December 2004

Strange Bedfellows: The New Washington Attorney Lien Statute and the Blaney Cases

by Deborah D. Brookings

Two recent Washington cases have the potential to increase defendants’ exposure in discrimination lawsuits. The increased exposure comes as a result of trial courts now being directed to consider awarding to successful discrimination plaintiffs the increased tax consequences of lump-sum awards. In the meantime, a sweeping change to the attorney lien statute, RCW 60.40.010, became effective on June 10, 2004. This change negates some of the impact of the increased tax consequences with which defendants are now charged. However, it also has the potential to alter the way defendants pay judgments and negotiate and pay settlements — not just in discrimination cases, but in other cases, primarily contingent fee cases — as well. These matters are intertwined and more than a little convoluted, so some history and explanation are in order.

Defendants’ Responsibility for Plaintiffs’ Tax Consequences

How and when did the issue of federal income taxes arise for litigants in discrimination cases?

The Washington Law Against Discrimination, RCW 49.60 (WLAD), was enacted in 1949 and has since undergone many revisions. One such revision was to RCW 49.60.030 in 1973, when the Legislature added a section to provide for the recovery of several types of relief, including reasonable attorneys’ fees.1 At the time, any recovery was not gross income to a plaintiff because the Internal Revenue Code (IRC) excluded from gross income all damages received on account of personal injuries or sickness.2 Prior to 1996 the Internal Revenue Service (IRS) had interpreted this language to exclude from gross income damages obtained from all tort-type actions, which would include damages obtained from discrimination lawsuits.

The issue of large tax bites arose in 1996. That year Congress changed the IRC to provide that only those damages obtained on account of personal physical injuries or physical sickness were excluded from gross income.3 Simultaneously, Congress provided a new definition of emotional distress, stating that it would not be treated as a physical injury or a physical sickness.4 As of 1996, therefore, damages awarded to successful discrimination plaintiffs, along with the attorneys’ fees awarded by statute, became taxable income to plaintiffs.5

Why are federal income taxes to plaintiffs so high?

Typical components of damages awards in discrimination lawsuits include back pay, front pay, and emotional distress. Because these amounts are all paid to a plaintiff in a lump sum, rather than over time, the award can be expected to be taxed at a higher rate than if the money had been received over a number of years. This is because, under the IRC, any income received above a certain amount is taxed at a higher marginal rate than income received up to that amount. In addition, the attorney fee award, considered to be gross income to the plaintiff, is often a nondeductible expense to the plaintiff. This is because a successful discrimination plaintiff reporting a large damages award and attorney fee award in a single tax year is likely to implicate the alternative minimum tax (AMT).

The AMT was implemented in 1986 and designed to ensure that no taxpayer with substantial economic income can avoid significant tax liability by using exclusions, deductions, and credits.6 The likely effect of the AMT is to eliminate deductions a taxpayer might have had before its application, including deductions for attorney’s fees incurred in obtaining income.7 Calculating the AMT is quite complicated and beyond the expertise of this writer; however, the critical issue for discrimination plaintiffs is that miscellaneous itemized deductions — which include attorneys’ fees — are not deductible from the AMT tax base for purposes of calculating the AMT.8

It was the confluence of events, namely the inclusion of awards for non-physical injuries as gross income in 1996 and the institution of the AMT in 1986, that created the problem of a large tax liability to successful discrimination plaintiffs. It was the Blaney decisions that tossed the problem to defendants, by making defendants responsible for that huge tax bite.

How did defendants get the responsibility for plaintiffs’ tax bill?

Two Washington decisions have addressed the issue of who should pay a discrimination plaintiff’s large tax bill. On April 1, 2004, the Washington State Supreme Court issued Blaney v. Association of Workers, 151 Wn.2d 203, ___ P.3d ___ (2004). In essence, Blaney affirmed the decision of Division I of the Washington State Court of Appeals in Blaney v. Association of Workers, 114 Wn. App. 80, 55 P.3d 1208 (2002). The effect of these cases is to make defendants responsible for paying the additional tax consequences faced by a successful discrimination plaintiff who obtains an award following trial.

Linda Blaney (Blaney) sued her union, the International Association of Machinists and Aerospace Workers, District No. 160 (defendant). She alleged gender discrimination under WLAD. Following trial, a jury found that the defendant had discriminated against Blaney and awarded her damages for back pay, front pay, and emotional distress. The total amount of these damages was $638,764. Judgment was entered in that amount.

Blaney then moved for an award of litigation expenses to cover attorney’s fees, costs, and pre-judgment interest. The court entered a supplemental judgment for those expenses in the amount of $235,625.38. Blaney then brought a motion for a second supplemental judgment to compensate her for the adverse federal tax consequences she would incur as a result of receiving a lump-sum payment of $874,389.38 in a single tax year.9

To support her motion for this second supplemental judgment, Blaney presented the expert testimony of a certified public accountant that she would owe $244,753 more in federal income taxes than she would have owed but for the awards. The trial court denied Blaney’s motion for this judgment, concluding that no authority existed for allowing such an award. The defendant then appealed the giving of an erroneous instruction (unrelated to the present issue), and Blaney cross-appealed the issue of denial of a supplemental award for adverse tax consequences.

The Court of Appeals found that Blaney was entitled to the adverse tax consequences of her combined judgments (damages award plus award for litigation expenses, including attorney’s fees), holding that “adverse federal tax consequences triggered by payment of a judgment for violation of the WLAD are within the scope of the term “actual damages” compensable under RCW 49.60.030(2).10 The court then remanded the matter to the trial court to determine an appropriate supplemental judgment.11 The defendant petitioned the Washington State Supreme Court for review, and review was granted.

The Washington State Supreme Court affirmed the Court of Appeals. It concluded that successful discrimination plaintiffs could recover from defendants the adverse tax consequences of their judgments.12 However, such a remedy was to be considered an equitable remedy under the “any other appropriate remedy” language of RCW 49.60.030(2), instead of “actual damages.”13

Amendment to RCW 60.40.010

Has the Washington State Legislature taken any action to address the problem of tax consequences to discrimination plaintiffs?

Yes. On June 10, 2004, amendments to RCW 60.40.010, the attorney lien statute, became effective. This statute had gone unchanged for many years, until its very recent rewrite. A new Section 1 sets forth the reasons for the amendments:14

The purpose of this act is to end double taxation of attorneys’ fees obtained through judgments and settlements, whether paid by the client from the recovery or by the defendant pursuant to a statute or a contract. Through this legislation, Washington law clearly recognizes that attorneys have a property interest in their clients’ cases so that the attorney’s fee portion of an award or settlement may be taxed only once and against the attorney who actually receives the fee. This statute should be liberally construed to effectuate its purpose. This act is curative and remedial, and intended to ensure that Washington residents do not incur double taxation on attorneys’ fees received in litigation and owed to their attorneys. Thus, except for RCW 60.40.010(4), the statute is intended to apply retroactively.
(Emphasis added.)
 
The amended statute is far more sweeping and specific than its predecessor. While retaining the original language giving an attorney a lien on papers and money held by the attorney and belonging to the client, as well as money in the hands of the adverse party, the statute creates a property right in the attorney as to those fees. This is true of both contingent fees as well as fees awarded by operation of statute (and presumably contract). RCW 60.40.010 further provides that the lien held by the attorney is superior to all other liens and is not affected by any settlement between the parties to the action until that lien is satisfied in full. The statute applies whether the action results in a settlement through mediation or otherwise, by arbitration, or following a judgment. In a nutshell, Washington attorneys now have the same right and power over actions to enforce their liens as their clients have for amounts due them.

How is the new statute likely to be interpreted?

Washington’s amended attorney lien statute closely follows that of Oregon.15 Oregon’s lien statute was recently construed by the 9th Circuit Court of Appeals in Banaitis v. Commissioner of Internal Revenue.16 Banaitis had obtained a jury verdict on a claim for wrongful termination and related employment torts. An appeal followed, and the case was eventually settled between the parties. The total amount paid by the two defendants was $8,728,559. Banaitis’s attorney was paid $3,864,012 directly. The remaining $4,864,547 went directly to Banaitis.

Banaitis filed a federal income tax return for 1995, the year payments were made pursuant to the settlement. He excluded from his gross income the full settlement total. The IRS ultimately calculated that Banaitis owed an additional $1,708,216 in 1995 income tax. As the court noted, this was due to the effect of the AMT, which resulted, in effect, in taxing the portion of Banaitis’s gross income that was paid to his lawyers.

Banaitis petitioned the U.S. Tax Court seeking a re-determination of the deficiency. The tax court found in favor of the IRS, and Banaitis appealed to the 9th Circuit. In analyzing the issue of includability of attorneys’ fees as gross income to the plaintiff, the 9th Circuit determined that whether attorneys’ fees paid under a contingent fee contract with the plaintiff are includable in the plaintiff’s gross income involves two related questions: (1) How state law defines the attorney’s rights in the action, and (2) How federal tax law operates in light of the state law definition of interests.17

The court then examined Oregon state law to determine how it defines attorneys’ rights with respect to payment. The court specifically looked at whether the plaintiffs’ attorneys “have particular property interests arising as a matter of law in the judgment or settlement independent of the fee contract.” It found that Oregon law affords attorneys generous property interests in judgments and settlements.18 It noted that an attorney’s lien in Oregon is superior to all other liens except tax liens.19 The court also observed that Oregon law provided that attorneys would have the “same right and power over actions, suits, proceedings, judgments, decrees, orders, and awards to enforce their liens as their clients have for the amount of judgment due thereon to them.”20 The court thus concluded that “fees paid directly to [the attorney] were not includable in Banaitis’s gross income for the relevant year,” and reversed the tax court.21

The 9th Circuit’s construction of Oregon’s attorney lien statute is instructive for Washington practitioners and their clients. It suggests that Washington’s attorney lien statute will get a similar interpretation, as the pivotal language is present in both statutes.

What is the combined effect of the Blaney decisions and RCW 60.40.010?

The practitioner must now read the Blaney decisions in conjunction with the recent amendments to RCW 60.40.010. It is evident that the latter removes any need to charge defendants with the tax consequences of attorney fee awards to successful discrimination plaintiffs, because under RCW 60.40.010, attorneys’ fees, whether contingent or awarded by statute, are now the property of the attorney, not the client, and thus not includable in the plaintiff’s gross income. However, tax consequences on any award for damages to a successful discrimination plaintiff are nevertheless includable in gross income and subject to adverse tax consequences. As a result, under the Blaney decisions, defendants will be charged with those additional tax consequences if the court, following a bench or jury trial, determines that a tax offset is an equitable remedy to which the plaintiff is entitled. Neither Blaney decision provides for adverse tax consequences on an award in anything other than discrimination cases.22

Are the feds trying to end double taxation of attorneys’ fees or otherwise soften the tax blow to discrimination plaintiffs?

The IRS is not interested. At least one source has estimated that $230 million in additional revenue has been raised by amending 26 U.S.C. § 104(a) (2) to make damage awards for non-physical injuries taxable.23 However, a bill titled “The Civil Rights Tax Relief Act” to amend the IRC of 1986 was introduced in the U.S. House of Representatives on March 1, 2001,24 introduced in the Senate on May 21, 2001,25 and referred to the Finance Committee.

An amended bill26 was introduced in the Senate on March 6, 2003, read twice, and referred to the Finance Committee. There it remains.27

The current proposed Civil Rights Tax Relief Act would grant much more tax relief to successful discrimination plaintiffs than simple exclusion of attorney fee awards from a plaintiff’s gross income. It would exclude from gross income amounts received on account of claims based on unlawful employment discrimination and allow income averaging for back pay and front pay damages on such claims. Unless or until this act becomes law, successful discrimination plaintiffs will continue to include damage awards in gross income and pay taxes thereon. In this state, under Blaney, defendants will pay whatever tax consequences the court deems appropriate.28 Defendants will be spared the tax consequences of attorney fee awards under revised RCW 60.40.010, since attorneys’ fees are now the property of the attorney and thus not taxable income to plaintiffs.

Unintended Consequences of Amendments to RCW 60.40.010

As set forth above, the Legislature made clear that its purpose in amending RCW 60.40.010 was to end taxation of attorneys’ fees to plaintiffs who turned those fees over directly to their attorneys. As is typically the case, there are undoubtedly some unintended consequences of the new statute.  

Can plaintiff attorneys now sue defendants for attorneys’ fees?

Probably. It is likely that a plaintiff’s attorney can sue a defendant directly for his or her attorney’s fees when not paid in full, even though the defendant has paid the plaintiff in full. In Potter v. Schlesser Company,29 a recent decision of the Oregon Supreme Court construing its state attorney lien statute, the plaintiff had settled privately with the defendant but did not pay Potter, his attorney. Potter sued the defendant, not the plaintiff. The trial court granted summary judgment dismissal in favor of the defendant, and the Oregon Court of Appeals affirmed. The Oregon Supreme Court reversed, finding that under Oregon’s attorney lien statute, both the plaintiff and the defendant “are statutorily obligated to satisfy the attorney’s lien to the extent of the action’s value.”30 It then held that an attorney had a right to sue a defendant for attorney’s fees that were left unsatisfied by a private settlement with the attorney’s clients, finding that “plaintiff’s separate action against defendant is an acceptable method to enforce plaintiff’s attorney’s lien.”31

The 9th Circuit relied on the Potter decision as well as its own analysis of the Oregon attorney lien statute for its holding in Banaitis, supra. It concluded that Oregon law “vests attorneys with property interests that cannot be extinguished or discharged by the parties to the action except by payment to the attorney.”32

Oregon’s interpretation of its statute is not binding on Washington courts. However, the 9th Circuit relied on the Oregon statute and the Potter case to reach the conclusion in Banaitis that attorney’s fees are property of the attorney in Oregon. Because those fees are property of the attorney, they are not property of the plaintiff. Since the newly amended RCW 60.40.010 is now substantially similar to Oregon’s attorney lien statute, it is reasonable to assume a comparable result would be reached in Washington.

In light of our new RCW 60.40.010, Banaitis, and Potter, what changes in procedures may be implicated?

1. On a judgment summary following an award of damages to a discrimination plaintiff, should the attorney be listed as a creditor, along with the plaintiff? Should defendants issue two checks — one to the plaintiff and one to the attorney? Should a satisfaction of judgment from both the plaintiff and the plaintiff’s attorney be obtained and filed?

2. Following an award to a plaintiff, a defendant should be entitled to know what portion of the damage award is to be paid to the attorney under a contingent-fee agreement. This information is necessary, because, under Blaney, defendants may be ordered to pay all or a portion of the additional tax consequences incurred by the plaintiff on a damage award. But in light of the amendments to RCW 60.40.010, defendants would not be charged with any adverse tax consequences as to attorneys’ fees. It is therefore essential that defendants know exactly what percentage of the damage award the plaintiff will report as damages, and what amount will be deemed property of the plaintiff’s attorney.33 Should defendants therefore be entitled to see the contingent-fee agreement? At the least, should defendants be entitled to obtain a declaration from the attorney setting forth the amount of recovery or percent of recovery the attorney will receive under such an agreement?

3. The Washington State Supreme Court in Blaney did not provide any procedural guidance for handling the nuts and bolts of obtaining an award for tax consequences. In the absence of any tips from the Court, the process outlined by the Court of Appeals in its Blaney decision is likely to be followed: The judge decides “whether and to what extent damages for adverse tax consequences will be awarded,” the burden of proof is on the plaintiff to establish the tax consequences he or she will incur as a result of receiving a lump-sum damage award, and expert opinion is required.34 As a practical matter, this is a post-trial issue, and the testimony of the plaintiff’s expert is likely to be by declaration. To ensure accuracy, defense attorneys should retain an accountant familiar with these types of calculations to vet the figures generated by the plaintiff’s expert. At the least, the calculations should be based on the actual tax returns filed by the plaintiff and spouse, if applicable, for the tax year immediately preceding the year in which the damage award will be received. The tax return should include W-2s as well as all accompanying additional schedules. Any calculations of tax consequences must be made based on the expected tax rates which will apply in the year the damage award is received.

4. With respect to settlements, should defendants cut separate checks — one to the plaintiff and one to the plaintiff’s attorney? Should the parties include in the language of the settlement agreement and release a specified amount that will be paid to the attorney? Should defendants obtain the signature of the attorney on the settlement agreement and release? Although the Blaney decisions do not implicate settlements, amended RCW 60.40.010 appears to make a plaintiff’s attorney as much a creditor of the defendant as is the plaintiff. Just as finality regarding the plaintiff’s claims has always been the aim of settlement, now a concomitant objective should be finality with respect to any potential claims by the plaintiff’s attorney.35

_____________________________

Deborah Brookings is a shareholder with Keating Bucklin & McCormack, P.S. (www.kbmlawyers.com) in Seattle.

NOTES
1 RCW 49.60.030(2).
2 26 U.S.C. § 104(a)(2).
3 Id. 
4  26 U.S.C. § 104(a).
5 The attorney who ultimately receives these fees also pays taxes on them.
6 26 U.S.C. § 55(a)(1)-(2); Jennifer S. Neumann, Comment, The Discrimination Created by the Tax Treatment of Attorney’s Fees in Federal Civil Rights Cases, 51 Kan. L. Rev. 595, 609 n.94 (May 2003). 
7 The IRS allows attorneys’ fees to be deducted as a miscellaneous itemized deduction where they are incurred as an “expense for the production or collection of income.” 26 C.F.R. § 1.67-IT.
8  Id.; 26 U.S.C. § 56(b) (1) (A) (i). See also IRS Publication 17 § 31(2003).
9 This is the combined amount of the damages award plus the litigation expenses, including attorneys’ fees. 
10 Blaney, 114 Wn. App. at 98.
11 The total amount the defendant would have to pay, if the trial court then granted all relief Blaney requested for adverse tax consequences, would amount to $1,119,142.38, almost twice the damages award.
12 The Court of Appeals expressly stated that it offered no opinion whether adverse tax consequences arising from damages and/or attorneys’ fees in cases other than those under the WLAD may serve as a basis for these types of damages. Blaney, 114 Wn. App. at 100. The decision of the Washington State Supreme Court contains no such specific limiting language, but appears to apply only to tax consequences arising from discrimination cases. 
13 The court determined that the “any other appropriate remedy” clause amounted to a third “catch-all” remedy under the WLAD, providing relief afforded by Title VII of the Civil Rights Act of 1964, 42 U.S.C. § 2000e. Blaney, 151 Wn.2d at 214-217.
14 In all likelihood, the Legislature’s primary objective was to address the anomaly that plaintiffs and their attorneys were paying federal income taxes on the attorney fee awards.
15 Oregon Revised Statutes (ORS) 87.430-490.
16 340 F.3d 1074 (August 2003). 
17 Banaitis, 340 F.3d at 1081.
18 Id. By contrast, the court noted that Alaska did not grant attorneys a superior lien or ownership interest in the cause of action, did not confer ownership interest in attorneys, and did not grant attorneys any right and power over the suits, judgments, or decrees of their clients. As a result, attorney’s fees were the plaintiff’s property and thus includable in the plaintiff’s gross income. See Coady v. Commissioner, 213 F.3d 1187, 1190-91 (9th Cir. 2000).   
19 Banaitis, 340 F.3d at 1082; ORS § 87.490. 
20 Id.; ORS § 87.480.   
21 Banaitis, 340 F.3d at 1083.
22 Damages on account of physical injuries are not considered gross income to plaintiffs in any event. Left open is the question of damages for other non-physical-type injuries, such as defamation, tortious interference with a business expectancy, etc.
23 See Neumann, 51 Kan. L. Rev. at 609 n.43.
24 H.R. 840.
25 S. 917.
26 Now H.R. 1155 and S. 557.
27 Despite some apparent support, at least one commentator believes this act is unlikely to pass, because it goes too far in providing relief, and it has been before Congress for two sessions without a vote. See Neumann, 51 Kan. L. Rev. at 621 n.150.
28 At least one King County Superior Court judge recently determined that tax consequences were awardable on the wage-loss portion of the plaintiff’s damages only, based on the fact that the federal cases relied on by the Blaney courts approved awards for tax consequences on lump sums for back pay and front pay. See Sears v. Atchison Topeka & Santa Fe Railway, 749 F.2d 1451 (10th Cir. 1984) (holding that “the district court did not abuse its discretion when it included a tax component in the back-pay award to compensate class members for their additional tax liability as a result of receiving over 17 years of back pay in one lump sum, but that a tax component may not be appropriate in a “typical Title VII case”). See also EEOC v. Joe’s Stone Crab, Inc., 15 F. Supp. 2d 1364 (S.D. Fla. 1998) (holding that a district court, in its discretion, may include a tax component to Title VII plaintiffs with respect to their back-pay awards). Nor do other federal discrimination cases recognize any relief from tax consequences for awards other than those for economic damages. See, e.g., Gelof v. Papineau, 829 F.2d 452 (3d Cir. 1987) (upholding the concept of a judgment under the Age Discrimination in Employment Act for the negative tax impacts of a lump-sum payment for back pay, back pension benefits, and back health benefits, but remanding for recalculation of the amount because the tax rates used to calculate the amount were not those of the year in which the award would be paid); O’Neill v. Sears Roebuck & Co., 108 F. Supp. 2d 443 (E.D. Penn. 2000) (concluding that a plaintiff who prevailed under the Age Discrimination in Employment Act and received a large award of back pay and front pay was entitled to an award for negative tax consequences, but only as to the increased tax liability on the award of front and back pay). 
29 335 Or. 209, 63 P.3d 1172 (Feb. 2003).
30 Potter, 63 P.3d at 1176.
31 Id. 
32 Banaitis, 340 F.3d at 1083.
33 For example, if the plaintiff obtains a damage award of $30,000, but pursuant to a contingent fee agreement between the plaintiff and the attorney, $10,000 of that award is attorney’s fees, the defendant could not be charged with tax consequences on anything more than the $20,000 that the plaintiff will presumably report on his or her income tax return.
34 Blaney, 114 Wn. App. at 100.
35 It should be noted that although there are no tax consequences to plaintiffs with physical injuries, i.e., from sidewalk fall-downs, motor vehicle accidents, etc., so that Blaney has no applicability to those types of claims, the amendments to RCW 60.40.010 affect all actions in which attorneys are to be paid from a settlement or judgment.

Back to table of contents >>