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 [indisc.]. 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 explained: 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 justice. 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 disparity. 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.