Title of Rule: Amendatory section WAC 458-20-207 Legal, arbitration, and mediation services.

Purpose: To explain the taxability of amounts received for legal, arbitration, and mediation services.

Statutory Authority for Adoption: RCW 82.32.300.

Statute Being Implemented: RCW 82.04.290.

Summary: This rule amendment notes that legal, arbitration, and mediation services are subject to the service and other activities tax classification and tax rate after July 1, 1998. The amendment also deletes some language and examples specific to the previous selected business services tax classification.

Reasons Supporting Proposal: To incorporate the change in law repealing selected business services classification. Sections 2 and 5, chapter 7, Laws of 1997 (EHB 1821).

Name of Agency Personnel Responsible for Drafting: Edward Ratcliffe, 711 Capitol Way South, Suite #303, Olympia, WA, (360) 586-3505; Implementation: Claire Hesselholt, 711 Capitol Way South, Suite #303, Olympia, WA, (360) 753-3446; and Enforcement: Russell Brubaker, 711 Capitol Way South, Suite #303, Olympia, WA (360) 586-0257.

Name of Proponent: Department of Revenue, governmental.

Rule is not necessitated by federal law, federal or state court decision.

Explanation of Rule, its Purpose, and Anticipated Effects: This rule explains the taxability of amounts received for legal, arbitration, and mediation services. This rule amendment updated the rule for the repeal of the selected business tax rate by sections 2 and 5, chapter 7, Laws of 1997 (EHB 1821). The selected business services tax rate was the specific business and occupation (B&O) tax rate for legal, arbitration, and mediation services prior to July 1, 1998. The amended rule notes that legal, arbitration, and mediation services are subject to the service and other activities B&O tax rate and classification on and after July 1, 1998. The amendment also deletes some language and examples specific to the previous selected business services tax rate.

Proposal Changes the Following Existing Rules: This proposed rule amends the current version of WAC 458-20-207. The amendments reflect the repeal of the selected business services classification effective July 1, 1998. The amendment informs the taxpayer that after July 1, 1998, the service and other business classification should by used for reporting legal, mediation, and arbitration services.

March 25, 1999

Claire Hesselholt, Rules Manager

Legislation and Policy Division

OTS-2920.1

AMENDATORY SECTION(Amending WSR 95-15-013, filed 7/7/95, effective 8/7/95)

WAC 458-20-207
Legal, arbitration, and mediation services.

(1) Introduction.  This ((section)) 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) (("Collective investment fund" means:

(i) A mutual fund or other regulated investment company as defined in Internal Revenue Code section 851(a);

(ii) An "investment company" as that term is used in section 3(a) of the Investment Company Act of 1940 as well as an entity that would be an investment company under section 3(a) of the Investment Company Act of 1940 except for the section 3 (c)(1) or (11) exemptions, or except that it is a foreign country;

(iii) An "employee benefit plan," which includes any plan, trust, commingled employee benefit trusts, or custodial arrangement that is subject to the Employee Retirement Income Security Act of 1974, as amended, 29 U.S.C. Sec. 1001 et seq., or that is described in Internal Revenue Code sections 125, 401, 403, 408, 457, or 501 (c)(9) and (17) through (23), or similar plan maintained by state or local governments, or plans, trusts, or custodial arrangements established to self-insure benefits required by federal, state, or local law;

(iv) A fund maintained by a tax exempt organization as defined in Internal Revenue Code sections 501 (c)(3) or 509(a) for operating, quasi-endowment, or endowment purposes; or

(v) Funds that are established for the benefit of such tax exempt organization such as charitable remainder trusts, charitable lead trusts, charitable annuity trusts, or other similar trusts.

(e))) "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.

(((f))) (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. ((Every person whose business is providing legal, arbitration or mediation services, is taxable under the selected business services classification upon the gross income of the business, unless such services are provided to a collective investment fund or related to the identification, investigation, or cleanup arising out of the release or threatened release of hazardous substances when done to determine if a release of hazardous substances has occurred or is likely to occur.)) Beginning July 1, 1998, gross income from legal arbitration or mediation services is subject to the service and other activities classification. (See section 2, chapter 7, Laws of 1997.) Previously, legal, arbitration, and mediation services were taxable under the selected business service tax 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 ((includable)) 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 ((includable)) 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 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) ((Excluded services.  The following legal services are excluded from the selected business services tax classification.

(i) Hazardous waste.  Legal, arbitration, or mediation services related to the identification, investigation, or cleanup arising out of the release or threatened release of hazardous substances when the services are performed to determine if a release of hazardous substances has occurred or is likely to occur are not taxable as selected business services.  Income from these excluded services are taxable under the service and other business activities classification (see WAC 458-20-224).  For example, a legal opinion specifically determining whether and to what extent a client is subject to federal and state law as it concerns hazardous waste identification, investigation, and cleanup would not be taxable as a selected business service.

Also, arbitration or mediation services provided to resolve or negotiate settlement in a case determining the liability for or the release of hazardous substances are examples of excluded services which would not be taxable as selected business services.

(ii) Collective investment funds.  Income derived from legal, arbitration, or mediation services provided to, performed for, on behalf of, or for the benefit of a collective investment fund is excluded from gross income under the selected business services classification.  Income received from these clients is taxable under the service and other business activities classification (see WAC 458-20-224).

(e))) 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((, acting as the trustee for a trust, acting as the personal representative of an estate, etc.))).  In some circumstances, income from these other business activities will be subject to tax under a different tax classification ((other than selected business services)).

(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 ((selected business services)) service and other activities classification.  ((Legal activities specifically excluded from the selected business services tax classification will be treated as an independent business activity taxable under the other services and business activities tax classification, provided the excluded service is separately accounted for and/or itemized as a separate amount in billings or invoices to the client.))

(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).

(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 ((selected business services)) 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 ((selected business services)) 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).

(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.

(((V) An attorney acts as the trustee for a testamentary trust which the attorney drafted.  The attorney maintains the trust records, invests the assets of the trust, reviews distributions, accounts for trust assets, earnings, and distributions to the trust beneficiaries, and files all required returns and forms for the trust.  The trust pays an annual fee for these services.  On occasion, the attorney provides general legal advice to the trust which is billed to the trust at an hourly rate.  After the death of the settlor, the primary activity engaged in by the attorney for this client is that of trustee.  Accordingly, the gross income from the trust administration activities after the death of the settlor are taxed separately under the other service and business activities classification.  The separately accounted for legal services are taxed under the selected business services rate.

(VI) An attorney acts as the trustee for an inter-vivos trust which the attorney drafted.  After being appointed trustee, the attorney continues to represent the settlor of the trust (who is also the primary beneficiary) and provides legal advice to the trust.  The attorney is paid an annual fee for duties as a trustee and an hourly rate for legal services.  The initial relationship between the parties was that of attorney and client.  The attorney continues to actively maintain this relationship and provides legal services to the settlor and the trust.  Accordingly, the primary activity engaged in by the attorney for this client is that of attorney.  The gross income from this activity would be taxed under the selected business services classification.  However, if the inter-vivos trust was an excluded services trust (i.e., a charitable lead trust) any legal services provided the trust would be reported under the other service and business activities 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 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.]

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