Current through Register Vol. 24-06, March 15, 2024
(1)
Introduction. This rule
explains the taxability of amounts received for legal, arbitration, and
mediation services.
(2)
Definitions.
(a) "Arbitration"
means the process by which the parties to a dispute submit to the hearing and
judgment of an impartial person or group appointed by mutual consent or
statute.
(b) "Arbitration services"
means services relating to the resolution of a dispute submitted to
arbitration.
(c) "Attorney" means
an active member of a state Bar Association engaged in the practice of law. The
term also includes a professional service corporation incorporated under
chapter
18.100 RCW, a
professional limited liability company formed under chapter 18.190 RCW, or a
partnership, provided the ownership of these business entities are properly
restricted to attorneys and organized primarily for engaging in the practice of
law.
(d) "Legal services" means
services relating to or concerned with the law. Such services include, but are
not limited to, representation by an attorney (or other person, when permitted)
in an administrative or legal proceeding, legal drafting, paralegal services,
legal research services, arbitration, mediation, and court reporting
services.
(e) "Mediation" means the
process by which the parties to a dispute or negotiations agree to have an
intermediary hear their differences and/or positions and facilitate and/or make
suggestions concerning an agreement and/or the resolution of their
dispute.
(3)
Business and occupation tax. Gross income from legal, arbitration,
or mediation services is subject to the service and other activities
classification.
(a) Gross income. The gross
income of the business generally includes the amount of compensation paid for
legal, arbitration, or mediation services and amounts attributable to providing
those services (i.e., charges for tangible personal property directly used or
consumed in supplying legal, arbitration, or mediation services). Reimbursed
general overhead costs are generally included in the gross income of the
business even though indirectly related to litigation. Any reimbursed costs
(not directly related to litigation) for which the attorney assumes personal
liability for payment are also included in gross income.
(b) Overhead costs. Amounts received (or, for
taxpayers reporting under the accrual accounting method, accrued) to compensate
for overhead costs are fully subject to tax. Such overhead costs are taxable
even though they may be separately stated on the billings or expressly
denominated as costs of the client. Examples of such overhead costs include,
but are not limited to:
(i) Photocopy or other
reproduction charges, except charges paid to the provider, or the agent of the
provider, for the official or original copy of a record, or other document,
provided for litigation;
(ii) Long
distance telephone tolls;
(iii)
Secretarial expenses;
(iv) Office
rent;
(v) Office
supplies;
(vi) Travel, meals and
lodging;
(vii) Utilities, including
facsimile telephone charges; and
(viii) Postage, unless paid for service of
legal papers as a direct cost of litigation.
(c) Excluded amounts. The following amounts
are excluded from gross income if complete and accurate records are maintained
of these amounts.
(i) Client trust accounts.
The gross income of the business does not include amounts held in trust for the
client.
(ii) Litigation expenses.
Attorneys are bound by the rules of professional conduct. RPC 1.8(e) prohibits
an attorney from financing the expenses of contemplated or pending litigation
unless the client remains ultimately liable for these expenses. This means that
an attorney normally acts solely as the agent for the client when financing
litigation. Accordingly, amounts received from a client for the direct expenses
of litigation do not constitute gross income to the attorney. Amounts received
(or, for taxpayers reporting under the accrual accounting method, accrued) to
compensate for the following direct litigation expenses are not included in
gross income:
(A) Filing fees and court
costs;
(B) Process server and
messenger fees;
(C) Court reporter
fees;
(D) Expert witness fees;
and
(E) Costs of associate counsel.
A cash basis taxpayer cannot exclude or deduct amounts of
unreimbursed litigation expenses. For example, an attorney advances all the
litigation expenses for a contingency fee case. The case is ultimately resolved
against the attorney's client and the expenses are not repaid because of the
client's bankruptcy. The attorney cannot then deduct these expenses as a bad
debt or otherwise exclude them against other income earned by the
attorney.
(iii)
Expense advances and reimbursements. Sometimes in the regular course of
business an attorney may receive amounts from a client for expenses of
third-party providers or other costs incurred in connection with a legal matter
other than litigation. Such amounts are excluded from the business and
occupation tax only if the attorney has no obligation for payment other than as
agent for the client or equivalent commitment for their payment (see WAC
458-20-111, Advances and
reimbursements). Generally, such amounts will be for third-party service
providers (for example, accountants, appraisers, architects, artists, drafters,
economists, engineers, investigators, physicians, etc.). However, these costs
could also include client expenses for registration, licensing or maintenance
fees, title and other insurance premiums, and escrow fees paid to third-party
escrow agents. These costs are excludable only when the attorney does not have
any personal liability to the third-party provider for their payment.
(iv) Records requirement. In order to support
the exclusion from taxable gross income of any of the foregoing expenses, the
attorney must maintain records which indicate the amount of the payment
received from the client, the name of the client, the name of the person to
whom the attorney has made payment, and a description of the item for which
payment was made. If the foregoing expenses are incurred outside the context of
litigation or contemplated litigation, the attorney must maintain records which
indicate the amount of the payment received, the name of the client, and the
person to whom the attorney makes payment. In addition, the attorney must
provide the person to whom payment is made with written notice that:
(A) Payment is made, or will be made on
behalf of a named client; and
(B)
The attorney assumes no liability for payment, other than as agent for the
named client.
(d) Multiple business activities. Attorneys
and other persons engaged in providing legal, arbitration, and mediation
services sometimes engage in other business activities which are classified
under a different tax classification (i.e., escrow services). In some
circumstances, income from these other business activities will be subject to
tax under a different tax classification.
(i)
Independent business activities. If the other activities engaged in by the
person are independent from the legal, arbitration, or mediation services
provided to the client, these activities are taxed based on the tax
classification that applies to each of those other activities, provided these
other activities are separately accounted for and/or itemized as a separate
amount in billings or invoices to the client. Failure to separately account
and/or itemize for such activities will result in classification of all
activities under the service and other activities classification.
(ii) Combined business activities. If the
other activities are related to the legal, arbitration, or mediation services
provided to the client, the primary activity provided the client in each
taxable period will determine the tax classification. Generally, the activity
will be considered as related when there is some interaction between the two
activities to reach an ultimate goal (i.e., a law firm which provides legal
advice and brokers the financing of a business arrangement). There are a number
of elements which may be examined to determine whether a sufficient
relationship between the multiple activities exist. Some elements considered
are the timing for the selection and provision of services, the relationship
between the contracting parties, the procedure used in the selection process,
the dependence of the relationship between the two or more activities, the
relationship of the prices between the two activities, and the means of payment
selected for the activities.
(iii)
Examples. The following examples identify a number of facts and then state a
conclusion. These examples should be used only as a general guide. The tax
status of each situation must be determined after a review of all of the facts
and circumstances.
(A) A law firm has an
escrow department. This escrow department is run by employees who are not
attorneys (but the supervising employee is a limited practice officer who has
experience as a certified escrow agent), has a separate phone number, separate
bank account, separate trust account, separate computer system, and maintains
its own accounting system. Contracts for the escrow services state that the law
firm is being retained as an independent escrow agent and not to represent any
person involved in the transaction. Further, the contract states that the law
firm shall not offer legal advice upon the transaction. The escrow department
of this law firm would be considered an independent business activity and be
taxed separately under the retailing classification for escrow businesses (see
WAC 458-20-156, Abstract, title
insurance, and escrow business).
(B) A law firm limits its practice to real
estate. It primarily provides escrow services and real estate closings. Even
though this firm has chosen to limit its practice, it is the nature and the
character of its activities which will determine the primary activity for each
closing. When a closing includes the preparation, selection, or drafting of the
deed between the purchaser and seller, drafting legal documents to obtain clear
title, and/or the preparation, selection or drafting of the promissory notes,
deeds of trust, mortgages, and agreements modifying these documents, it will be
presumed that the primary activity performed for the client is providing these
legal services.
(I) The law firm closed a real
estate transaction performing all the escrow services. Except for
the escrow services provided, the firm represented the buyer in the closing.
Although an attorney from the firm reviewed and approved the legal documents
provided by the seller, the attorney did not prepare any legal documents for
the transaction. Since the firm was representing a specific client in this real
estate closing, the escrow services are considered incidental to the legal
services provided. Accordingly, the firm will report the income from this
transaction under the service and other activities classification.
(II) The firm was engaged by both parties in
a real estate transaction to handle a real estate closing. An attorney for the
firm selected and prepared the earnest money escrow agreement, the purchase and
sales agreement, the closing agreement, and the deeds for the transfer. Title
was clear and did not require any additional drafting. The firm also entered
into an escrow agreement with both parties and held in escrow the buyer's
deposit and the seller's deed. Since an attorney for the law firm was required
to select, analyze, and review the legal documents in this transaction, the
escrow activity will be considered incidental. This closing is reported under
the service and other activities classification for legal services.
(III) A certified escrow agency, owned by a
principal qualified under APR 12 (the limited practice rule for limited
practice officers), provides both escrow and the limited legal services allowed
under APR 12 to its clients. The escrow company itemizes the services provided.
APR 12(d) allows a limited practice officer to select, prepare and complete
documents in a form previously approved by the board for use in closing a loan,
extension of credit, sale or other transfer of real or personal property. The
nature of this limited license prevents an escrow company using limited
practice officers from ever engaging in legal services as a primary activity in
a real estate closing. Accordingly, the escrow company will report the income
from escrow and closings under the retail sales classification (see WAC
458-20-156, Abstract, title
insurance, and escrow business).
(IV) The same facts as above, but the escrow
company hires employees who are attorneys to provide the allowable limited
legal services. The result is the same. Under RPC 5.4, an attorney is
prohibited from sharing legal fees with a nonlawyer and, under RPC 5.5, cannot
assist a person who is not a member of the Bar Association in the performance
of an activity that constitutes the unauthorized practice of law, and under RPC
7.1 a lawyer cannot make false or misleading communications about the lawyer or
the lawyer's services. Accordingly, an attorney hired by an escrow company
would not be providing legal services to the escrow companies' clients except
to the extent authorized for a limited practice officer. Since only limited
legal services can be offered, the escrow company would continue to report all
fees from both the escrow and closing services under the retail sales tax
classification.
(4)
Retail sales tax. Sales of
tangible personal property to attorneys for use in rendering professional
services are retail sales upon which the retail sales tax must be collected.
Such sales include, among others, sales of office furniture and equipment,
stationery, office supplies, law books, and reference materials.
(5)
Use tax.
(a) The use tax applies upon the use of
articles purchased or manufactured for use upon which retail sales tax has not
been paid or collected. This includes, but is not limited to, the following:
(i) Materials used and consumed while
rendering legal, arbitration, or mediation services; and
(ii) Office supplies and office equipment
purchased by the firm for its own use.
(b) The use tax also applies to all purchases
of tangible personal property acquired without payment of retail sales tax and
resold to clients but not separately stated from legal services rendered on the
agency's billing.
Statutory Authority:
RCW
82.32.300 and
82.01.060(2).
04-13-091, § 458-20-207, filed 6/18/04, effective 7/19/04. Statutory
Authority:
RCW
82.32.300. 99-13-092, § 458-20-207,
filed 6/14/99, effective 7/15/99. Statutory Authority:
RCW
82.32.300 and
34.05.410. 95-15-013, §
458-20-207, filed 7/7/95, effective 8/7/95. Statutory Authority:
RCW
82.32.300. 85-20-012 (Order ET 85-4), §
458-20-207, filed 9/20/85; Order ET 70-3, § 458-20-207 (Rule 207), filed
5/29/70, effective 7/1/70.