Legislature(2003 - 2004)

02/09/2004 08:12 AM Senate JUD

Audio Topic
* first hearing in first committee of referral
+ teleconferenced
= bill was previously heard/scheduled
                     SB 300-ATTORNEY'S LIEN                                                                                 
SENATOR BERT STEDMAN, prime sponsor  of SB 300, told members that                                                               
SB 300  is a  housekeeping measure to  avoid double  taxation. He                                                               
explained   that  when   court  settlements   are  awarded,   the                                                               
prevailing  party must  pay income  tax on  phantom income  - the                                                               
gross amount  of the  award even  though part  of that  income is                                                               
paid to the  party's attorney. The attorney must then  pay tax on                                                               
the income received, resulting in  double taxation. The structure                                                               
of  the system  in the  State of  Oregon differs  so that  if the                                                               
proper documents are  filed, the court settlement is  paid to the                                                               
attorney who,  after retaining attorney fees,  pays the remainder                                                               
to the  client, thereby avoiding double  taxation. Attorneys have                                                               
structured  trust accounts  to hold  court  settlements, so  this                                                               
mechanism would pose no danger to the client.                                                                                   
8:16 a.m.                                                                                                                       
SENATOR  HOLLIS FRENCH  asked for  an example  to illustrate  the                                                               
double taxation problem.                                                                                                        
SENATOR  STEDMAN said  a wrongfully  damaged  plaintiff might  be                                                               
awarded  $10,000. The  plaintiff would  have to  claim income  of                                                               
$10,000 and  pay tax  on that amount,  $2,000 if  the plaintiff's                                                               
tax  bracket was  20  percent.  The plaintiff  must  also pay  30                                                               
percent of the  $10,000 for attorney fees,  equaling 3,000. Then,                                                               
the  attorney must  pay tax  on his  fee of  $3,000. SB  300 will                                                               
avoid  double taxation  by paying  the attorney  off the  top, so                                                               
that the plaintiff would claim gross revenue of $7,000.                                                                         
SENATOR FRENCH surmised  that two parties would  be paying income                                                               
tax on the $3,000.                                                                                                              
SENATOR STEDMAN said that is correct.  He said there is no way an                                                               
attorney could avoid  paying taxes on his or her  fees, so SB 300                                                               
will  not affect  the  attorney.  It will,  however,  have a  big                                                               
impact on the citizen who must pay tax on the attorney fees.                                                                    
SENATOR  GENE  THERRIAULT  asked  if  the  way  to  avoid  double                                                               
taxation is to  have the attorney file the  proper lien paperwork                                                               
so  that the  jury award  becomes the  property of  the attorney.                                                               
Then, once the attorney's lien is  paid, the remainder is paid to                                                               
the client via contract.                                                                                                        
SENATOR STEDMAN  said that is  correct and that the  client would                                                               
pay taxes on  the actual amount paid to him  or her. He clarified                                                               
that the award  funds paid to the attorney would  be protected by                                                               
a litany of regulations to provide safety for the client.                                                                       
SENATOR THERRIAULT asked  if SB 300 passes, the  plaintiff in the                                                               
previous  example would  receive  $7,000 and  the attorney  would                                                               
receive  $3,000, while  under the  current system,  the plaintiff                                                               
would only receive $5,000.                                                                                                      
SENATOR STEDMAN said that is correct.                                                                                           
SENATOR FRENCH  asked if  any damage award  would go  directly to                                                               
the attorney.                                                                                                                   
SENATOR STEDMAN  said yes, if  the attorney has filed  the proper                                                               
liens, and the attorney would  disburse the funds directly to the                                                               
client. The plaintiff  would then claim only  the income received                                                               
from the attorney, not the gross amount.                                                                                        
SENATOR  FRENCH  noted  letters  of  support  from  attorneys  in                                                               
members' files  but asked if  Senator Stedman has heard  from any                                                               
plaintiffs who  are concerned that  attorneys might sit  on their                                                               
money for too long.                                                                                                             
CHAIR SEEKINS said  that witnesses were available  to testify and                                                               
might be able to answer that question. He took public testimony.                                                                
MR. WILLIAM SCHENDEL, an attorney  who has practiced in Fairbanks                                                               
for about 30 years, told members  that the issue behind SB 300 is                                                               
double  taxation and  is one  of  the biggest  problems that  has                                                               
faced both employers  and employees over the last  five years. In                                                               
essence, the  plaintiff is  taxed on the  attorney fees  that the                                                               
plaintiff does  not receive.  The consequence  of that  system is                                                               
that the  plaintiff is prompted to  try to recover more  from the                                                               
defendant, typically  the employer, and  that drives up  the cost                                                               
of settlements. SB 300 will do  away with double taxation so that                                                               
the plaintiff is only taxed on the net award.                                                                                   
MS. JO  KUCHLE, a Fairbanks  attorney for 17 years,  told members                                                               
that regarding the  trust account issue, the funds  do not always                                                               
flow  through the  trust account;  sometimes the  funds are  paid                                                               
directly  to the  prevailing party.  She said  under the  current                                                               
scheme this issue not only  arises with settlements, it can occur                                                               
with judgments or  in any case in which the  prevailing party has                                                               
won damages and pays attorney fees. She pointed out:                                                                            
     This has  been primarily the  result of rulings  by the                                                                    
     Ninth  Circuit Court  of Appeals,  which has  basically                                                                    
     determined  that  for  federal tax  purposes,  the  fee                                                                    
     award, though it goes directly  to the taxpayer and the                                                                    
     taxpayer has  to pay the attorney,  gets taxed entirely                                                                    
     to  the  taxpayer.  They carved  out  an  exception  in                                                                    
     Oregon  on  Oregon's lien  law.  That's  why the  group                                                                    
     before you  has requested, and we're  very pleased that                                                                    
     Senator Stedman  has introduced  this bill,  to correct                                                                    
     this  disparity  with  Oregon taxpayers  and  that  all                                                                    
     taxpayers really in  the Ninth Circuit -  all states in                                                                    
     the  Ninth  Circuit  are   affected  by  this  taxpayer                                                                    
MR. KEN COVELL,  a Fairbanks attorney for 18  years, told members                                                               
he focuses on personal injury and  employment law, and that he is                                                               
concerned that in civil rights  actions, a plaintiff will receive                                                               
nominal  damages   of  $1.  However,  attorney   fees  are  often                                                               
$100,000.  These  cases  are often  very  important  and  involve                                                               
racial discrimination.  It is conceivable that  a plaintiff could                                                               
receive a  $1 award but have  a $30,000 tax liability  because of                                                               
the  $100,000 attorney  fee. He  pointed out  that clients  often                                                               
take  on  such  cases  at  great  emotional  and  personal  risk.                                                               
Therefore, if  an attorney has to  tell that client he  or she is                                                               
liable for  an additional  $30,000 tax,  clients will  not pursue                                                               
important  cases. SB  300 would  put  the citizens  of Alaska  on                                                               
equal footing with citizens of  various other states. He repeated                                                               
that the  current system  creates a  disincentive for  clients to                                                               
pursue important issues.                                                                                                        
MR. KEVIN WALSH,  a certified public accountant  in Fairbanks for                                                               
25 years,  thanked members for  considering SB 300. He  said this                                                               
issue is  near and dear  to him as he  runs into this  problem in                                                               
his  tax  practice  and  must  advise  potential  plaintiffs.  It                                                               
creates different classes of  taxpayers and affects opportunities                                                               
that  people have  to  correct injustices  changes  based on  tax                                                               
advice. He  considers that to  be wrong and  looks to SB  300 for                                                               
resolution. He  said this  issue is based  on federal  income tax                                                               
law,  which is  based on  taxing the  owner of  income. A  recent                                                               
Supreme  Court decision  basically said,  "tax the  fruit of  the                                                               
tree to the tree from which it  falls." This lien law is based on                                                               
establishing property rights  - who owned the case  and who owned                                                               
what  right under  the case.  Current  federal tax  law says  the                                                               
entire  case  belongs to  the  plaintiff;  therefore all  amounts                                                               
flowing  from  that  case  are   taxable  to  the  plaintiff.  He                                                               
     Then, if the  plaintiff is allowed a  deduction for the                                                                    
     amount of  the attorney fees  that they pay,  then they                                                                    
     end up  [indisc.] income  tax only  on the  net amount.                                                                    
     This  is  absolutely  true for  any  business  that  is                                                                    
     successful  in a  suit.  Businesses  report the  entire                                                                    
     damage  amount as  income, deduct  all of  the attorney                                                                    
     fees.  They only  pay  income tax  on  the net  amount.                                                                    
     People that are injured  in a personal injury situation                                                                    
     don't pay taxes at all. This  is not an issue for them.                                                                    
     So it  boils down to  the only people impacted  on this                                                                    
     are  the employees.  Employees who  bring suit  against                                                                    
     their  employers   for  whatever  reason  and   end  up                                                                    
     successful, end  up having to report  the entire amount                                                                    
     of the  attorney fees  and their  own award  as income.                                                                    
     They are then  allowed a deduction for  the amount that                                                                    
     they pay the attorneys.                                                                                                    
     Unfortunately the deduction is  limited to two separate                                                                    
     distinct  events:   one,  it  is  only   allowed  as  a                                                                    
     miscellaneous  itemized deduction  and  limited to  the                                                                    
     amount that  exceeds 2 percent of  their adjusted gross                                                                    
     income.... Unfortunately, the  alternative minimum tax,                                                                    
     which if you  have - is a parallel tax  system that was                                                                    
     established many years  ago to make sure  that the rich                                                                    
     paid   at  least   a  minimum   tax  every   year,  the                                                                    
     consequence  of  that  tax  is  that  no  miscellaneous                                                                    
     itemized  deductions  of  any   type  are  allowed  for                                                                    
     purposes of  computing that tax  and then the  tax rate                                                                    
     is  25, 28  percent applied  to the  net income  coming                                                                    
     from that.                                                                                                                 
     So let  me give you a  real live example coming  out of                                                                    
     our  practice. We  had a  public interest  litigant, an                                                                    
     employee  who was  [indisc.].  They sued  successfully.                                                                    
     The received  approximately $105,000.  Their attorney's                                                                    
     fees were $100,000  and that was understood  to be part                                                                    
     of  the award.  In other  words, their  net amount  was                                                                    
     about $5,000. They ended up  with a tax bill associated                                                                    
     with  that of  approximately $30,000.  In other  words,                                                                    
     understand,  they  got  to  keep  $5,000  and  had  the                                                                    
     obligation to  pay $30[,000],  so by  taking corrective                                                                    
     action through  the judicial system  to get a  court to                                                                    
     correct an  employer's egregious behavior, they  had to                                                                    
     reach  in  their  pocket  and  take  out  approximately                                                                    
     $25,000.  I  consider  that  to  be  a  miscarriage  of                                                                    
MR. WALSH  gave other examples and  said that the origin  of this                                                               
situation  is based  on  property law  in  Alabama, Michigan  and                                                               
Oregon. The  court reviewed it  and found the attorneys  in those                                                               
cases  had a  sufficient property  right in  their piece  of that                                                               
case so that  income was taxed to them and  not to the taxpayers.                                                               
The Alaska  Supreme Court  has reviewed this  issue and  said the                                                               
person receiving  the award  "gets the  shaft." He  said Alaska's                                                               
law should be  changed so that a public interest  litigant is not                                                               
penalized.   He  noted   the  Supreme   Court  has   had  several                                                               
opportunities to correct the disparity  between the circuit court                                                               
and has basically said it  does not care. Similarly, Congress has                                                               
had  the opportunity  to take  this matter  up several  times but                                                               
declined to do so. He encouraged the Legislature to take action.                                                                
8:37 a.m.                                                                                                                       
CHAIR SEEKINS asked, "As I  understand it, this lien exists until                                                               
it  is satisfied  and  only affects  the  previously agreed  upon                                                               
fees. Is that correct?"                                                                                                         
MR. COVELL said that is correct.                                                                                                
CHAIR SEEKINS asked if SB  300 passes, the prevailing party would                                                               
pay taxes only on the award less the attorney fees.                                                                             
MR. COVELL agreed.                                                                                                              
CHAIR  SEEKINS  asked   if  SB  300  will   correct  the  current                                                               
MR. COVELL said it would.                                                                                                       
CHAIR SEEKINS  asked if it  would have  any fiscal impact  on the                                                               
State of Alaska.                                                                                                                
MR. COVELL said it would not.                                                                                                   
SENATOR  THERRIAULT asked  if attorney  fees and  the costs  of a                                                               
case  are  categorized  separately  and  whether  they  would  be                                                               
treated the same way.                                                                                                           
MR. COVELL  said he believes  so; nothing would change  in regard                                                               
to cost.                                                                                                                        
CHAIR SEEKINS  said as is  the common practice of  the committee,                                                               
he would  hold the  bill for  a second hearing  to see  if anyone                                                               
else wants to comment. He said  he believes SB 300 is good public                                                               
policy and thanked all participants.                                                                                            

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