining was how to apply the statute of limitations for the tax, penalties and attorney fees. On cross-motions for summary judgment, the court rejected both the “work-product” and “final assessment” date rules. It held that the date of “discovery” applied and that this factual question precluded dismissal on a summary judgment motion.
The court granted the defendant’s subsequent motion to bifurcate the trial and try the statute-of-limitations issue first. During the trial the court held that while the final assessment was within three years of filing the suit, the discovery was not. Thus the suit was not brought timely, and the issues of liability and damages were moot.
A possible solution
Why not specify in the agreement that the statute of limitations for an error or omission claim is limited to one year? This would substantially reduce the period in which a claim may be brought. Clients would likely bring fewer claims, making this provision attractive regardless of which state rule triggers the running of the statute.
UCC 2-725(1) allows parties to a contract to stipulate a shorter period of exposure (not less than one year) in the agreement. The one-year period is appropriate because it is also specified as the time period of liability exposure under the 1933 Securities Exchange Act.
For personal services engagements, such as reporting and consulting services, the same principles apply. In IBM v. Catamore, 548 F.2d 1065 (lst Cir. 1976) the court upheld a contractual provision agreeing to a one-year period of limitations for claims arising from an MAS engagement. The opinion stated, “When a supplier and its customer, neither of whom is helpless in the marketplace, agree on terms limiting the period of liability for future services to one year, those terms must be respected.”
For more on this issue, see also Hays v. Mobil Oil, 930 F.2d 96 (lst Cir. 1991) and Kardios v. Perkins, 645 F. Supp. 506 (D. Md. 1986). Both of these opinions referred with approval to the IBM precedent particularly as it applies between sophisticated parties. This loss prevention technique is most useful when it is applied to a CPA’s business clients who are knowledgeable about commercial matters. The application to consumers may be less certain.
Implications for CPAs
CPAs should specify in their client engagement letters that there is a one-year period to bring a claim for error or omission. Such a provision would reduce the time period in which a claim could be brought against the CPA. The downside risk for CPAs in including a limitation provision in a contract is that courts could hold the limitation unenforceable, thereby restoring the state’s default rule.
Editor’s note. Thanks to James J. Rigos, CPA, JD, LLM, www.cpariskprevention.com , for submitting this article on statute of limitations issues for the CPA.
—Edited by Wayne Baliga, CPA, JD, CPCU, CFE president of Aon Technical Insurance Services.