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Dec 1990

The AICPA proposal to permit practice in commercial corporations - potential cure of false hope for limiting liability? (American Institute of Certified Public Accountants)

by Stremba, Lee W.

    Abstract- The American Institute of Certified Public Accountants' (AICPA) proposal to allow CPAs to practice in commercial corporations may not limit their liability. The AICPA is attempting to amend Rule 505 of its Code of Professional Ethics so that CPAs can practice as limited liability corporations, as opposed to professional corporations (PC). Limited liability corporations do not generally provide any more advantages than PCs in terms of personal liability.

In October 21, 1990, the Council of the AICPA authorized a mail ballot of the entire AICPA membership to amend Rule 505 of the AICPA Code of Professional Ethics to make it possible for CPAs to practice as "limited liability corporations." The term limited liability corporation" is not a legal term of art. The AICPA's Board apparently uses the term to refer to regular commercial corporations, as distinct from professional corporations ("PCs"), which are already permitted under the existing version of Rule 505.

Unfortunately, the Board's terminology is somewhat misleading. By using the term "limited liability corporation" to distinguish commercial corporations from PCs, the drafters of the proposed amendment suggest that the shareholders of a commercial corporation enjoy significantly greater protection from personal liability than shareholders of a PC. That is not typically the case.

Practitioners should understand that neither form of incorporation would insulate a CPA shareholder from liability for his or her own deliberate or negligent acts Of malpractice. On the other hand, under either form of incorporation, the CPA shareholder would be protected from liability for the general debts and obligations of the corporation and, to some extent, from liability, for the negligence or deliberate misconduct of other shareholders or employees of the corporation (the latter protection varies from state to state for shareholders of a PC, as discussed below). Thus, from the standpoint of a CPA's potential personal liability, commercial corporations are not significantly more advantageous than the typical PC

Published accounts of the AICPA activities have justifiably generated both interest and confusion. Many practitioners are wondering exactly what the AICPA Board is proposing and of what significance an AICPA enactment might be to accounting firms across the country. We shall offer some answers to those questions in this article.


The express impetus for the stirrings at the AICPA is the well recognized desire of many firms for a method of limiting the personal liability of individual partners in malpractice actions. It is common knowledge among accountants and the accountants' liability bar that accounting firms are increasingly finding themselves targeted as deep pockets in malpractice actions brought by lenders, investors, audit clients (or bankruptcy trustees of defunct audit clients), and mann, others who claim to have relied to their detriment upon the accounting firm's audit work or other services.

Large verdicts and large settlements involving major accounting firms have indeed become commonplace, and the availability and affordability of insurance coverage has accordingly been severely impacted. The problem has become even more acute because, with increased frequency, claims are asserted against accountants under the Racketeer influenced and Corrupt Organizations Act (RICO) which provides for treble damages, as to which there is, in all likelihood, no insurance coverage.

To some extent, the AICPA Code of Professional Ethics already reflects the desire of member firms for reasonable limitations on personal liability. Rule 505 of the Code states:

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.

The Resolutions of Council regarding professional corporations provide, in part, that all shareholders of a professional corporation must be engaged in the practice of public accounting, must own their shares in their own right, and must be the beneficial owners of those shares.

Thus, the AICPA Code already permits a member firm to organize as a PC rather than as a partnership. Organizing as a PC may be an effective way for many firms to limit the personal malpractice liability of their members. However, as indicated in the discussion below, many firms do not quality for PC status and therefore derive no comfort from the AICPA's current policy.


Professional corporations are creatures of state statutory law. most states have enacted PC statutes. As with a commercial corporation, ownership of a PC is divided among its shareholders, not among partners. However, the shareholders of a PC all share a common characteristic-- then, are all licensed professionals involved in the firm's practice.

PCs are similar to commercial corporations in other respects. Both are legal entities separate and apart from their shareholders. As such, the PC, like a commercial corporation, is liable to the full extent of its assets for all debts of the corporation or claims against the corporation. On the other hand, shareholders of the PC, like shareholders of a commercial corporation, are not personally liable for the general debts and obligations of the corporation. In addition, PCs and commercial corporations are alike in that neither form of incorporation insulates shareholders from personal liability for their own negligence or deliberate misconduct, whether committed in a direct or supervisory capacity.

PCs can differ from regular commercial corporations in the extent to which innocent shareholders--those who are not personally implicated in acts of negligence or deliberate misconduct--may be vicariously liable for the negligent or deliberate misconduct of other shareholders or employees of the corporation. In a regular corporation, an innocent shareholder generally has no such liability. In a PC, the extent to which a shareholder has such liability is determined by the language of the PC statute of the state of incorporation. In most states, shareholders of a PC receive substantial protection from vicarious liability. However, the laws of the 50 states vary a great deal on this issue.

Several states insulate innocent shareholders of a PC fully from liability for the acts of fellow shareholders or employees--treating them just like shareholders of a regular business corporation. In a few of those states, this extra degree of protection is granted, but only if specified levels of professional liability insurance are maintained by the firm. Several other states make an innocent shareholder vicariously liable for the acts of another shareholder or employee, but only if that shareholder or employee was under the innocent shareholder's direct supervision or control. New York is an example of a state taking this approach BCL Sec. 1505(a). New Jersey is another example N.J.S.A. Sec. 14A: 17-81. In a few of the remaining states, shareholders of a PC are jointly and severally liable for the negligent or wrongful acts of an;, other shareholder or any employee who acts under the direct supervision or control of any shareholder. In essence, such states hold shareholders personally liable as partners despite the corporate form of organization, so that incorporation as a PC provides the innocent shareholder little, if any, protection from malpractice actions.

As the foregoing analysis indicates, organization as a PC may offer substantial benefits in the form of limited liability for members of a firm. However, PC status is not the answer for ever\, firm. As indicated, not all states authorize the formation of PCs. In addition, the degree of protection offered in a practitioner's home state may not he sufficient to be attractive, or may, come at too high a cost if significant additional insurance must be purchased to qualify for protection. Also, many small firms choose not to incorporate on the theory that clients or potential clients prefer to do business with a firm that bas not chosen to limit the liability of its members.

More importantly, the PC statutes uniformly contain restrictions that make it impossible or impracticable for firms with multi-state practices to incorporate, In most states, all shareholders of a PC must be licensed in the state of incorporation. In addition, manx' states expressly prohibit practice within the state by a foreign PC, or at least require that any work done in the state by a foreign PC he done by a professional licensed in the state. As a result, only those firms that are willing to limit their practice to a single state are likely to find the PC form attractive. That obviously leaves out a large segment of the AICPA's membership, including not only the Big 6 accounting firms but also hundreds of smaller multi-state practices across the country.


As indicated above, Rule 505 already permits member firms to organize as PCS. The AICPA could seek the benefits of limited personal liability for all member firms by advocating that the states amend their PC statutes. Those statutes that presently afford insufficient protection from vicarious liability could be amended to strengthen those protections. In addition, if accountants licensed in foreign states could own stock of a domestic PC, and if foreign PCs could practice in the home state, the concept of the "professional" corporation could be broadened to accommodate multi-state practices.


The objectives of the AICPA could be embodied in a Model PC Act, that could be promoted in a coordinated, nationwide appeal to the legislatures of each state. The model act could define the limits of personal liability for all professionals practicing as shareholders of a PC. It could also provide for incorporation of multi-state practices.

Although it will be difficult to convince state legislatures to enact any legislation addressed to the personal liability issue, a Model PC Act may offer the best chance for success. It is probably more likely that state legislatures would entertain the idea of amendments to existing PC statutes than consider any fundamentally new approach to the practice of accounting. Moreover, a Model PC Act could apply to attorneys, doctors or other professionals as well as to accountants.

Support from professional associations outside the accounting field could greatly increase the likelihood of state legislative action, and the involvement of other professions would counter any suggestion that the AICPA is seeking special or unique treatment for accountants.

IT'S ALREADY BEEN PROPOSED BY THE AICPA Interestingly, in an October 15, 1986 memorandum, an AICPA Special Committee on Accountants' Legal Liability proposed to the State CPA Societies the same type of legislative initiative described above. In its memorandum, the Special Committee recommended a nationwide effort to have existing PC statutes modified, both to permit multistate practices, and to make uniform from state to state the degree to which CPA shareholders are exposed to vicarious personal liability. The AICPA Board's present proposal to amend Rule 505 is a radical departure from the approach recommended four years ago by the AICPA's Special Committee. It is not clear whether the Board considered those recommendations before it formulated its present proposal.


On October 21, 1990, the AICPA Council considered the following agenda item proposed by the Board:

Council Authorization of a Mail Ballot of the Membership to Amend Rule 505-Form of Practice and Name--to Make it Possible to Practice in Limited Liability Corporations.

The mail ballot was indeed authorized, and the AICPA's 300,000 members will accordingly be asked to vote in the near future.

The Board's proposal would revise Rule 505 by dropping the word "professional" as a modifier of the word "corporation." As amended, Rule 505 would then allow members to practice either as "a proprietorship, a partnership, or a corporation whose characteristics conform to resolutions of Council." The present resolutions of Council, which restrict the ownership of shares in a "professional corporation," would be modified to apply equally to ownership of shares in a "corporation." In addition, the resolutions would be amended to impose a financial responsibility requirement" of $500,000 minimum accrual basis capital or professional liability (malpractice) insurance coverage, upon firms practicing as "limited liability corporations." The maximum capital or insurance requirement would be $300,000, computed at the rate of $50,000 per professional. This additional requirement will likely be a source of considerable controversy among AICPA members.

At the heart of the Board's proposal is the concept of the "limited liability corporation." CPAs who see the term "limited liability corporation" used to refer to regular commercial corporations may be led to believe that CPA shareholders of a commercial corporation would have significantly better protection from personal tort liability than shareholders of a PC. As indicated above, that is not the case. Again, shareholders of a PC, as well as shareholders of a commercial corporation, remain liable for their own deliberate or negligent wrong doing, whether committed in a direct or supervisory capacity.

On the other hand, innocent shareholders of both types of corporations typically enjoy some protection from liability for the wrongful acts of other shareholders or employees of the corporation. Thus, the term "limited liability corporation" tends to exaggerate the protection afforded to shareholders of a commercial corporation and undervalues the protection afforded to shareholders of a typical PC

Moreover, the Board's choice of terminology is unfortunate because it may discourage a thoughtful discussion of all the possible alternatives for achieving the Board's stated goals. In its current proposal, the Board implicitly rejects the PC as a vehicle for achieving rational limitations on professional liability. Perhaps the Board's approach is most likely to achieve the stated goal, perhaps not. The likelihood that any alternative will result in the passage of meaningful state legislation is a difficult and complex matter to assess. Before the AICPA membership commits to a course of action, it should at least be aware that there are alternatives worth considering. The Board's proposal discourages such awareness.


The limitation of personal liability may not be the sole motivation of some AICPA member firms in championing the corporate form of organization. Member firms may desire the commercial corporation's ability to make private or public offerings of stock. Some accounting firms might use a public stock offering as a method of raising capital to expand or modernize a practice. Other firms might expand their practice into non-accounting areas by issuing stock to non-accountants who would become principals in a mixed-practice firm.

The current proposal for an amendment of Rule 505 does not advocate such fundamental changes in the ownership and management of accounting firms. Under that proposal, the Council's resolutions prohibiting stock ownership by non-CPAs would apply to an accounting firm practicing either as a PC or as a commercial corporation. If some members of the AICPA are advocating the formation of commercial corporations as a means of raising capital or expanding into non-accounting businesses, the current proposal would not accomplish those objectives. Of course, some observers might view the current proposal as a significant step in that direction.


It appears that there is a movement afoot in the AICPA to make the commercial corporation a form of organization available to all member firms as a means of limiting the personal liability, of accounting professionals. It is not evident that the AICPA's Board has fully explored and assessed alternative courses of action or formulated a concrete plan to achieve its stated objectives.

In any event, PC status is presently the only option available to accounting firms beyond the traditional partnership form of organization. Practitioners should consider whether the PC form of organization is available to them, and if so, whether the advantages outweigh anN. disadvantages. Even if the AICPA can formulate a concrete program for change, any significant change in the regulatory framework governing the practice of accounting in the 50 states is not likely for years to come.

Lee W. Stremba is a Partner of the New York City law firm of Parker Chapin Flattau & Klimpl, where he specializes in accountants' liability and securities litigation.

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