The professional governance regarding the form of practice for CPAs in public practice is stated in Rule 505 of the AICPA Code of Professional Ethics. This rule states, in part: "A member may practice public accounting only in the form of a proprietorship, a partnership or a professional corporation whose characteristics conform to resolutions of Council." Allowing a CPA the option of practicing as a professional corporation (PC) is relatively new. It was preceded by changes in state laws to provide the option of incorporation to accountants as well as other licensed professionals.

Historically, the primary motivations for selecting a PC over a proprietorship or a partnership have been the tax benefits and personal liability limitation. With recent changes in federal income tax laws, many if not most, of the tax benefits of a PC may have disappeared. For example, beginning in 1988, Sec. 11(b)(2) denies the graduated tax rates to PCs, resulting in a flat tax rate of 34%. Since any individual's tax rate currently cannot exceed 33%, a PC becomes unattractive from a tax perspective.

From a non-tax perspective, the issue of limiting liability remains of interest to CPAs, especially in consideration of a recent change to the Code of Professional Ethics. The resolutions of Council consist of seven sections: 1) name; 2) purpose; 3) ownership; 4) transfer of shares; 5) directors and officers; 6) conduct (ethical); and 7) liability. From October 1979 until May 1986, Sec. 7 of the resolutions stated that members practicing as shareholders in a PC were required to be jointly and severally liable for the actions of other shareholders, except where adequate professional liability insurance was carried or sufficient capitalization was mentioned. This section, among others, was deleted in May 1986, and as a result, AICPA members practicing as shareholders in a PC are no longer required to be jointly and severally liable for the actions of other shareholders. While the Code of Professional Ethics governs all members, each member is also subject to applicable state statutes. In a June 1986 Special Report, The CPA Letter encouraged members to investigate the possibility of practicing as a PC, yet warned that laws may vary from state to state. Unfortunately, there is a dearth of assistance for coping with this AICPA warning.

This article investigates both the general legal guidelines affecting the types of accountant's liability and the specific rules prescribed by states contained in PC statutes, and categorizes all 50 states into four PC liability models. Based on this study, licensed accounting professionals concerned with professional liability in their states can easily consider the available and appropriate vehicle of practice, whether that may be a sole proprietorship, partnership, or PC.

THE FIVE TYPES OF

ACCOUNTANTS' LIABILITY

Before licensed accounting professionals can consider reducing their professional liability exposure by incorporating, they must understand the legal guidelines applicable not only to their acts or omissions, but also to their partners' and employees' acts and omissions. These professional acts and obligations fit into five major categories.

Type Act or Obligation

I. Acts Performed Personally

II. Acts of Partners

III. Acts of Supervised Employees

IV. Acts of Unsupervised Employees

V. General Business Obligations

To understand the impact of incorporation, each category is discussed in the context that the professional is practicing, either as a sole proprietor or in a partnership.

I. Acts Performed Personally

CPAs are exposed to professional liability for their negligent acts or omissions. This fact of professional life exists because they owe their clients and certain members of the public a duty of due care as measured by the mythical reasonably prudent and experienced CPA. If that duty is breached, damages for the tort of negligence can be sought against the professional and his or her personal assets. Regardless of the business entity chosen, no state alters this result.

II. Acts of Partners

Under general principles of partnership law, each partner is both an agent and a principal of his or her other partners and is generally liable for the acts of other partners. Accordingly, in the event of a claim for negligence against one of the partners, a plaintiff could look not only to the assets of the partnership, but also to the assets of each partner, not just the partner committing the negligence. This liability for all types of acts and obligations is called joint and several liability, in that each partner is individually acting as a guarantor for all acts and obligations of the partnership. Due to this extreme exposure to personal risk in the face of increasing difficulty in securing adequate professional liability insurance, CPAs have ample incentive to consider incorporating their professional practice under their state's PC legislation when available.

III. Acts of Supervised Employees

Supervised negligent acts or omissions committed by an employee within the scope of employment can also subject the CPA to professional liability under the legal principle known as respondent superior-- employers are responsible for the acts of their employees. It makes no difference that the supervision by the CPA is not in itself negligent. However, if the supervision is negligently handled, then damages can also be obtained for the tort of negligence from the supervising CPA.

IV. Acts of Unsupervised

Employees

Sometimes employees are unsupervised by the CPA or they are supervised (or supposed to be) by another partner in the firm. Regardless, under the legal principle of respondent superior, (i.e., employers are responsible for all acts by employees committed within the scope of their employment), the CPA would be liable for damages personally (not vicariously), even though not directly involved in the negligent act. Here again, if the lack of supervision were itself negligent under the circumstances, the partner who failed to properly supervise is automatically liable for negligence, while the other partners also are liable under vicarious partnership liability rules.

V. General Business Obligations

The ongoing business obligations of a sole proprietorship or partnership such as rent and payroll can also subject the owner's or partner's personal assets to risk. These obligations are the reason many entrepreneurs incorporate--to avoid losing their personal assets should the company become bankrupt.

THE FOUR MAJOR

CATEGORIES OF STATE PC

LIABILITY LAW

Each state has adopted an explicit or implicit policy on how much limited liability a CPA-shareholder can enjoy through the protection of the corporate veil under the state's PC statute. If the state wishes to protect the public to the detriment of the licensed professional, then the state adopts the unlimited liability rules associated with partnership. On the other hand, if the state weights heavily the interest of the professional in limiting liability and thus insurance costs, then the state incorporates the liberal liability rules of regular corporations into its PC statute. In between these two extremes, many states have adopted a middle-of-the-road approach that perhaps better balances the interests of the two groups. However, by not legislating a PC statute, some states do not allow CPAs to limit their professional liability in any way.

Most states have professional corporation statutes that define a PC. The Proposed Draft of Model Professional Corporation Act defines "Professional Corporation" in Sec. 11 as a:

"corporation which is organized and existing under the laws of this state for pecuniary profit for the sole and specific purpose of rendering a single professional service and which has as its shareholders only individuals who themselves are duly licensed or otherwise legally authorized within the state to render the same professional service as the corporation."

In contrast to a sole proprietorship or partnership, the salient feature of the PC is its legal existence as an entity separate and distinct from the owners/shareholders of the accounting practice. Consequently, unless modified by state law, the PC, not the shareholders, is responsible for all the acts and obligations of the PC to the extent of the PC's assets. However, shareholders in all corporations, including PCs, run the risk that creditors might "pierce the corporate veil" to get to shareholders' assets. Courts allow creditors to pierce under the following two circumstances: 1) the shareholders do not observe the necessary corporate formalities to keep the corporate business separate from the shareholders; and 2) shareholders thinly capitalize the corporation, leaving little capital for creditors to access. This article's discussion of states' PC liability rules assumes that the corporation does not run the risk of having its veil pierced.

It should be noted that the guidelines developed herein are not applicable to multi-state practices. Most states limit the shareholders in a professional corporation to professionals duly licensed within the state, while at the same time prohibiting practice within the state by a foreign (out-of-state) professional corporation. However, some statutes deal expressly with out-of-state PCs practicing in jurisdictions other than where they were formed. Even where practice by out-of-state PCs is permitted, services may be performed only by employees licensed to practice in the jurisdiction in which the out-of-state PC desires to practice. Where the statute is silent, out-of-state practice should be avoided.

The four categories of state PC liability law are: 1) partnership rules category; 2) supervising and controlling liability; 3) joint and several liability--insurance; and 4) corporation rules category.

Partnership Rules Category

Some states have enacted PC statutes to allow licensed professionals to take advantage of the tax benefits of practicing as a corporation. The states in this category, however, continue to make shareholders jointly and severally liable for all acts and omissions committed by the PC's employees. Consequently, from a liability standpoint, there is no difference between PCs and partnerships in these states. The following Oregon PC statute Sec. 58.185(2)(c) is an example:

"Shareholders shall be jointly and severally liable with all of the other shareholders of the corporation for the negligent or wrongful acts or misconduct of any shareholder, or by a person under the direct supervision and control of any shareholder."

This statute makes it clear that joint and several liability exists for all PC shareholders similar to partnership rules.

Supervising and Controlling

Liability

Many states allow limited liability to the extent of the general obligations of the PC and the acts and omissions of other shareholders. However, these states do not diminish the liability attaching to the CPA-shareholder due to his or her negligent acts or the acts of others he or she supervises or controls, regardless of whether the supervision is negligent. It is sufficient that the CPA had the responsibility to supervise the negligent employee. The following Washington PC statute (Sec. 18.100.070) is an example:

"Any shareholder of a corporation shall remain personally and fully liable and accountable for any negligent or wrongful acts or misconduct committed by him or by any person under his direct supervision and control, while rendering professional services on behalf of a corporation."

While the shareholder is not personally liable for acts by other shareholders, the PC itself is jointly and severally liable for employee acts under the legal doctrine of a respondent superior.

Joint and Several

Liability--Insurance

A few states adopted the recently deleted rule of the AICPA--namely, allowing the CPA-shareholder to avoid vicarious liability for the acts of others he or she supervises when adequate insurance or capital is maintained by the PC. The following statute from Colorado (Sec. 12-2- 131) is an example:

"All shareholders of the PC shall be jointly and severally liable for all acts, errors, and omissions of the employees of the corporation except during periods of time when the corporation maintains in good standing professional liability insurance...."

This PC category clearly removes joint and several liability at the shareholder level because all vicarious liability is negated by the statute when proper insurance, or in some states, capital, is present.

Corporation Rules Category

The most liberal states decided that CPAs should be shielded from all vicarious liability--namely, the negligent acts of other CPA- shareholders and employees whether supervised or unsupervised. Of course, shareholders remain personally liable for their own negligent acts. These states merely incorporate the liability rules for regular corporations to obtain this result. For example, the following Arizona statute (Sec. 10-905) provides:

"... no shareholder of a professional corporation organized under this chapter is individually liable for the debts of or the claims against the corporation unless the debt or claim arises as a result of a wrongful act or omission of the shareholder."

This statute follows the common law of tort liability as illustrated in Alabama Music Co. v. Nelson: where a tort of negligence is committed by an employee of a corporation, that employee is liable individually to the injured person whether or not the employee was acting within the scope of his or her employment. If the negligence is committed by the employee within the scope of employment, the corporation is also liable- -vicariously or secondarily under the doctrine of respondent superior. The employee, of course, remains primarily liable, and might enjoy a right to indemnification from the corporation. If the negligence is committed by the employee outside the scope of employment, the corporation is not liable; only the employee is liable. Finally, at common law, absent personal participation, an employee is usually not liable for the acts of negligence of other corporate personnel.

Table 1 sets forth the extent to which each of the four categories of PC statutes limits the professional's liability according to the class of liability.

Three observations should be made regarding the table. First, it assumes that the professional practice has been properly incorporated according to the state's PC statutes and that the PC cannot be "pierced" by creditors or injured clients due to lack of capitalization or failure to observe corporate formalities. Second, it assumes that the limited liability status afforded by the PC statutes is not successfully attacked on the basis of recent cases in the attorney/PC setting which state that PC statutes that diminish legal liability are contrary to public policy. For example, in First Bank & Trust Co. v. Zagoria the court stated:

"The professional nature of the law practice and its obligations to the public interest require that each lawyer be civilly responsible for his professional acts. A lawyer's relationship to his client is a very special one. So also is the relationship between a lawyer and the other members of his or her firm a special one. When a client engages the services of a lawyer the client has the right to expect the fidelity of other members of the firm. It is inappropriate for the lawyer to be able to play hide-and-seek in the shadows and folds of the corporate veil and thus escape the responsibilities of professionalism."

This case dramatically illustrates the point that an attorney in the state of incorporation should be consulted to determine the effect case law and the corresponding differing interpretations of the statute and policy considerations might have on the extent to which the PC statute limits liability.

Judicial intervention might also occur in the following circumstances. Finding themselves in a professional partnership, some partners who want to limit their liability have individually incorporated themselves and allowed the PCs to become partners of the partnership in their place. Theoretically, the incorporating partner could shield personal assets against the joint and several liability for all partners' negligence. This is true because only the PC's assets, not the partner/shareholder assets, are available to satisfy claims, because the PC, not the partner/shareholder, is the partner in the professional partnership. However, there is a distinct possibility that a court might find this maneuver unconscionable or contrary to public policy, because clients dealing with a professional partnership would expect to satisfy claims against all the partners individually. Consequently, a court addressing the issue could allow the client aggrieved by the negligent act of one of the partners to satisfy his or her judgment not only against the personal assets of all the partners including the PC's assets, but also against the shareholders of the PCs in the partnership.

An accompanying sidebar categorizes each state according to the PC liability classifications described. States that have no PC statutes are listed under the "Partnership Liability Rules" column. Due to the differing treatment of some liability types, some states may not fit precisely within these models. Because this exhibit is based on tentative interpretations of each state's PC statute, which could be modified by judicial interpretations, readers should consult an attorney in their state before incorporating a professional practice.

HAS THE QUESTION BEEN

ANSWERED?

It is clear that state legislatures have differing opinions on the extent to which professionals should enjoy limited liability in their professional services. The extent that the accounting profession can limit its liability through the use of PC in each state evolves into an issue of public policy. At issue is the weighing of the interest of the public seeking redress for professional negligence against the legitimate interest of the professional in limiting liability.

Patsy L. Lee, PhD, CPA, is an Associate Professor of Accounting at The University of Houston-Clear Lake, Houston, TX. She received her doctorate from the University of North Texas.

Kevin O. O'Brien, JD, LLM, CPA, is an Associate Professor at the School of Accountancy and the Graduate Tax Program of the University of Denver, Denver, CO.