O'BRYAN v. Ashland

#23596, #23609-a-JKK

2006 SD 56

IN THE SUPREME COURT
OF THE
STATE OF SOUTH DAKOTA

* * * *

DOUG O’BRYAN, JONI
O’BRYAN, individually and
as DOUG O’BRYAN
CONTRACTING, INC., Plaintiffs and Appellees,

BRUCE ASHLAND, Defendant and Appellant.

* * * *

APPEAL FROM THE CIRCUIT COURT OF
THE SEVENTH JUDICIAL CIRCUIT
PENNINGTON COUNTY, SOUTH DAKOTA

* * * *

HONORABLE JANINE M. KERN
Judge

* * * *

THOMAS H. BARNES
STEPHEN C. HOFFMAN of
Costello, Porter, Hill, Heisterkamp,
Bushnell & Carpenter Attorneys for plaintiffs
Rapid City, South Dakota and appellees.

JOHN K. NOONEY of
Thomas, Nooney, Braun,
Solay & Bernard Attorneys for defendant
Rapid City, South Dakota and appellant.

* * * *

ARGUED ON JANUARY 11, 2006

OPINION FILED 06/21/06
#23596, #23609

KONENKAMP, Justice

[¶1.] In ordinary circumstances, 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 negligent advice, but from the

ongoing obligation to pay the tax. An issue never before decided in South Dakota,

however, is whether the taxpayer can recover from the negligent advisor the

accrued interest the IRS charged on the delinquent tax. Here, Bruce Ashland, an

accountant, improperly completed federal income tax returns for Doug O’Bryan’s

contracting business. When the mistakes were later uncovered, O’Bryan incurred a

large delinquent tax liability, together with accrued interest on the unpaid tax. He

sued Ashland for accountant malpractice. At trial, Ashland conceded negligence

and left for the jury the question of damages. Through special interrogatories, the

jury held Ashland liable for, among other things, the interest the IRS assessed

against O’Bryan. On appeal, Ashland challenges only the interest award. He urges

us to follow a line of authority generally holding that recovery of interest payable to

the IRS is not allowed because taxpayers have the interim use of the taxes, and

therefore they are not damaged by later having to pay interest for the period of that

use. We conclude that the better reasoned authority allows for recovery of interest

depending on the particular circumstances of each case. Under the facts here,

interest was recoverable, and thus we affirm the jury’s verdict.

Background

[¶2.] Ashland is a certified public accountant. He began providing services

for Doug O’Bryan Contracting in 1987-1988. From 1979 through the first quarter of

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1995, O’Bryan operated as a sole proprietorship. O’Bryan’s well-drilling business

prospered and grew in the early 1990s. On several occasions over the years,

Ashland recommended to O’Bryan that he incorporate. O’Bryan ultimately followed

Ashland’s advice and incorporated effective April 1, 1995.

[¶3.] For taxation purposes, incorporating in April meant that O’Bryan

remained a cash basis taxpayer for the first quarter of the year, January 1, 1995

through March 31, 1995. Then, on incorporation, the business changed to accrual

basis accounting for the last three quarters, April 1, 1995 through December 31,

1995. 1 But, when Ashland prepared O’Bryan’s 1995 tax return in October 1996, he

mistakenly calculated O’Bryan’s income for the first quarter using accrual based

figures. As a result, Ashland understated, and consequently underreported, the

income O’Bryan realized for the first quarter. 2

[¶4.] Ashland’s mistake was discovered by another accountant during

O’Bryan’s divorce proceedings in 1997. After the accountant informed Ashland, he

wrote a letter to O’Bryan disclosing the mistake and the need to correct the tax

return. O’Bryan’s divorce attorney hired a different accountant to review and

amend the mistaken return, and, as of June 28, 1998, O’Bryan had $239,933 in

1. According to Ashland, “[a]s a cash basis taxpayer, O’Bryan was obligated to
pay tax on the actual receipts of cash he had realized in the first quarter, and
for the last nine months of 1995, O’Bryan owed the IRS tax on the services
billed and/or completed during that time period, even though the company
may not have yet realized actual cash for such services and/or billings.”

2. In addition to understating O’Bryan’s income for 1995, Ashland also failed to
use an Indian Employment Tax Credit for O’Bryan’s 1994 return. Ashland
conceded he was negligent in this regard.

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additional tax liability for 1995, together with approximately $50,000 in interest. 3

O’Bryan brought suit against Ashland seeking recovery for the additional expenses

he incurred in correcting the erroneous tax returns. He also sought the interest the

IRS charged on his unpaid tax liability.

[¶5.] As a matter of settled law, the circuit court ruled that O’Bryan’s

delinquent tax debt ($239,933) could not be included in his measure of damages

because it was solely O’Bryan’s obligation, which he would have owed regardless of

his accountant’s negligence. However, the court allowed the jury to consider

whether O’Bryan could recover as damages the interest assessed by the IRS on his

unpaid tax liability. Accordingly, the issue whether the interest charge actually

damaged O’Bryan was extensively argued, and each side offered theories on

whether and why the interest assessed by the IRS should or should not be

recoverable.

[¶6.] While Ashland conceded that under certain situations a negligent

accountant should pay interest assessed against the taxpayer, such requirement

would apply only to situations where the client had “the money just sitting in their

one percent savings account. . . .” Here, Ashland argued, the situation was

distinguishable because O’Bryan did not have the cash readily available when his

1995 tax return was originally filed in October 1996, and if it would have been

correctly filed, O’Bryan would have had to borrow the money to pay the tax at a

3. According to Ashland, by “the time of trial, O’Bryan still owed the IRS
$182,369 of the original $239,933, as well as the interest. . . .”

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higher interest rate than the IRS charged. As a result, Ashland contended that the

loss O’Bryan sustained should not include the interest assessed by the IRS.

[¶7.] O’Bryan, on the other hand, maintained that he would have been able

to fully pay his 1995 tax obligation had it been properly calculated, and thus he

would have incurred no interest. O’Bryan also asserted that Ashland committed

additional negligence when he incorporated O’Bryan’s business in April rather than

at the beginning of the year. To support his theory, O’Bryan offered expert

testimony that had Ashland incorporated O’Bryan’s business at the beginning of the

year, rather than in April, O’Bryan would have been able to use a transitional

reporting method, termed the “Three Year Rule.” Use of the “Three Year Rule,”

according to O’Bryan’s expert, would have softened the effect of changing from a

cash based taxpayer to an accrual based taxpayer. 4 Consequently, the damage

O’Bryan claimed he suffered was that Ashland’s negligence prevented him from

spreading out the effect of changing from a cash based taxpayer as a sole proprietor

to an accrual based taxpayer through incorporation.5

4. Before O’Bryan incorporated he recognized income when it was actually
received because he was a cash basis taxpayer. After the date O’Bryan
incorporated, his business recognized income when the job or service was
completed or billed. As a result, when O’Bryan changed reporting methods in
the middle of 1995, he was required to recognize all his accounts receivable as
income for the last three quarters of the year. Had he been allowed to use
the “Three Year Rule”, he would have been able to spread out the adjustment
over three years. For example, O’Bryan’s expert stated that if O’Bryan had
$790,000 in accounts receivable for 1995 and would have been able to use the
Three Year Rule, he would have spread out the tax obligation on the
$790,000 over three years, rather than being required to pay it all in 1995.

5. O’Bryan argued that Ashland’s failure to incorporate at the beginning of the
year was in fact essential to the issue of damages and related to the interest
(continued . . .)
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[¶8.] According to Ashland, however, O’Bryan’s “Three Year Rule” argument

only confused the issues: use or non use of the “Three Year Rule” was in no way

connected to the case and was “nothing more than a smoke screen. . . .” In

Ashland’s view, the IRS interest charge related exclusively to O’Bryan’s unpaid tax

liability for 1995. Thus, the “Three Year Rule” was immaterial, and Ashland

claimed that the focus should be on the real issue: what damage did O’Bryan suffer

from Ashland’s miscalculation of O’Bryan’s income realized for the first quarter of

1995? 6

[¶9.] O’Bryan and Ashland presented their conflicting theories on how

damages should be calculated and what factors should be considered within that

calculation. Ultimately, the jury concluded that O’Bryan had been damaged by

Ashland’s negligence and found, among other things, that the interest O’Bryan

_______________________
(. . . continued)
assessed by the IRS. First, O’Bryan testified that use of the “Three Year
Rule” would have spread out his 1995 tax obligation over three years, and
thus the 1995 obligation would have been far less. Second, because it would
have been less, O’Bryan maintained he could have paid the obligation, and
thus avoided incurring any interest charges. Third, because of Ashland’s
negligence in failing to incorporate in January, O’Bryan argued that these
circumstances warranted including the interest assessed by the IRS as a
measure of damages.

6. Ashland asserted that the interest O’Bryan was charged was not a penalty,
but a function of having the use of $239,933, money O’Bryan would otherwise
not have had if the tax had been paid when originally due. Accordingly,
Ashland argued that O’Bryan was not damaged by the interest charged
because the rate assessed by the IRS was less than the rate O’Bryan would
have obtained had the tax been properly calculated and O’Bryan had to pay
the $239,339 when the 1995 tax return was originally filed. Ashland offered
that the interest rate charged by the IRS was only 4% to 9%, and O’Bryan
would have had to borrow funds to pay the 1995 tax obligation at 10½%.

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incurred should be included in the measure of damages. The jury awarded O’Bryan

interest charged from October 10, 1996, through June 23, 1998, which was later

calculated to be $39,038.03.

[¶10.] Ashland appeals only the award of interest charged by the IRS,

claiming that, as a matter of law, it is not includable as an element of recoverable

damages in professional negligence actions. 7 By notice of review, O’Bryan contends

that interest should have been figured from April 15, 1995, the date the original

return was due, instead of October 10, 1996, the date the mistaken return was filed.

Standard of Review

[¶11.] Whether a plaintiff may recover the interest due the IRS in an

accounting malpractice action is a question of law. Questions of law are reviewed

de novo. See Convenience Center, Inc. v. Cole, 2004 SD 42, ¶11, 678 NW2d 774,

777; Parks v. Cooper, 2004 SD 27, ¶20, 676 NW2d 823, 829; Truhe v. Turnac Group,

LLC, 1999 SD 118, ¶11, 599 NW2d 378, 380.

Analysis and Decision

[¶12.] Ashland asks us to adopt a categorical rule that interest payable to the

IRS is not recoverable as a measure of damages. O’Bryan, on the other hand,

asserts that he was damaged by the interest charged against him, and he should be

allowed to recover it. These conflicting arguments have divided the courts around

the country. Some jurisdictions hold that interest is never recoverable because

7. The jury also awarded damages (1) from the failure to take the Indian
Employment Credit on O’Bryan’s 1994 taxes; and (2) the additional
accounting fees incurred for the 1994, 1995, and 1996 amended tax returns.
Ashland does not appeal these awards.

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delinquent taxpayers will have had the interim use of the funds owed to the IRS,

and thus they are not damaged by having to pay interest for the period of that use.

Other jurisdictions conclude that taxpayers would not have had to pay interest if

they had received competent advice, and therefore awarding interest allows them to

be restored to the situation they would have been in had they not received the

faulty advice. To discern the better approach, we must examine both positions.

[¶13.] We first consider the rationale used in those jurisdictions where

recovery of interest is precluded as a matter of law. See Eckert Cold Storage, Inc. v.

Behl, 943 FSupp 1230 (EDCal 1996); Orsini v. Bratten, 713 P2d 791, 794 (Alaska

1986); Alpert v. Shea Gould Climenko & Casey, 160 Ad2d 67, 72 (NY 1990);

Leendersten v. Price Waterhouse, 916 P2d 449, 451 (WashCtApp 1996). In

Leendersten, 916 P2d at 451, the taxpayer received an excessive refund from the

IRS because of accounting negligence and incurred, among other charges, an IRS

interest assessment. The taxpayer sought recovery from the accountant, but the

court held that the taxpayer had the use of this money, and to obtain payment from

another source for that use would unjustly enrich the taxpayer.

[¶14.] Likewise, in Eckert Cold Storage, Inc., 943 FSupp at 1234, a taxpayer

argued that the accountant gave negligent advice on certain investments causing

the taxpayer damage upon incurring back taxes and interest. The taxpayer

attempted to prove damages, arguing that, but for the negligent advice, the

taxpayer would not have had the back taxes or interest charges. The court

examined whether interest payable to the IRS should be recoverable and held that

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the better rule would exclude it because “to the extent that the IRS charges the

market rate,” it has not damaged the taxpayer. Id. at 1235.

[¶15.] Also prohibiting recovery, Alaska’s Supreme Court concluded that the

taxpayer was in no worse position as a result of the interest. Orsini, 713 P2d at

794. The same result can be seen in New York, where the court ruled that a

windfall would result if recovery was allowed. Alpert, 160 Ad2d at 72. Essentially,

the argument against allowing interest as a measure of damages hinges on the

theory that the IRS does not charge interest to penalize the taxpayer. Rather, it is

merely a charge for the use of money that the taxpayer should have earlier paid to

the government. See Eckert Cold Storage, Inc., 943 FSupp at 1235; Orsini, 713 P2d

at 794; Alpert, 160 Ad2d at 72; Leendersten, 916 P2d at 451.

[¶16.] But what if taxpayers can prove they were truly damaged?

Acknowledging this possibility, several courts refuse to adopt an absolute rule

barring recovery: whether a taxpayer has been damaged is left to the finder of fact,

with the burden of proof on the taxpayer. See Jobe v. Int’l Ins. Co., 933 FSupp 844

(DAriz 1995); Ronson v. Talesnick, 33 FSupp2d 347, 353 (DNJ 1999); Dail v.

Adamson, 570 NE2d 1167 (IllCtApp 1991); Wynn v. Estate of Holmes, 815 P2d 1231

(OKCtApp 1991); McCulloch v. Price Waterhouse, LLP, 971 P2d 414 (ORCtApp

1998). The courts taking this approach recognize that, under traditional damage

principles, if the taxpayer has been injured, recovery should be allowed. These

decisions focus on the position the parties would have been in had they not received

the negligent advice.

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[¶17.] The Oregon Court of Appeals considered the two concerns identified in

those decisions denying recovery: “(1) a windfall: i.e., the taxpayer could recover

damages for interest and at the same time a return from the use of the monies that

could have been applied to the tax liability; and (2) the speculative nature of the

causation of the damages.” McCulloch, 971 P2d at 419 (discussing Leendersten, 916

P2d at 451). Because the burden is on the taxpayer to prove “the causation and

amount of each claim of damage[,]” the court held that “neither concern supports the

absolute bar to recovery of damages arising from accrued interest. . . .” Id.

(emphasis added). Nonetheless, while the Oregon court refused to follow

Leednersten, it acknowledged that in certain circumstances an award of interest

may not be warranted when taxpayers fail to meet their burden of proof. But

ultimately the issue should depend on the circumstances of each case.8 Id.

[¶18.] Similarly, a New Jersey court considered the split in authority on this

question and concluded that the better reasoned process would allow the jury to

determine whether the taxpayer was damaged by the interest assessed. 9 Ronson,

8. In addition to the cases cited, the following authorities also allow for recovery
of interest: Jamison, Money, Farmer & Co., PC v. Standeffer, 678 So2d 1061
(Ala 1996); Jones v. Childers, 1992 WL 300845 (DCFla) (unreported), aff’d in
part, and rev’d in part, 18 F3d 899 (11thCir 1994); Jerry Clark Equip., Inc. v.
Hibbits, 612 NE2d 858 (IllAppCt 1993), appeal den., 622 NE2d 1208 (Ill
1993); Warmbrodt v. Blanchard, 692 P2d 1282 (Nev 1984); Wyatt v. Smith,
1993 WL 518630 (OhioCtApp) (unreported); Merriam v. Continental Casualty
Co., 597 NW2d 774 (WisCtApp 1999) (“unpublished limited precedent
opinion”), review den., 604 NW2d 572 (Wis 1999); Adel v. Parkhurst, 681 P2d
886 (Wyo 1984).

9. When the court listed the various decisions that have addressed the issue, it
placed South Dakota among the jurisdictions that allow recovery of interest.
Id. at 352. The court cited, Lien v. McGladrey & Pullen, 509 NW2d 421, 426
(continued . . .)
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33 FSupp2d at 354. The court found particularly compelling certain tort damage

principles, such as the collateral source rule and the benefits rule. Along those

lines, the court stated that “[a] blanket prohibition against the recovery of IRS

interest under the circumstances presented is not reconcilable with one of the

underlying policies of the collateral source rule that a tortfeasor should not benefit

from the ingenuity of a harmed plaintiff.” Id. at 355. Thus, it held that “New

Jersey would permit recovery of IRS interest as damages in accounting malpractice

actions.” Id. at 354.

[¶19.] In sum, the Ronson court deduced that this was “the only reasonable

interpretation that furthers the overriding tort damages principle of restoring the

plaintiff to the position he or she would have been in but for the actions of the

tortfeasor.” Id. Moreover, “[d]enying recovery of IRS interest from a negligent

accountant permits the tortfeasor to benefit from the presumption that a harmed

taxpayer should have been ingenious enough to (1) maintain a sum of money that

he would have otherwise had to pay over to the IRS and (2) invest that money in a

manner in which he earned interest in an amount comparable to the rate charged

by the IRS.” Id. at 355.

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(. . . continued)
(SD 1994), where we stated that the appropriate measure of damages in
professional negligence actions in South Dakota is “the difference between
what the taxpayer would have owed absent the negligence, and what [the
taxpayer] paid because of [the] accountant’s negligence, plus incidental
damages.” While this is an appropriate statement of our law, it does not
stand for the proposition asserted in Ronson. Until today, we have never
determined whether a taxpayer in South Dakota may recover interest
payable to the IRS as a measure of damages in professional negligence
actions.

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[¶20.] Our own precedent supports the rule that “[i]n a professional

negligence action, the appropriate measure of damages is the difference between

what the taxpayer would have owed absent the negligence, and what [the taxpayer]

paid because of [the] accountant’s negligence, plus incidental damages.” Lien, 509

NW2d at 426 (citing Thomas v. Cleary, 768 P2d 1090, 1091-92 n5 (Alaska 1989)).

While this standard does not expressly include interest payable to the IRS, it does

lay the foundation for such an award. For instance, the court in Dail, 570 NE2d at

1169, used the Thomas measure and allowed recovery of the interest assessed by

the IRS. The same occurred in Jobe, 933 FSupp at 860, where the court adopted the

standard in Thomas and then concluded that interest was recoverable as an

appropriate measure of damages.

[¶21.] Our case law has long emphasized that the “object of compensatory

damages is to make the injured party whole.” Hulstein v. Meilman Food Industries,

Inc., 293 NW2d 889, 891 (SD 1980) (citing Ralston Purina Co. v. Jungers, 86 SD

583, 199 NW2d 600 (1972)). Accordingly, we conclude that the issue whether a

plaintiff has actually been damaged from the interest charged by the IRS to the

taxpayer on unpaid tax liability is a question of fact and align ourselves with those

jurisdictions that refuse to adopt a blanket rule forbidding interest recovery in

accounting malpractice actions.

[¶22.] Having concluded that interest charged by the IRS may be recoverable

in the proper circumstance, we now examine the facts of this case. Here, negligence

was conceded, thus the jury was only required to determine what, if any, damages

O’Bryan suffered as a result. Both Ashland and O’Bryan offered evidence on

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damages. O’Bryan’s expert asserted that the interest charged by the IRS did in fact

damage O’Bryan. Ashland’s expert responded that the IRS charged a 4% to 9%

interest rate and O’Bryan would have been required to pay a 10½% market interest

rate when the obligation was due. As a result, Ashland suggested that O’Bryan was

not damaged from the negligence because he had a more favorable interest rate

from the IRS than he would have obtained elsewhere.

[¶23.] Confronted with O’Bryan’s and Ashland’s conflicting theories, the trial

court allowed them to be evaluated by the jury, and, through special interrogatories,

the jury found that O’Bryan was damaged by the interest assessed. We examine

the evidence in a light most favorable to the verdict. Parker v. Casa Del Rey, 2002

SD 29, ¶5, 641 NW2d 112, 115. There was evidence to support this verdict.

O’Bryan did not have the unpaid tax money deposited somewhere earning

interest. 10 But he said that had he been able to use the “Three Year Rule” to spread

his tax liability, and had he known of the tax when it was due, he would have been

able to pay it. He said that he would not have necessarily had to borrow the money

from a bank; he may have been able to borrow money from his family as he had

done before. Only a trier of fact could adequately assess these claims. We conclude

that there was sufficient evidence in the record to support the jury’s determination

that the interest charged by the IRS was directly related to Ashland’s negligence

and that O’Bryan suffered a loss as a result. Therefore, the circuit court did not err

when it allowed the issue to go to the jury.

10. There was testimony, albeit contested, that O’Bryan had $565,000 in profit
from his business in 1996 available to pay taxes.

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[¶24.] Perhaps, under the appropriate facts, an equitable burdens and

benefits analysis might be used to more finely ascertain the proper damages in this

type of case. Our laws are not designed to allow plaintiffs to profit from their

injuries. Big Rock Mountain Corp. v. Stearns-Roger Corp., 388 F2d 165, 169

(8thCir 1968); see also Reed v. Consol. Feldspar Corp., 71 SD 189, 23 NW2d 154. As

the court in Ronson concluded, “defendants should be permitted to come forward

with evidence of benefit from the malpractice that could be applied to reduce the

plaintiff’s recovery.” 33 FSupp2d at 355 (citing Lein, 509 NW2d at 426). 11 This

measure balances the policy of preventing plaintiffs from recovering a windfall

against allowing tortfeasors to escape without making plaintiffs whole. Such a

method may cut a pragmatic course between two rigid theories: plaintiffs had use

of the money and therefore cannot recover interest, or interest must be recovered to

put plaintiffs in the position they would have been in had it not been for the tax

advisor’s negligence. See Caroline Rule, What and When Can a Taxpayer Recover

From a Negligent Tax Advisor?, 92 J Tax’n 176 (March 2000). Whether this

approach should be used in South Dakota must be decided in the appropriate future

case. Here, neither party raised the specific question whether any benefits O’Bryan

may have had from Ashland’s negligence should be offset against any damages.

Each side simply argued that interest was recoverable or not recoverable.

11. The court in Ronson cited our statement in Lein that “[j]ust as [the plaintiff’s]
expert was permitted to testify regarding the damages incurred as a result of
the negligent advice, so must [defendant] be allowed to elicit testimony
discrediting [plaintiff’s] computations and demonstrating the benefits which
[plaintiff] received.” 33 FSupp2d at 355 n14 (citing Lein, 509 NW2d at 426).

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[¶25.] Lastly, on notice of review, O’Bryan contends that the interest award

should have started on the date the 1995 taxes were originally due, April 15, 1995,

instead of the date the jury settled on, October 10, 1996. In response, Ashland

argues that this issue was not preserved for appeal. At the close of the case,

O’Bryan moved for a directed verdict under SDCL 15-6-50(a). His motion was

denied. At no time thereafter did O’Bryan move for judgment notwithstanding the

verdict under SDCL 15-6-50(b). Therefore, whatever the merits of his interest date

argument, the issue was not preserved for appeal by the failure to move for

judgment notwithstanding the verdict. S.D. Bldg. Auth. v. Geiger-Berger Assocs.,

414 NW2d 15, 25 (SD 1987). The only exception available is under the plain error

rule, but we find no support in the record for plain error. SDCL 19-9-6 (Rule 103

(d)).

[¶26.] Affirmed.

[¶27.] GILBERTSON, Chief Justice, and SABERS, ZINTER, and

MEIERHENRY, Justices, concur.

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