BILL ANALYSIS Ó SENATE GOVERNANCE & FINANCE COMMITTEE Senator Lois Wolk, Chair BILL NO: SB 342 HEARING: 04/27/11 AUTHOR: Wolk FISCAL: Yes VERSION: 04/25/11 TAX LEVY: No CONSULTANT: Miller and Grinnell CONTINGENCY & ATTORNEY'S FEES Prohibits contingency fees in tax matters and limits the computation of attorney's fees to the Revenue & Taxation Code. Background and Existing Law I. Contingency fees. Federal law allows the Secretary of the Treasury to regulate practitioners with cases before the Internal Revenue Service (IRS). IRS Circular 230 generally spells out requirements for these practitioners, and also regulates the conduct of anyone providing tax advice or preparing tax returns for compensation, including attorneys, certified public accountants, and enrolled agents. In 2009, IRS revised Circular 230 to bar individuals practicing before the IRS from charging clients contingency fees, with specified exceptions, because of the potential to exploit the audit selection process and compromise a practitioner's duty of independent judgment. Federal law also applies an erroneous claim for refund penalty equal to 20% of the amount of the claim that lacks a reasonable basis for the refund. California does not conform to this penalty (See Comment #4). Additionally, the American Institute of Certified Public Accountants Code of Professional Conduct precludes accountants from charging contingency fees for preparing an original or amended tax return, with specified exceptions. State law restricts commissions charged by certified public accountants in specified circumstances (SB 1289, Calderon, 1998). However, sophisticated cottage industries of non-accountant tax consultants have grown considerably in recent years, offering to amend a taxpayer's previous state income tax returns seeking refunds of previous taxes paid by claiming tax credits not included on the taxpayer's original return. Additionally, consultants assist SB 342 -- 4/25/11 -- Page 2 taxpayers protesting an assessor's valuation of his or her property by pursuing appeals seeking to reduce the value with county assessment appeals boards. In both cases, the taxpayer compensates the consultant as a percentage of the refund, providing a significant incentive to file aggressive claims with questionable justification. As many of these consultants are neither accountants subject to state law or codes of ethics, nor practitioners covered by Circular 230, they may charge taxpayers contingency fees without any limitation. II. Attorney's fees. Current state law provides two methods for determining attorney's fees in tax related cases: the Revenue & Taxation Code which caps attorney's fees at an hourly rate, and the Code of Civil Procedure which uses a multiplier to determine attorney's fees. The California Constitution requires a state agency to enforce a statute until an appellate court determines it unconstitutional. To be substantially justified, the state's position must have a reasonable basis in law and fact. It does not need to be a winning argument. The Revenue & Taxation Code provides that certain parties that prevail against Franchise Tax Board (FTB) in a civil proceeding may be awarded reasonable litigation costs, defined to include court costs, expert witness fees, the cost of studies, and attorney fees. To receive attorney fees, a prevailing party must meet three requirements: (1) Exhausted all available administrative remedies prior to initiating the lawsuit, (2) Reasonable litigation costs allocable solely to the State of California, (3) Reasonable litigation costs during the civil proceeding, except for the period in which the prevailing party has unreasonably protracted that proceeding. The hourly rate for attorney fees is capped and adjusted each calendar year using a statutory cost-of-living rate. The rate for calendar year 2006 is $140 per hour. The rate for calendar year 2007 is $150 per hour. A court may award attorney fees above the capped rate when a special factor presents itself. The statutory examples of special factors are: (1) The availability of qualified attorneys for the type of case, (2) The difficulty of the case, SB 342 -- 4/25/11 -- Page 3 (3) The local availability of tax attorneys. To be considered a prevailing party, the party must substantially prevail on the disputed amount, or substantially prevail on the significant issues in the case. However, if the State of California establishes that its position was substantially justified, then the prevailing party may not recover any litigation costs. Under the Code of Civil Procedure, a prevailing party whose litigation results in the enforcement of an important public interest may be awarded attorney fees. To receive attorney fees a party must meet three requirements: (1) Provide a significant benefit to the general public, (2) Have a financial burden that makes the attorney fee award appropriate, (3) To achieve justice the circumstances require that attorney fees be provided in addition to the recovery. A financial burden makes an award appropriate is one where the cost of victory exceeds the party's personal interest so that the cost of the lawsuit is disproportionate to the disputed issue. A court may award less than the full amount of attorney fees when a successful party's financial gain warrants. Public entities may not receive attorney fees in litigation against individuals. Attorney fees are calculated by determining the lodestar and applying a multiplier. The lodestar is the product of hours the attorney worked times a reasonable hourly rate. The trial court may increase or decrease the lodestar by a multiplier. For example, if an attorney worked ten hours at a reasonable hourly rate of $350, then the lodestar is $3,500. If a multiplier of 2 is applied, the final attorney fees awarded are $7,000. Unlike the Revenue & Taxation Code section, the Code of Civil Procedure and the Private Attorney General Doctrine do not require the exhaustion of administrative remedies and allows an award of attorney fees even if the defendant (here FTB) was substantially justified in defending the lawsuit. Current federal law provides similar provisions to the state Revenue & Taxation Code for capping attorney's fees with no additional option for increased fees. SB 342 -- 4/25/11 -- Page 4 Specifically, parties that prevail against the Internal Revenue Service (IRS) may be awarded reasonable litigation costs. To receive attorney fees, a prevailing party must meet three requirements: (1) have exhausted all available administrative remedies prior to initiating the lawsuit, (2) have reasonable litigation costs allocable solely to the United States, and (3) have reasonable litigation costs during the court proceeding, except for the period in which the prevailing party has unreasonably protracted that proceeding. Reasonable litigation costs include court costs, expert witness fees, the cost of studies, and attorney fees. The hourly rate for attorney fees is capped. The cap is adjusted each calendar year using a statutory cost-of-living rate. The rate for calendar year 2006 is $160 per hour. A court may award attorney fees above the capped rate when a special factor presents itself. The statutory examples of special factors include the following: the availability of qualified attorneys for the type of case, the difficulty of the case, and the local availability of tax attorneys. To be considered a prevailing party, the party must substantially prevail on the disputed amount, or substantially prevail on the significant issues in the case. The Internal Revenue Code (IRC) contains a net worth requirement that is not found in the Revenue & Taxation Code. Under the IRC, to qualify for the award, an individual's net worth may not exceed $2,000,000, and a business may not have a net worth over $7,000,000 and over 500 employees. However, if the IRS establishes that its position was substantially justified, then the prevailing party may not recover any attorney fees or litigation costs. To be substantially justified, the IRS's position must have a reasonable basis in law and fact. It does not need to be a winning argument. The Private Attorney General Doctrine. In 1974, the United States Court of Appeals for the District of Columbia awarded the Wilderness Society, Environmental Defense Fund, and Friends of the Earth attorney fees for serving as a private attorney general. The attorney fees were sought for the plaintiff's litigation to prevent construction of an Alaskan pipeline. The Court of Appeals found that the plaintiffs acted as a private attorney general by enforcing public policy and should not have to finance litigation that was for a public benefit. The fee shifting was not intended to be punitive. In 1975, the United States Supreme Court reversed the decision in Alyeska Pipeline SB 342 -- 4/25/11 -- Page 5 Serv. Co. v. Wilderness Soc'y because the Court of Appeals awarded the attorney fees without a statutory basis and because this award was contrary to "the general 'American rule' that the prevailing party may not recover attorneys' fees as costs or otherwise." The Supreme Court in this case also stated that it was within the authority of Congress to create a private attorney general doctrine. Proposed Law I. Contingency fees. Senate Bill 342 prohibits a person from charging a contingency fee for services rendered in connection with any matter before the State Board of Equalization, Franchise Tax Board, or assessment appeals board, or for any other tax imposed under state law. The prohibition applies to all fee arrangements entered into on or after the effective date of the bill. The bill defines "contingent fee" identically to Circular 230, but without the exceptions, as any fee that is: Based in whole or in part on whether or not a position on a tax return or other filing avoids challenge or is sustained either by the State Board of Equalization, the Franchise Tax Board, or in litigation. A fee that is based on the percentage of the refund reported on a return, a fee that is based on a percentage of the taxes saved, or a fee that depends on the specific tax result attained. Any fee arrangement in which the party to whom services are rendered, or a designee of the party to whom services are rendered, is reimbursed or credited for all or a portion of the fee paid or agreed to be paid if a position taken on a tax return or other filing is challenged or is not sustained, whether pursuant to an indemnity agreement, a guarantee, a right of rescission, or any other arrangement with similar effect. The governmental entity responsible for administering the tax shall impose a penalty equal to the amount of the contingency fee for persons who fail to comply. II. Attorney's fees. Senate Bill 342 specifies that the Revenue & Taxation Code section is the exclusive attorney SB 342 -- 4/25/11 -- Page 6 fee remedy for a party that prevails in a law suit against the FTB. State Revenue Impact An FTB estimate for prohibiting contingency fee arrangements is pending. According to the FTB, this bill could result in savings to the State but the amount of savings is unknown because it depends on the frequency of relevant litigation and on the size of future awards, both of which are unknown. SB 342 -- 4/25/11 -- Page 7 Comments 1. Purpose of the bill . According to the Author, "In today's fiscal crisis, state and local governments across the country have been forced to ask citizens for higher taxes and enacted significant cuts in public services. We recently enacted billions of dollars in cuts, with several billion more on the horizon, often requiring sacrifices from the most vulnerable among us. SB 342 provides a way to make the tax system more honest by taking away the incentive for unregulated consultants to seek aggressive tax returns on a contingency fee basis. Contingency fees tie a consultant's compensation to the amount of a taxpayer's tax refund, providing a strong incentive to play fast and loose with rules, requiring pay outs of big tax refunds from taxes previously collected and spent, and often leading unsophisticated firms into audits. This bill doesn't affect a taxpayer's right to file a claim for refund for any tax, only regulates the way they pay unrelated third parties seeking refunds on their behalf." As it relates to attorney's fees, the author states "This bill clarifies a drafting error from 1983 when the state intended to conform to federal law requiring all attorney's fees related to tax cases to be awarded under the Revenue & Taxation Code with an hourly cap versus under the Code of Civil Procedure." 2. Back off . Many taxpayers prepare their tax returns unaware of many benefits to which they're lawfully entitled, such as Research and Development and Geographically Targeted Economic Development Area credits. Documenting eligibility, filing amended returns, or challenging an assessor's valuation can be time consuming and costly, often too much so for smaller businesses and individuals, who can only afford to pursue these benefits using a consultant willing to work on contingency. SB 342 would cut off a means for taxpayers to reduce their taxes to only that level that they truly owe under the law by ending contingency fee arrangements. 3. Balance of power. Opponents of this bill may argue that attorney's fees decisions are best left to the court and should not be dictated by the Legislature as this bill attempts to do. Unlike most cases, however, the State and the FTB have a constitutional requirement to enforce a statute until an appellate court determines it SB 342 -- 4/25/11 -- Page 8 unconstitutional. 4. Of skinning cats . SB 342's prohibition on contingency fees is one way to limit consultants from filing questionable and costly claims for refund for income and corporation taxes. The Legislature has also sought to conform California law to federal law's erroneous claim for refund penalty equal to 20% of a disallowed refund claim that lacks reasonable basis. The penalty is intended to ensure that taxpayers simply do not file conservative original returns to avoid understatement penalties, only to file more aggressive amended returns seeking refunds. FTB currently has no legal ability to apply a penalty on refund claims except in very limited circumstances, and can only deny a refund claim when detected during an audit, leaving taxpayers little incentive not to play the "audit lottery" and file the most aggressive refund claims possible. Since 2007, taxpayers have been subject to the penalty for federal income taxes, but not for California returns. Governor Arnold Schwarzenegger vetoed two measures that would have conformed California law to the federal penalty, AB 1580 (Calderon, 2009) and SBx1 28 (Wolk, 2010). 5. Show me some proof. The most recent encounters FTB has had with awards of attorneys' fees under the private Attorney General doctrine have been in connection with the litigation contesting the constitutionality of the LLC fee statute. To date, FTB has been named the defendant in four separate lawsuits on this topic with the same attorneys in all four cases. The first such case was Northwest Energetics, LLC v. Franchise Tax Board. The Northwest case involved an LLC that conducted no business in California and generated a Superior Court judgment ruling that the LLC fee was in fact a tax; that the tax, as applied to Northwest, was unconstitutional; that FTB refund all LLC "fees" paid by Northwest; and that Northwest's attorneys be paid $3.5 million for professional services rendered in that case. The award of attorneys' fees was based upon the private attorney general doctrine, with the court accepting the argument that Northwest's attorneys had performed a service that was beneficial to many LLCs other than their particular client, Northwest. The award was also less than the $5 million requested by Northwest's attorneys. SB 342 -- 4/25/11 -- Page 9 FTB appealed the Northwest judgment. Among other things, FTB argued that the statute was constitutional, that fees could not be awarded under either the private attorney general or common fund doctrines as the Revenue & Taxation code was the exclusive avenue upon which attorneys' fees could be recovered in tax litigation, and that if private attorney general recovery was permissible, the amount was excessive. In a published opinion, the Court of Appeal found that the statute was unconstitutional as applied to Northwest and that attorneys' fees could be awarded under the private attorney general doctrine. The Court of Appeal also found that the Superior Court had not properly considered many of the factors to be evaluated before awarding any such fees and remanded the matter to Superior Court for further consideration. On remand, the Superior Court revised its attorneys' fee award to slightly less than $1.8 million. FTB then negotiated and paid a compromise of that sum and the case is done. The second LLC fee case is Ventas Finance I, LLC v. Franchise Tax Board. For the tax years in question, Ventas was an LLC that conducted business both within and outside California. The Ventas case generated a Superior Court judgment ruling that the LLC fee was in fact a tax; that the tax as applied to Ventas was unconstitutional; that FTB refund all LLC "fees" paid by Ventas; and that Ventas' attorneys be paid more than $200,000 for professional services rendered in that case. The award of attorneys' fees was based upon the private attorney general doctrine, with the court accepting the argument that Northwest's attorneys had performed a service that was beneficial to many LLCs other than their particular client. However, the court declined to apply a significant multiplier to the dollar value of the time expended in prosecuting the case because the effort was duplicative of Northwest and the source of payment of the fees was likely to be the public. The award was also significantly less than the $30 million requested by Ventas' attorneys. The appellant challenged the Legislative remedy for the unconstitutional LLC fee in AB 195 (Calderon, 2007). The amount claimed has been reduced to just under $700,000, and a hearing is set for May 18 to decide the issue. The third and fourth LLC fee cases are Bakersfield Mall, LLC v. Franchise Tax Board and CA Centerside LLC v. SB 342 -- 4/25/11 -- Page 10 Franchise Tax Board. The Bakersfield Mall case began as a suit filed by an LLC doing business only in California, and sought class-action status for all similarly situated LLCs. Discovery in that case reveals, however, that Bakersfield Mall may well have conducted business both within and outside California, and, as such, should be controlled by Ventas. In addition, FTB appears to have successfully negated the attempt by Bakersfield's attorneys (same attorneys in all four cases) to obtain class-action certification as for all California-only LLCs. In the early stages of this case, FTB attacked the class-action certification attempt, seeking a Writ of Mandate from the Court of Appeal directing the Superior Court to throw out the class-action portion of the lawsuit, limiting Bakersfield to the role of representing no one but itself. While the Court of Appeal did not issue the writ requested, it did issue an order containing language stating it would entertain the writ petition should the Superior Court actually grant class-action status. CA Centerside is the most recent lawsuit filed in the LLC fee arena. The Complaint in this suit is substantially similar to the Complaint originally filed in the Bakersfield case and again seeks class-action certification. As in Bakersfield, FTB immediately attacked the class-action certification aspect of this case, again requesting the Court of Appeal to issue a Writ of Mandate directing the Superior Court to throw out the class-action portion of the lawsuit. Unfortunately, the Court of Appeal did not issue the writ, and did not indicate what it would do should the Superior Court actually certify the case as a class-action. While neither of these cases has been designated a class-action, the pursuit of class-action status is significant in that it clearly underscores the desire of the taxpayers' lawyers to put themselves in a position to request attorneys' fees on behalf of thousands of LLCs in these ongoing disputes. As noted above, the Court of Appeal in Northwest sanctioned the use of the private attorney general doctrine as a basis for requesting substantial attorneys' fees in cases finding a tax statute to be improper. Since that time, FTB has been sued in multiple cases seeking to have a statute deemed unconstitutional or otherwise infirm. These cases all request the recovery of attorneys' fees, and the bulk of them are cases in that the taxpayer did not take its SB 342 -- 4/25/11 -- Page 11 dispute to the Board of Equalization, a fact that would preclude recovery of fees under RTC 19717. These cases include: California Taxpayers' Association v. Franchise Tax Board ; Sacramento County Superior Court No. 34-20009-80000138; Court of Appeal, 3rd Appellate District No. C062791 Case attacked the validity of California's large corporate underpayment of tax penalty (no BOE). Case is final in favor of FTB and no attorney's fees awarded. Frank Cutler v. Franchise Tax Board; Los Angeles County Superior Court No. BC421864 Case attacks the constitutionality of California's small business stock statutes (BOE). The Gillette Company & Subsidiaries v Franchise Tax Board; San Francisco County Superior Court No. CGC10495911; consolidated with Jones Apparel Group, Inc. & Subsidiaries v. Franchise Tax Board, San Francisco County Superior court No. CGC10499083; Kimberly-Clark World Wide, Inc. & Subsidiaries v. Franchise Tax Board, San Francisco County Superior Court No. CGC10495916; Proctor & Gamble Manufacturing Co. & Affiliates v. Franchise Tax Board, San Francisco County Superior Court No. CGC10495912; RB Holdings (USA) Inc. & Subsidiaries v. Franchise Tax Board , San Francisco County Superior Court No. CGC10496438; and Sigma-Aldrich Corporation & Subsidiaries v Franchise Tax Board , San Francisco County Superior Court No. CGC10496437 Cases all contend that California's amendment of RTC 25128 during 1993, which introduced the double-weighting of the sales factor into the formula through which California taxes corporations engaged in multi-state business, is both unconstitutional and/or invalid because the Legislature only amended RTC 25128 as opposed to the entire Multistate Compact, of which 25128 is a part. (no BOE in any of them) Trial court ruling was in favor of FTB so no attorney's fees awarded at this time, but the case is pending with the Court of Appeal. Personal Selling Power, Inc. v Franchise Tax Board; Alameda County Superior Court No. RG09462520 Case purports to seek a determination of whether sales of SB 342 -- 4/25/11 -- Page 12 to-be-printed advertising constitutes a sale of tangible property for purposes of Public Law 86-272. (Principal amount in controversy is less than $1,000) (no BOE) This case has been settled, and no attorney's fees were paid. Quellos Financial Advisors, LLC v Franchise Tax Board; San Francisco County Superior Court No. CGC09487540; and Quellos Group, LLC v Franchise Tax Board; San Francisco County Superior Court No. CGC10501299 Both cases involve the constitutionality of California's abusive tax shelter promoter penalty (no BOE). Trial has started and is continuing. Taiheiyo Cement U.S.A., Inc. v Franchise Tax Board; Los Angeles County Superior Court No. BC422623 Case involves the interpretation of the language "placed in service" as used in California's enterprise zone sales and use tax credit statutes. ( BOE) FTB prevailed at trial court, but taxpayer has appealed. 6. Suggested amendments . Committee staff recommends the following amendments be adopted if the Committee approves the measure. Because the Senate Committee on Judiciary may request to hear the bill, amendments will need to be adopted there: Provide for a penalty that would be the greater of $5,000 or 100 percent of the contingent fee charged. Specify that contingent fee arrangements are against public policy and void and unenforceable. Allow BOE, FTB, and assessment appeals boards to obtain written certification, under penalty of perjury, that a fee for services is exclusive of any contingent fee. Authorize BOE and FTB to adopt regulations, exempt from the Administrative Procedure Act requirements, to prevent the use of contingent fee arrangements. 7. Double Referral. Should this bill get out of this committee, the motion should be do pass to the Rules Committee so that it can be referred to the Judiciary Committee. Support and Opposition (4/21/11) SB 342 -- 4/25/11 -- Page 13 Support : Franchise Tax Board (attorney fee portion). Opposition : Unknown.