Firm Articles

CPA’s Liability to Third Parties for the Acts of their Clients

By Benjamin J. Peeler

Some recent accounting scandals have created skepticism about the actions of CPAs regarding their historical role as financial stewards. This perception has caused an increase in claims against them from dissatisfied shareholders and creditors. Many CPAs are concerned about the extent to which this dissatisfaction affects them, if they simply act according to their clients’ lawful requests without knowledge of the clients’ bad acts.

The Court of Appeals for California recently decided some limits in Levine v. Higashi, __ Cal. App. 4th. __, G032995, 2005 Cal. App. LEXIS 1178 (July 27, 2005). The case involved a CPA engaged by a partnership to prepare its schedule K-1s. The partnership furnished the CPA with specific information and requested income allocations that differed from the partnership agreement. The CPA sent a letter to confirm the differing allocations. The managing partners signed and returned the confirmation. The CPA then proceeded as instructed by the partnership.

However, the spouse of a recently deceased partner disagreed with the income allocations and the timing of the partnership buyout. This was an internal matter not disclosed to the CPA. The disagreement led to an arbitration decided in favor of the remaining partners. Unable to recover against the partners, the spouse asserted her claim against the CPA.

She asserted four alternative theories attempting to establish a duty owed to her by the CPA. Her theories were, that: (1) a CPA owes a duty to a partner as an intended beneficiary of the contract with the partnership; (2) an individual partner becomes a client under an implied duty theory; (3) the CPA’s status as an agent of the partnership attributes the same fiduciary duty to the CPA as the partners have to one another; and (4) that statutes and regulations governing accounting practices establish a duty owed to partners under the contract with the partnership.  The Court held that no such duty arose under any theory put forth by the spouse.

CPA’s Duty to Third Party as an Intended Beneficiary

The Court found there is no duty to a third party as an intended beneficiary unless “…the purpose of retention of the… [CPA]…was for the specific objective of creating...a benefit” to that party, and it was the specific intention of the contracting party to create such a benefit. Id. citing, Johnson v. Superior Court, (1995) 38 Cal.App.4th 463, 471. The court could not find such an intended benefit, because such a benefit would have required the CPA to refuse the lawful instructions of his client without any knowledge of the adverse contentions by the supposed third party beneficiary -- the Plaintiff.

The court relied on Biakanja v. Irving, which considered such factors as the (1) “extent to which the transaction was intended to affect the plaintiff”; (2) “foreseeability of harm” to the Plaintiff; and (3) degree of certainty that the Plaintiff suffered injury. Id. citing Biakanja v. Irving, (1958) 49 Cal.2d 647, 650. The court found that the CPA had no contact with the Plaintiff, and was not privy to the internal disputes. Therefore, there was no way for him to foresee harm, let alone contemplate the certainty of harm to the Plaintiff. 

CPA’s Duty to Third Party as an Implied Client

The court found the accountant-client relationship must come from an agreement, which, if not expressed, must at least be implied-in-fact. Moreover, the court found it appropriate that the partnership, rather than individual partners, contracts with an accountant to perform tax preparation services. The court relied on Johnson v Superior Court, which considered whether an attorney-client relationship existed, and found such a relationship where there was an agreement that created a confidence and a duty of loyalty between parties. Id. citing, Johnson v. Superior Court, (1995) 38 Cal.App.4th 463, 474-479.

The court found the scope of the engagement did not include the determination of income allocations. The court did not find an accountant-client relationship, because there was no contact between the CPA and the Plaintiff. Without any direct contact, the CPA had no way to know that the Plaintiff had not participated in determining the income allocations. Therefore, an implied client relationship did not exist.

CPA’s Duty to a Third Party through Derivative Fiduciary Duty

The court held that a professional's representation of a fiduciary does not impose a fiduciary obligation to the beneficiary unless the beneficiary “…reposes trust and confidence in another and the person in whom such confidence is reposed obtains control over the other person’s affairs.” Id. citing, Lynch v. Cruttenden & Co., (1993) 18 Cal.App.4th 802, 809. The court refused to extend a fiduciary duty to the CPA because he had no contact with the Plaintiff.

CPA’s Duty to a Third Party based on Accountancy laws

Finally, the court refused to extend to third parties, such as “…an accountant, a responsibility to police the internal governance of the partnership or to assume that instructions from a client cannot be relied upon.” Id. The court could not find support in statutes and regulations governing accounting practice to create a duty to third parties based on the acts of the other partners even if those acts included instructions to the CPA that conflicted with other partners, if the CPA had no reason to know of a conflict.

The Plaintiff asserted that the Code of Federal Regulations created a duty to the individual partners, because Title 31, part 10.29 provides in part that, “No… [CPA]…shall represent conflicting interests in his practice before the Internal Revenue Service, except by express consent of all directly interested parties after full disclosure has been made.” The court rejected this argument in holding that preparing schedules K-1 was not practicing before the Internal Revenue Service.

Conclusion

The CPA’s request for the confirming letter was a significant factor; it made it easy for the court use the partnership as a buffer between him and the internal activities of the partnership. Moreover, that the Plaintiff failed to prevail against the partners themselves was also a significant factor. Still, this case establishes important guidelines to help prevent third party derivative claims from the actions of a client.

DISCLAIMER

As provided in Treasury Department Circular 230, this article is not intended or written by Lobb Cliff & Lester, LLP to be used, and cannot be used, by a client or any other person or entity for the purpose of avoiding tax penalties that may be imposed on any taxpayer.

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