New UBT Rules for Legal Work in NYC

New York City's 2006 Executive Budget, recently passed by the NY State Legislature (S5568/A8434), significantly changes the NYC Unincorporated Business Tax (UBT) rules. Assuming the law is signed by the governor, as expected, law firms working in NYC will need to adjust to changes in three areas:

• Apportionment: Retroactive to Jan. 1, 2005, the preferred method of apportionment changes from the separate-books-and-records method to the three-factor formula apportionment method.
• Sourcing: For law firms with gross receipts of $300,000 or more, receipts from services in taxable years beginning on or after July 1, 2007 will no longer be sourced to the assigned office of the timekeeper; instead the receipts will be sourced based on where the timekeeper actually works.
• Property: For UBT purposes, a law firm's taxable property in NYC will now include both rented real property and rented personal property. The value of such rented property is now codified at eight times the annual rent.

This legislation aims to modernize the UBT and to obtain greater conformity between the UBT and the NYC General Corporation Tax, both substantively and with respect to the Tax Commissioner's discretionary powers. Ironically, the changed UBT apportionment rule is now out of alignment with the corresponding tax rule for NY State. Whether the latter will be revised remains to be seen. It is also too early to tell how the Commissioner will apply his discretionary authority to determine what is fair for the City.

Following are some details of these UBT changes, some thoughts on how they may affect law firms, and our recommendations for how firms should respond.

Formula Apportionment

Now Generally Required

As revised, Section 11-508(b) of the City Tax Law requires that the formulary allocation method be used to allocate income for taxable years beginning after 2004, unless the Tax Commissioner determines that this method does not fairly and equitably reflect the taxpayer's income from the City.

A grandfathering provision allows some taxpayers to continue using the separate-books-and-records method until as late as the 2012 tax year. This provision includes a one-way option to switch to the formula method early. Both election and revocation of the grandfather clause are subject to override if the NYC Tax Commissioner decides the result is unfair to the city. Election of the grandfather clause can also be overridden if a firm experiences a more than 50% ownership change.

Since there is at least a potential option to revoke the grandfather-clause election, a law firm considering use of the clause should project annually whether switching to formula apportionment would reduce or increase its UBT for all taxable years beginning before Jan. 1, 2012.

Service Fee Receipts:

Tracking Actual Work Locations

Formerly, receipts for UBT purposes were simply those receipts attributable to individuals assigned to an NYC office. Section 11-508 of the City Tax Law now requires the sourcing of services to NYC to the extent that those services are actually performed within the city, regardless of the office to which the service provider is assigned.

Based on law firm gross receipts, the new sourcing rule will be phased in for the taxable year starting on or after July 1 of the following years: (We have confirmed with NYC that the term “gross receipts” refers to the total gross receipts of a law firm, not merely the New York gross receipts.)

The new rule may benefit some law firms (although the Tax Commissioner can thwart any excessive saving, by administrative override). Suppose a law firm has a highly profitable office in the City, but a large number of attorneys from that office actually work outside the City. All other factors the same, the firm may benefit from a reduction in its receipts factor and, therefore, its UBT liability.

Moreover, unlike the separate accounting method, formula apportionment starts with the overall profit/loss of the entire firm. Losses in firm offices outside NYC may therefore be usable for reducing UBT liability in NYC.

If a firm does not implement a tracking system that reliably identifies where timekeepers work, however, it is possible that NYC will not allow the firm to change to the formula apportionment method until such time as an acceptable tracking system is in place.

Especially because NY State has increased employee withholding tax audits, the new sourcing rule makes it imperative that firms update their policies and procedures to accurately track and substantiate the location of individuals. Alas, the work of enhanced tracking of individuals will be rewarded with even more work — and some level of risk:

• Tracking and maintaining records of where timekeepers work creates a record that other taxing jurisdictions can use to determine if a firm has sufficient nexus in their jurisdictions to require the filing of tax returns.
• When a law firm starts filing in a jurisdiction where it formerly did not, that jurisdiction may inquire regarding the activity of the law firm in prior years.
• A firm that knows its associates or paralegals are working in another jurisdiction may have a responsibility to withhold taxes in that jurisdiction. If withholding is required, these individuals will have to file tax returns in other jurisdictions to obtain refunds of over-withheld taxes. If the firm does not withhold and is later found negligent by the state, the firm could be subject to taxes and penalties.

Personal Property, Including Rented Tangible Personal Property

Since the new property factor in-cludes personal property, the benefits of a reduced sales factor may be offset to some extent by a possible increase in the property factor.

For the taxable year beginning on or after Jan. 1, 2005, the real and tangible personal property component of the UBT formula will include rented property. The value of such property rented to the unincorporated business is eight times the gross rents payable for the rental of such property during the taxable year.

For those law firms that have embraced leasing extensively (by renting copiers, computers, fax machines, furniture, equipment, etc.), the revised formula could dramatically increase the UBT due.

As described in a March 2005 A&FP article (“Leasehold Improvements: New Window of Opportunity for Tax Savings,” by Joseph A. Bailey and Amy Choquette Smith), a cost segmentation project can properly reclassify some leasehold improvements as personal property. Federal tax savings via that strategy remain feasible, but reclassification will no longer be helpful for UBT reduction. Although such reclassified property is not considered rented, it is taxable under the new rules simply because it is property.

Conclusion

These UBT changes will have administrative and cultural ramifications for law firms that are used to filing returns only where they have offices. Years ago, public accounting firms learned the hard way that compliance with state laws was a necessary expense of doing business. Law firms should be mindful of that lesson as they focus on tracking where work is done and filing state tax returns and withholding as required.

Since this legislation is retroactive to Jan. 1, 2005, tax planning should be begun promptly. In conjunction with having accountants run the numbers, firm management will want to consider the possible advantages of alternative staffing and property rental decisions.

New York City's 2006 Executive Budget, recently passed by the NY State Legislature (S5568/A8434), significantly changes the NYC Unincorporated Business Tax (UBT) rules. Assuming the law is signed by the governor, as expected, law firms working in NYC will need to adjust to changes in three areas:

• Apportionment: Retroactive to Jan. 1, 2005, the preferred method of apportionment changes from the separate-books-and-records method to the three-factor formula apportionment method.
• Sourcing: For law firms with gross receipts of $300,000 or more, receipts from services in taxable years beginning on or after July 1, 2007 will no longer be sourced to the assigned office of the timekeeper; instead the receipts will be sourced based on where the timekeeper actually works.
• Property: For UBT purposes, a law firm's taxable property in NYC will now include both rented real property and rented personal property. The value of such rented property is now codified at eight times the annual rent.

This legislation aims to modernize the UBT and to obtain greater conformity between the UBT and the NYC General Corporation Tax, both substantively and with respect to the Tax Commissioner's discretionary powers. Ironically, the changed UBT apportionment rule is now out of alignment with the corresponding tax rule for NY State. Whether the latter will be revised remains to be seen. It is also too early to tell how the Commissioner will apply his discretionary authority to determine what is fair for the City.

Following are some details of these UBT changes, some thoughts on how they may affect law firms, and our recommendations for how firms should respond.

Formula Apportionment

Now Generally Required

As revised, Section 11-508(b) of the City Tax Law requires that the formulary allocation method be used to allocate income for taxable years beginning after 2004, unless the Tax Commissioner determines that this method does not fairly and equitably reflect the taxpayer's income from the City.

A grandfathering provision allows some taxpayers to continue using the separate-books-and-records method until as late as the 2012 tax year. This provision includes a one-way option to switch to the formula method early. Both election and revocation of the grandfather clause are subject to override if the NYC Tax Commissioner decides the result is unfair to the city. Election of the grandfather clause can also be overridden if a firm experiences a more than 50% ownership change.

Since there is at least a potential option to revoke the grandfather-clause election, a law firm considering use of the clause should project annually whether switching to formula apportionment would reduce or increase its UBT for all taxable years beginning before Jan. 1, 2012.

Service Fee Receipts:

Tracking Actual Work Locations

Formerly, receipts for UBT purposes were simply those receipts attributable to individuals assigned to an NYC office. Section 11-508 of the City Tax Law now requires the sourcing of services to NYC to the extent that those services are actually performed within the city, regardless of the office to which the service provider is assigned.

Based on law firm gross receipts, the new sourcing rule will be phased in for the taxable year starting on or after July 1 of the following years: (We have confirmed with NYC that the term “gross receipts” refers to the total gross receipts of a law firm, not merely the New York gross receipts.)

The new rule may benefit some law firms (although the Tax Commissioner can thwart any excessive saving, by administrative override). Suppose a law firm has a highly profitable office in the City, but a large number of attorneys from that office actually work outside the City. All other factors the same, the firm may benefit from a reduction in its receipts factor and, therefore, its UBT liability.

Moreover, unlike the separate accounting method, formula apportionment starts with the overall profit/loss of the entire firm. Losses in firm offices outside NYC may therefore be usable for reducing UBT liability in NYC.

If a firm does not implement a tracking system that reliably identifies where timekeepers work, however, it is possible that NYC will not allow the firm to change to the formula apportionment method until such time as an acceptable tracking system is in place.

Especially because NY State has increased employee withholding tax audits, the new sourcing rule makes it imperative that firms update their policies and procedures to accurately track and substantiate the location of individuals. Alas, the work of enhanced tracking of individuals will be rewarded with even more work — and some level of risk:

• Tracking and maintaining records of where timekeepers work creates a record that other taxing jurisdictions can use to determine if a firm has sufficient nexus in their jurisdictions to require the filing of tax returns.
• When a law firm starts filing in a jurisdiction where it formerly did not, that jurisdiction may inquire regarding the activity of the law firm in prior years.
• A firm that knows its associates or paralegals are working in another jurisdiction may have a responsibility to withhold taxes in that jurisdiction. If withholding is required, these individuals will have to file tax returns in other jurisdictions to obtain refunds of over-withheld taxes. If the firm does not withhold and is later found negligent by the state, the firm could be subject to taxes and penalties.

Personal Property, Including Rented Tangible Personal Property

Since the new property factor in-cludes personal property, the benefits of a reduced sales factor may be offset to some extent by a possible increase in the property factor.

For the taxable year beginning on or after Jan. 1, 2005, the real and tangible personal property component of the UBT formula will include rented property. The value of such property rented to the unincorporated business is eight times the gross rents payable for the rental of such property during the taxable year.

For those law firms that have embraced leasing extensively (by renting copiers, computers, fax machines, furniture, equipment, etc.), the revised formula could dramatically increase the UBT due.

As described in a March 2005 A&FP article (“Leasehold Improvements: New Window of Opportunity for Tax Savings,” by Joseph A. Bailey and Amy Choquette Smith), a cost segmentation project can properly reclassify some leasehold improvements as personal property. Federal tax savings via that strategy remain feasible, but reclassification will no longer be helpful for UBT reduction. Although such reclassified property is not considered rented, it is taxable under the new rules simply because it is property.

Conclusion

These UBT changes will have administrative and cultural ramifications for law firms that are used to filing returns only where they have offices. Years ago, public accounting firms learned the hard way that compliance with state laws was a necessary expense of doing business. Law firms should be mindful of that lesson as they focus on tracking where work is done and filing state tax returns and withholding as required.

Since this legislation is retroactive to Jan. 1, 2005, tax planning should be begun promptly. In conjunction with having accountants run the numbers, firm management will want to consider the possible advantages of alternative staffing and property rental decisions.