In a case that highlights an option available to litigants challenging the constitutionality of invalid tax statutes, the California Court of Appeal recently held that a taxpayer was entitled to attorneys’ fees incurred in the action, despite the fact that the taxpayer itself received a significant refund. Cutler v. Franchise Tax Bd., No. B248270 (Cal. Ct. App., Sept. 2, 2014).

In the underlying lawsuit, Cutler challenged California’s statutory scheme allowing the deferral of certain gains on the sale of qualified small business stock, alleging that the statutory scheme created by sections 18038.5 and 18152.5 of the Revenue and Taxation Code was facially discriminatory and in violation of the commerce clause. In 2012, the Court of Appeal agreed. Rather than issuing refunds to the affected taxpayers, the FTB made the unpopular decision to provide meaningful backward-looking relief by disallowing all exclusions and deferrals made under the invalid statute, resulting in assessments to taxpayers who had benefited from the discriminatory exclusions and deferrals. However, the Legislature eliminated the need for such retroactive tax assessments by enacting Assembly Bill 1412 in 2013.

Notwithstanding the FTB and legislative efforts to deal with the fallout of the Court of Appeal decision that the enacted law was unconstitutional, Cutler filed a motion in superior court for attorneys’ fees under California’s private attorney general statute, section 1021.5 of the Code of Civil Procedure. Cutler alleged that although the Court of Appeal’s decision resulted in a refund of $442,000, his attorneys’ fees were over $685,000. Cutler contended that he vindicated a constitutional right for a large class of California taxpayers who invested in multi-state and out-of-state small businesses and was entitled to reimbursement for his efforts. In response, the FTB argued that the private attorney general statute was not intended to apply to sophisticated investors, and that there was no benefit to California or Californians because the incentive to invest in California small businesses had been eliminated. Further, the FTB alleged that Cutler was sufficiently motivated by his own self-interest in getting a substantial refund, because in addition to the taxes at issue in the instant case, Cutler stood to receive an additional refund of over $1 million for tax years not at issue. Thus, the FTB argued an potential benefit to the public was only incidental to Cutler ’s primary objective of obtaining a refund.

The trial court held in favor of the FTB, stating that Cutler “has significant assets, and was seeking to recover a significant sum of money. The private attorney general attorney fee statute is not required to provide the Plaintiff an incentive to bring this litigation, and any benefit to Plaintiff conferred upon the public is incidental.”

Citing the statutory and judicial requirements, the Court of Appeal explained that an award of attorneys’ fees under the private attorney general statute is proper when: (1) the plaintiffs’ action “has resulted in the enforcement of an important right affecting the public interest,” (2) “a significant benefit, whether pecuniary or nonpecuniary, has been conferred on the general public or a large class of persons,” (3) “the necessity and financial burden of private enforcement are such as to make the award appropriate.” and (4) “such fees should not in the interest of justice be paid out of the recovery, if any.”

With regard to the requirement that the lawsuit confer a significant pecuniary or nonpecuniary benefit on the general public or a large class of persons, the court noted that the statutory language “recognizes that in many cases the important gains or contributions rendered by public interest litigation will be reflected in nonmonetary advances” and that in some cases the “significant benefit” may be recognized “simply from the effectuation of a fundamental constitutional or statutory policy.”

Further, the court explained that “the purpose of section 1021.5 is not to compensate with attorney fees only those litigants who have altruistic or lofty motives, but rather all litigants and attorneys who step forward to engage in public interest litigation when there are insufficient financial incentives to justify the litigation in economic terms.” “An award on the ‘private attorney general’ theory is appropriate when the cost of the claimant’s legal victory transcends his personal interest, that is, when the necessity for pursuing the lawsuit placed a burden on the plaintiff out of proportion to his individual stake in the matter.” Thus, the trial court must not only “fix—or at least estimate—the monetary value of the benefits obtained by the successful litigants themselves,” but also “discount these total benefits by some estimate of the probability of success at the time the vital litigation decisions were made.” In other words, if success would yield the plaintiff a benefit of $10,000, but there is only a one-third chance of ultimate victory, the plaintiff likely would not proceed unless its litigation costs are substantially less than $3,000, and it is this discounted value that must be compared to the litigation costs. “A bounty will be appropriate except where the expected value of the litigant’s own monetary award exceeds by a substantial margin the actual litigation costs.”

Here, there was no dispute that Cutler ’s action resulted in the enforcement of an important right affecting the public interest, and the court found that significant benefits were conferred on a large class of persons because, among other things, the general public benefits by nondiscriminatory tax laws. The court also held that the trial court erred when it determined that the trial court erred by merely observing that Cutler sought a refund of $442,000, and did not consider the fact that the attorneys’ fees exceeded that amount by over $200,000. The trial court also erred by not discounting the $442,000 benefit by the probability of success at the time Cutler undertook the litigation. According to the court, substantial benefits to the general public should not depend on the financial status of the plaintiff or the charity of public-minded lawyers alone.

In addition, the court held that when no “common fund” has been created, like in tax refund cases, and “where it has been established that the financial burden of private enforcement exceeded the plaintiff’s personal stake in the litigation, the trial court does not have the discretion to determine, ‘in the interest of justice,’ that fees nonetheless should be paid from the plaintiff’s own recovery.” Consequently, because Cutler met all of the statutory and judicial requirements for attorneys’ fees under the private attorney general statute, the court remanded the matter for the superior court to determine the amount of fees to be awarded.

Obviously, the Court’s decision marks a significant victory for taxpayers who are often stuck with the Hobson’s choice between paying an invalid tax or shouldering the legal fees to challenge it. The taxing authorities and legislative bodies are fully aware of this predicament and often exploit it to their advantage. As such, its important for taxpayers to seek counsel from attorneys well versed in the nuances of the private attorney general statute when determining their options for challenging questionable statutes, regulations, and/or local ordinances.