Tax Malpractice Damages – Return to Fundamentals – Another Court Gets It Right
8.19.2020
If one were designing the measure of damages recoverable for negligent tax advice, the most obvious element of recoverable damages would be the avoidable extra taxes caused by the negligence. After all, minimizing taxes is at the heart of a tax representation. In most states, such avoidable taxes are recoverable. The situation in New York is more clouded. Under longstanding traditional tort principles, the additional taxes would be recoverable. However, a few outlier cases decided between 2007 and 2014 have held such additional taxes not recoverable.[1] There does not seem to be a principled rationale for these cases. Rather, they simply rely, directly or indirectly, on Alpert v. Shea Gould Climenko & Casey.[2] While Alpert did hold additional taxes were not recoverable, Alpert involved a fraud cause of action, and correctly applied longstanding principles of damages recoverable in fraud causes of action. But damages recoverable for fraud are different from, and more limited than, damages recoverable in tort causes of action. In Serino v. Lipper, [3] the First Department recognized this distinction and held that additional avoidable taxes are recoverable in negligence-based tax malpractice actions. Recently, a lower court, Bloostein v. Morrison Cohen LLP,[4] recognized the distinction and held that such additional, avoidable taxes are recoverable. While Bloostein reached the correct result, by failing to focus on the developments in this area of the law, Bloostein missed an opportunity to clarify the law and to clearly reset it on its proper path.
The factual background of Bloostein is most interesting and unusual. The case involved a pre-packaged tax product – a tax shelter, if you would – but there is no intimation in the case that it was abusive. The attorneys who drafted the tax opinion underlying the transaction obtained summary judgment dismissing all claims against them. In denying the defendant’s motion for summary judgment dismissing the plaintiffs’ claims, Bloostein addressed several fundamental issues of New York tax malpractice law. Centrally, unlike the few outlier post-Alpert cases, Bloostein, like Serino, correctly held that additional taxes proximately caused by a tax advisor’s negligence are recoverable in a negligence-based cause of action. Bloostein recognized there are different recoveries in tort versus fraud-based actions and correctly distinguished Alpert. In fact, Bloostein read Alpert very narrowly – perhaps even too narrowly.
Before discussing Bloostein, it would be helpful to focus briefly on the tax provision at the heart of the litigation, Internal Revenue Code (IRC) section 1042.[5] Without becoming enmeshed in the detailed requirements, section 1042 is an elective nonrecognition provision. It provides for the nonrecognition of long term capital gain realized on the sale of “qualified securities” to an employee stock ownership plan (ESOP) of the corporation issuing the qualified securities.[6] The nonrecognition applies only to the extent the proceeds from the sale of the qualified securities are used to purchase qualified replacement property (QRP) within the designated replacement period.[7] If the taxpayer disposes of the QRP, such as by sale, the previously unrecognized gain must be recognized in income then.[8] In such situations, section 1042 acts as a deferral provision, allowing the taxpayer to defer reporting the gain recognized on the sale of the qualified property until when the QRP is disposed of.
Death of the taxpayer electing section 1042 treatment does not trigger recognition of the previously unrecognized gain.[9] Under the IRC’s rules for the tax basis in inherited property,[10] the heir of the electing taxpayer will obtain a tax basis in the QRP equal to its fair market value at the electing taxpayer’s date of death. This “basis step-up” means that the original unrecognized gain will never be recognized for tax purposes. Under these circumstances, section 1042 results in the permanent nonrecognition of the original unrecognized gain – i.e., tax avoidance, not just tax deferral. Section 1042, therefore, can function either as a gain deferral or a gain exclusion mechanism, depending on who – the electing taxpayer, or his heir – sells the QRP.
Bloostein – Facts
The plaintiffs in Bloostein were owners of small to mid-sized businesses who engaged the defendant law firm, Morrison Cohen LLP and its attorney Brian Snarr, to represent them in connection with an IRC section 1042 reinvestment transaction. In a straightforward section 1042 transaction, the corporate shareholder sells some of his corporate shares to the corporation’s employees through the corporation’s ESOP and reinvests the proceeds in QRP of his choice. Thus, the shareholder has diversified his investment in his corporation’s shares, which by definition are not publicly tradable,[11] without incurring any present income taxes on the gain realized. The owner, however, has gained no liquidity, unless he chooses to recognize a portion of his gain by not reinvesting all his proceeds in QRP. The transaction involved was designed by Stonebridge Capital to enable the corporate shareholder to also obtain liquidity by borrowing funds, indirectly secured by the QRP.
Under the Stonebridge plan, each plaintiff formed a special purpose vehicle, an LLC, the existence of which was to be ignored for income tax purposes, though fully recognized otherwise. Each of these vehicles was called a “1042 LLC.” Stonebridge formed the Stonebridge Pass-Through Trust (“Stonebridge Trust”). The funds used to purchase the QRP were borrowed by the Stonebridge Trust from Nomura International PLC, and in turn lent to each plaintiff’s 1042 LLC. Each plaintiff’s 1042 LLC used the borrowed funds and certain cash contributed by the plaintiffs to purchase certain corporate bonds as QRP. The corporate bonds were insured by an insurance company and were pledged as collateral for the loan from Stonebridge Trust to the 1042 LLC and were repledged as collateral to Nomura for the loan Nomura made to Stonebridge Trust.
Several days before the transaction closed, a change was made in the Event of Default section of the Nomura loan documents. The original documents provided that Nomura could declare a default if:
[T]he rating with respect to any Underlying Bond fails to or falls below “B2 by Moody’s or “B” by S&P.
The revised documents provided that Nomura could call a default if:
[T]he rating with respect to any [sic] financial guaranty insurance policy related to any Underlying Bond fails to or falls below “B2 by Moody’s or “B” by S&P.[12]
Under the original default provision, Nomura could call a default if there was a downgrade in rating of any of the bonds purchased as QRP. Under the revised provision, though the language is unclear, it was held[13] that a default could be called by Nomura if the rating of the insurer of the QRP bonds was downgraded, regardless of the rating of the bonds themselves. This change in the default provision was never called to the plaintiffs’ attention by the defendant and the plaintiffs never agreed to the change.
Following the closing of the transaction on September 26, 2007, the rating of the insurer of the QRP bonds was downgraded and Nomura called a default. The bonds of five of the plaintiffs were sold to pay the loan, thereby causing immediate recognition of the gain intended to be deferred under section 1042. The sixth plaintiff, Bloostein, incurred additional costs, but managed to obtain another loan and avoid having his bonds sold. The five plaintiffs who incurred the additional taxes instituted this suit to recover the avoidable taxes incurred. Bloostein sought to recover the costs he incurred to obtain the replacement financing.[14]
The plaintiffs commenced this action against their attorney,[15] alleging he was negligent in failing to address the revised default provision to which the plaintiffs did not agree, and sought to recover the significant additional capital gains taxes they had expected to defer. Although the underlying controversy generated several third-party claims, a related litigation and an arbitration, all of these were previously resolved and are not relevant. In Bloostein, before addressing the defendant’s motion for summary judgment dismissing the plaintiffs’ claims, the court granted summary judgment to the attorneys who rendered the tax opinion that the underlying transaction was viable taxwise dismissing the defendant’s claim against them for contribution.[16]
Defendant’s motion for summary judgment
The basic factual argument asserted by the defendant in support of its motion for summary judgment dismissing the complaint is that attorney Snarr acted reasonably and did not commit malpractice when he made a strategic and calculated decision to accept the revised event of default provision and to not even discuss the change with the plaintiffs. The basis for this was Snarr’s good faith belief that the revised provision was unenforceable because insurance companies are rated, not insurance policies. This argument is not very compelling. At best, it seems like a hyper-technical argument. The judge in Bloostein characterized this as a gamble on Snarr’s part that he was correct.[17] It was also a very extreme gamble for Snarr to be so sure of the invalidity as to not even mention the change to his clients. In fact, Snarr was wrong and the argument was unsuccessful when asserted in a separate litigation challenging the validity of the default called by Nomura.[18]
The legal argument presented by the defendant was that taxes are not recoverable as damages under New York law and, in any event, that the taxes sought here are too speculative to be recoverable under New York law. While Bloostein’s analysis of the speculativeness issue is significant and noteworthy, it will not be focused upon herein.[19] As support for its argument that taxes are not recoverable under New York law, the defendant relied primarily[20] on Alpert v. Shea Gould Climenko & Casey.[21] Alpert involved a fraud cause of action. While a few outlier cases did apply the Alpert result in negligence causes of action,[22] the court in Bloostein correctly recognized the distinction and held the taxes were recoverable. The court immediately cut to the chase and began its analysis of Alpert by stating: “[p]utting aside that Alpert involved fraud and not malpractice . . .”[23] Bloostein correctly understood the distinction between damages recoverable in tort versus damages recoverable in fraud.
Interestingly, Bloostein did not review the traditional fraud versus negligence jurisprudence. It simply assumed the distinction existed. While I believe this to be the correct result, it seems odd that the court did not focus even briefly on the developments in this area, especially in light of the few outlier cases that arose between 2007 and 2014 that incorrectly applied the fraud measure of damages in negligence causes of action. I believe a brief[24] overview of this jurisprudence is helpful to understand the context and significance of Bloostein.
Traditional Negligence and Fraud Measures of Damages
Under New York law the damages recoverable in attorney malpractice situations based on negligence was established over one-hundred years ago as “the difference in the pecuniary position of the client from what it should have been had the attorney acted without negligence.”[25] This was more recently restated in a concurrence by then Judge Judith S. Kaye of the Court of Appeals:
In lawyer malpractice cases, as in all negligence cases, the focus in damages inquiries must be on the injured plaintiff . . . the objective being to put the injured plaintiff in as good a position as she would have been in had there been no breach of duty.[26]
This is an expectancy measure of damages, i.e., the difference between what should have been and what was with the negligence. Any additional, avoidable taxes incurred would seem to fit within the measure and be recoverable.[27]
The New York measure of damages for fraud is the “out-of-pocket” rule. While quite old,[28] the most recent reiteration of the rule by the Court of Appeals is that:
The loss is computed by ascertaining the “difference between the value of the bargain which a plaintiff was induced by fraud to make and the amount or value of the consideration exacted as the price of the bargain” . . . Damages are to be calculated to compensate plaintiffs for what they lost because of the fraud, not to compensate them for what they might have gained . . . there can be no recovery of profits which would have been realized in the absence of fraud.[29]
Nor does the out-of-pocket rule allow for recovery of the payment of taxes couched as consequential damages or otherwise.[30]
Recent Case-law Developments
Despite the traditional different measures of damages recoverable in negligence-based versus fraud-based causes of action, several cases between 2007 and 2014 simply applied the fraud out-of-pocket rule to negligence-based causes of action and concluded that additional taxes caused by negligence are not recoverable. The first, and probably most egregious of these “outlier” cases is Menard M. Gertler, M.D. v. Sol Masch & Co.[31] Gertler involved an action against an accountant for professional malpractice. Fraud was never mentioned in the opinion. In affirming the lower court’s directed verdict dismissing the complaint on the issue of damages, the First Department, citing only Alpert, a fraud case, held simply “taxes . . . are not recoverable under New York law.”[32] Gertler, without any reasoning or explanation, simply transported the fraud rule to the negligence area and misstated the negligence law.
In Chen v. Huang,[33] the plaintiff alleged the defendant attorney failed to properly effectuate a tax-free exchange of property under IRC section 1031[34] despite undertaking to do so. Under general tax provisions, if someone owns property A and exchanges it for property B, the exchange is treated as a sale of property A and any gain or loss inherent in property A must be recognized then for tax purposes. Under a valid section 1031 exchange, the exchange is not treated as a taxable event and any gain or loss inherent in property A will not be recognized for tax purposes until the disposition of property B. In Chen, the plaintiff sought to recover the damages incurred by the inability to defer taxation of the gain. The plaintiff asserted causes of action for breach of contract, breach of fiduciary duty and malpractice. The defendant moved to dismiss the complaint on grounds that the plaintiff did not allege any compensable damages. Although the complaint did not allege any fraud cause of action, the court held “defendant correctly asserts that taxes paid are generally not recoverable under New York law.”[35] As authority the court cited Gertler, Alpert and Lama Holding. Alpert and Lama Holding are fraud cases and not relevant. While Gertler did involve a malpractice cause of action, it conclusorily and incorrectly, simply mis-applied the Alpert fraud rule.
Finally, in Solin v. Domino,[36] the plaintiff sued his insurance agent/financial advisor for professional malpractice and negligent misrepresentation. The plaintiff had an annuity worth over $3 million. He was contemplating whether to (1) roll over the annuity tax-free into another annuity thereby deferring tax on the gain inherent in the annuity; or (2) surrender the annuity in a taxable transaction, pay the tax and invest the remaining balance in a taxable account. Based on the defendant’s advice that the tax incurred under option (2) would be approximately $200,000, the plaintiff chose option (2). It turned out the tax was approximately $600,000. The plaintiff commenced this action to recover the additional $400,000 of tax.
Sitting in diversity, the Southern District of New York applied New York law. In addressing the possible recoverability of taxes in New York, the court applied the fraud out-of-pocket rule. Relying on Alpert and Lama Holding, both fraud cases, the court held taxes are not recoverable.[37] On appeal, the Second Circuit affirmed. It, too, applied the fraud out-of-pocket rule, relying on Lama Holding.[38] The Second Circuit also cited Gertler for the proposition that taxes are not recoverable in New York.[39]
Contrary to the foregoing cases, in Serino v. Lipper,[40] the First Department clearly returned to the long established fundamental principles. The court explicitly held that fraud and negligence causes of action have different measures of damages and that taxes may be recoverable in a negligence, but not in a fraud cause of action.
Serino arose from alleged malfeasance by the auditor, PricewaterhouseCoopers (PWC), of an investment company and its hedge funds in failing to detect the substantial overvaluation of securities owned by the hedge funds. Serino involved cross claims by the owner of the investment company, Lipper, against PWC arising from the overvaluation. In addition to performing services for the investment company and hedge funds, PWC also prepared Lipper’s tax returns and provided him with personal financial advice. In rendering personal advice to Lipper, PWC utilized the inflated value of the hedge funds’ securities thereby overstating Lipper’s net worth. Relying on the inflated values, in connection with his divorce, Lipper agreed to make certain gifts to his daughters and incurred over $6 million in gift taxes. One of the cross claims asserted by Lipper against PWC was to recover the gift taxes paid. Causes of action for recovery of the gift taxes paid were asserted in fraud, negligence/malpractice, breach of contract, breach of fiduciary duty and negligent misrepresentation.
In reversing the lower court’s dismissal of all asserted causes of action for recovery of the gift taxes, the First Department held that recovery of the gift taxes paid under the fraud cause of action was barred by New York’s out-of-pocket damages rule. However, the court went on to hold that the out-of-pocket rule did not bar the recovery of such taxes under the negligence/malpractice cause of action.[41] The court thus properly distinguished the negligence/malpractice damages from the more limited fraud out-of-pocket measure of damages.
Bloostein’s Analysis
Rather than focus on the bigger picture described above and, perhaps, clarify this area that was unsettled by the Gertler, Chen and Solin cases, Bloostein focused very narrowly only on distinguishing Alpert. Alpert involved two plaintiffs who invested in a tax shelter whose attraction was the immediate deduction of advance minimum royalty payments for the right to mine coal in the future. The shelter turned out to be invalid and the plaintiffs paid substantial back taxes. The plaintiffs sought to recover the back taxes, interest and other losses. They sued the defendants, who were the attorneys who opined the tax shelter was valid, for fraudulent misrepresentation – i.e., fraud. The lower court in Alpert granted the defendants’ motion for partial summary judgment dismissing the plaintiffs’ claim for back taxes. In affirming this portion of the lower court’s opinion, the First Department held:
The recovery of consequential damages naturally flowing from a fraud is limited to that which is necessary to restore a party to the position occupied before commission of the fraud. . . . in the instant case, recovery of back taxes would place plaintiffs in a better position than had they never invested in the . . . [tax shelter][42]
Rather than simply distinguishing Alpert as involving a fraud claim and the fraud measure of damages, Bloostein went further. It focused closely on the facts in Alpert and decided that in Alpert there was no recovery because no fraud was perpetuated. In Alpert the plaintiffs purchased the tax shelter on December 30, 1977 and claimed a large deduction on their 1977 tax returns for prepaid royalty payments for the right to mine coal in the future. On December 16, 1977 the relevant tax regulations were amended to prohibit any deduction for such prepaid royalty payments. On December 19, 1977 the IRS issued a Revenue Ruling specifically advising that such prepaid royalty payments were not deductible when paid but could be deducted only over the period for which they were paid.
As a result of these developments, the defendant law firm which issued the original tax opinion that the tax shelter was valid withdrew that opinion and warned that the IRS would likely attack on audit any deduction for prepaid royalties. The promoters of the tax shelter then obtained a tax opinion from another law firm which argued there was a reasonable basis for concluding the IRS’ Revenue Ruling was invalid. But this opinion went on to caution that the argument that the Revenue Ruling is invalid may not prevail and the prepaid royalty payments would then not be deductible.[43]
Bloostein’s analysis is that no fraud occurred in Alpert. The second law firm appropriately disclosed and opined about the change in the law. A fortiori, the first law firm which withdrew its original opinion and warned of the likely IRS challenge to any attempted deduction of prepaid royalties.
Under Bloostein’s reading of Alpert, there was no fraud committed by the defendant law firms so obviously there could be no recovery of any additional taxes (or other costs) incurred. Conceivably, under Bloostein, if fraud had actually occurred, perhaps taxes might have been recoverable. Nevertheless, in Lama Holding the Court of Appeals held that taxes are not recoverable in a fraud cause of action[44] under the out-of–pocket damages rule and it cited Alpert with approval on this point.[45]
In conclusion, Bloostein correctly held that Alpert, a fraud case, is not relevant to the issue of whether additional taxes caused by negligence in a tax malpractice situation may be recoverable as damages in New York. Bloostein correctly further held that such additional taxes may be recoverable as damages in a negligence-based cause of action. What Bloostein did not do is to explore and clarify the developments in this area of law. While I personally wish Bloostein had focused on the bigger picture in this area of New York law and properly reset it, nevertheless, Bloostein got the ultimate result right!
Jacob L. Todres is professor of law at St. John’s University School of Law.
This article is an update to my earlier article, Return to Fundamentals? Tax Malpractice Damages – Recovery of Additional Taxes, N.Y. St. B.J. 32 (June 2017), p. 89.
[1] See, e.g. Menard M. Gertler, M.D.P.C. v. Sol Masch & Co., 40 A.D.3d, 282, 283 (1st Dep’t 2007); Chen v. Huang, 43 Misc. 3d 1207(A), (Sup. Ct., Kings Co. 2014); see also Solin v. Domino, 2009 WL 536052 at *3 (S.D.N.Y. Feb. 25. 2009), aff’d, 501 Fed. App’x 19 (2d Cir. 2012).
[2] 160 A.D.2d 67 (1st Dep’t 1990).
[3] 123 A.D.3d 34 (1st Dep’t 2014).
[4] 61 Misc. 3d 1122(A) (#651242/2012) (unreported disposition); 2019 N.Y. Slip Op. 50199 (U) (Sup., Ct. N.Y. Co. Feb. 2019) (Westlaw).
[5] 26 U.S.C. § 1042.
[6] I.R.C. § 1042(a) & (b), 26 U.S.C. § 1042(a) & (b).
[7] Id.
[8] I.R.C. § 1042(e), 26 U.S.C. § 1042(e).
[9] I.R.C. § 1042(e)(3)(B), 26 U.S.C. § 1042(e)(3)(B).
[10] I.R.C. § 1014, 26 U.S.C. § 1014.
[11] I.R.C. § 1042(c)(1)(A), 26 U.S.C. § 1042(c)(1)(A).
[12] Bloostein, 2019 N.Y. Slip Op. 50199(U) at *2–*3.
[13] Stonebridge Capital, LLC v. Nomura Int’l. PLC, 68 A.D.3d 546 (1st Dep’t. 2009).
[14] Plaintiff Bloostein’s damages for the costs incurred for replacement financing will not be mentioned further in the discussion since the focus is on the recoverability of additional taxes. The Court held these additional costs incurred were potentially recoverable as damages. Bloostein, 2019 N.Y. Slip Op. 50199(U) at *10.
[15] For ease of reference, both defendants Brian Snarr and Morrison Cohen LLP will be referred to herein interchangeably and in the singular as defendant or attorney.
[16] The defendant’s counterclaim against the attorneys rendering the tax opinion was dismissed on several grounds including that the opinion was not shown to be incorrect and that the issues opined upon were not involved in the present controversy. Bloostein, 2019 N.Y. Slip Op. 50199(U) at *5–*6.
[17] Bloostein, 2019 N.Y. Slip Op. 50199(U) at *6.
[18] Stonebridge Capital, LLC v. Nomura Int’l, PLC, 68 A.D.3d 546 (1st Dep’t 2009).
[19] Bloostein held the asserted damages for additional taxes were not speculative despite the fact that IRC section 1042 can result in either tax deferral or tax avoidance. The court held that reference to life expectancy tables could eliminate the speculativeness. Bloostein, 2019 N.Y. Slip Op. 50199(U) at *9–*10.
[20] The defendant also cited Thies v. Bryan Cave LLP, 13 Misc. 3d 1220[A] (Sup. Ct., N.Y. Co. 2006) but that case involved only the recovery of interest incurred due to claimed tax malpractice, not additional taxes.
[21] 160 A.D.2d 67 (1st Dep’t 1990).
[22] These cases are cited in note 2, supra.
[23] Bloostein, 2019 N.Y. Slip Op. 50199(U) at *7.
[24] A longer discussion is contained in my article, New York’s Law of Tax Malpractice Damages: Balanced or Biased?, 86 St. John’s L. Rev. 143, 171 (2012).
[25] Flynn v Judge, 149 A.D. 278, 280 (2d Dep’t 1912).
[26] Campagnola v. Mulholland, Minion & Roe, 76 N.Y.2d 38, 45–46 (1990). See also Sanders v. Rosen, 159 Misc. 2d 563, 572 (Sup. Ct., N.Y. Co. 1993).
[27] See, e.g., Serino v. Lipper, 123 A.D.3d 34 (1st Dep’t 2014); Fielding v. Kupferman, 65 A.D.3d 437 (1st Dep’t 2009); Proskauer Rose Goetz & Mendelsohn v. Munao, 270 A.D.2d 150 (1st Dep’t 2000).
[28] Reno v. Bull, 226 N.Y. 546 (1919).
[29] Lama Holding Co. v. Smith Barney Inc., 88 N.Y.2d 413, 421 (1996).
[30] Id. at 422.
[31] 40 A.D.3d, 282, 283 (1st Dep’t 2007).
[32] Id. at 283.
[33] 43 Misc. 3d 1207(A), (Sup. Ct., Kings Co. 2014).
[34] 26 U.S.C. § 1031.
[35] Chen, 43 Misc. 3d 1207(A) at *2.
[36] 2009 WL 536052 (S.D.N.Y. Feb. 25. 2009), aff’d, 501 Fed. App’x 19 (2d Cir. 2012).
[37] 2009 WL 536052 at *3.
[38] 501 Fed. App’x at 22.
[39] Id. at 21.
[40] 123 A.D.3d 34 (1st Dep’t 2014).
[41] Id. at 35–36.
[42] Alpert, 160 A.D.2d at 71–72.
[43] Bloostein, 2019 N.Y. Slip Op. 50199(U) at *7.
[44] Lama Holding, 88 N.Y.2d at 421.
[45] Id. at 422.
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