PC Partners Face NY Tax Challenge: Will Other States Follow?

Last year, we informed LFPBR readers of the rediscovery by some partners in multi-state partnerships of the benefits of becoming a professional corporation ('PC') partner in their law firms, primarily to obtain state income tax savings. See, Banoff, 'To PC or Not to PC: The Rise and Fall and Rise (Again) of Professional Corporation Partners in Law Firms,' LFPBR, Vol. 12, No. 9 (Oct. 2006), p. 1. We observed that some firms have accommodated (and in some cases encouraged) some of their partners to consider the incorporation alternative. As discussed below, New York recently enacted legislation that would potentially adversely affect that strategy, including those who incorporated long before the legislation was passed, and it is unclear whether other states may follow.

Anecdotal evidence indicates a rebirth in recent years in the use of PCs for partners of profitable multi-state law partnerships, to provide aggregate (multi-state) income tax savings for some or many of the firms' highly paid partners. The PC structure is particularly useful for highly profitable law firm partnerships, limited liability partnerships ('LLPs'), and limited liability companies ('LLCs') ' taxable as partnerships that have a substantial amount of their income attributable to offices in states having high income tax rates applicable to individual partners.

In a typical favorable scenario, the firm will have at least one office located in a zero or low individual income tax rate state (e.g., Florida, Texas, or Illinois) and at least one other office in a relatively high tax bracket state (e.g., California or New York). Due to long-established rules on apportionment of a partnership's income for state income tax purposes, those partners who physically reside and practice primarily in the zero or low tax rate state nonetheless are subject to a substantial out-of-state tax liability. If a substantial portion of the firm's income is allocable to high-rate states, the problem is magnified.

The individual partners in the low tax rate states are penalized by having to pay income taxes on a substantial amount of out-of-state income taxed at high rates, and receiving only a zero or low out-of-state tax credit against their residence state's income tax liability. For example, Illinois only provides a 3% tax credit for an individual's out-of-state taxes, even if Illinois partners pay taxes at rates exceeding 9% elsewhere on their out-of-state apportioned income. Texas and Florida resident partners (who pay no home-state income taxes) face the highest tax differential on partnership income allocated to high tax rate states. (Unfortunately, the multi-state tax rules provide no offsetting income tax benefit for the law firm's other partners working or residing in high tax rate states.)

A PC structure may mitigate this multi-state tax problem for those partners residing and practicing in low or zero tax rate states. If the low tax rate state individual partner transfers his or her partnership interest to a wholly owned PC, and the corporation annually pays W-2 salary, payroll taxes, and other expenses approximately equal to the PC's net income (before compensation), then his or her compensation presumably would be deemed to be earned and received in the state in which the partner provides services (i.e., the low tax rate state). As a result, the PC (which itself would remain subject to multi-state income allocation on its net income, if any) would largely protect the attorney-shareholder from being subject to taxation in the high tax rate state.

A cost/benefit analysis is appropriate for individual partners considering incorporation. Is the state income tax savings generated by use of the PC-partner format worth the effort? Calculation of the potential tax savings is not easy and requires annual, intricate computations as to the individual's federal, state, and local tax liability, prognosticating the firm's ever-changing allocation or apportionment of its income among the various jurisdictions in which it conducts business, and several other factors. As discussed in the October 2006 LFPBR article, a number of tax and non-tax factors must be considered in making the analysis, and the choice of form of entity for lawyers is deceptively complex.

Moreover, the administrative planning and ongoing strategic and operative questions (and hassles) that arise from a partner's operating in PC form should not be understated. Many partners who have operated in PC form for a number of years can attest to the problems of doing it right. Also, the firm itself faces numerous burdens and costs, which may substantially reduce the computed tax savings, and it is recognized that the audit of one aggressive PC partner (with adjustments resulting in his or his PC owing taxes and interest) might lead to audits of the firm's other PCs (including those taking more conservative tax reporting positions) and possibly an audit of the law firm partnership itself. Even if no tax adjustments arise from such audits, the cost and hassle arising from responding to IRS and state tax agencies' information requests (and possibly mounting an audit defense) might not be worth the aggravation. Nonetheless, when the savings for individual, highly paid (and important) partners may substantially exceed $10,000 per year, it is easier for them to downplay the potential negatives of forming and operating as a PC, and the potentially formidable tax costs of the ultimate liquidation of the PC. Adopting PC status has been described as a lobster trap. See, Banoff, Shop Talk, 'Are Personal Service Corporations Back in Style?', Journal of Taxation, Vol. 105, p. 62 (July 2006).

Time Has Told

In our October 2006 LFPBR article, we asked whether high-tax states will ultimately recognize the validity of the PCs, which (this time around) are providing primarily state tax benefits (rather than pension law benefits or a personal limited liability shield). If not, then the upside of the planning will not be achieved, but the downsides may continue to exist (particularly if the PC's creation, existence, and liquidation are all given effect for federal income tax purposes!). We stated that only time will tell.

Well, time has told ' at least in New York, which has struck back with legislation that empowers the state's tax authorities to undo the desired tax benefits in New York. Moreover, it is possible that similar legislation will be enacted in one or more other states, which in turn may have unanticipated tax consequences for those law firm partners who chose the incorporation route.

As states increasingly search for sources of revenues, one could predict that the tax-favored use of PCs would come under scrutiny and, ultimately, attack. On April 9, 2007, New York Governor Eliot Spitzer signed legislation that gives the state taxing authorities the power to make adjustments to the income of PCs and their employee-owners to prevent evasion of New York taxes. Added to the New York Tax Law (Chapter 60 of the Laws of 2007) is a new '632-a, 'Personal Service Corporations and S-corporations Formed or Availed of to Avoid or Evade New York State Income Tax.' In relevant part, '632-a provides that if: 1) substantially all of the services of a PC are performed for or on behalf of another corporation, partnership, or other entity, and 2) the effect of performing or availing of such PC is the avoidance or evasion of New York income tax by reducing the income of, or, in the case of a non-resident, reducing the New York source of, or securing the benefit of any expense, deduction, credit, exclusion, or other allowance for, any employee-owner which otherwise would not be available, then the New York Commissioner of Taxation may allocate all income, deductions, credits, exclusions, and other allowances between such PC and its employee-owners, provided such allocation is necessary to prevent avoidance or evasion of New York income tax or to clearly reflect the source and the amount of the income of the PC or any of its employee-owners. The provision is effective for taxable years beginning on or after Jan. 1, 2007. The New York State Department of Taxation and Finance, Office of Tax Policy Analysis, 'Summary of Tax Provisions in SFY 2007-2008 Budget,' (April 2007), p. 3, refers to this legislation as a 'partnership tax abuse remedy' that authorizes the Tax Commissioner 'to disregard personal service or S-corporations formed or availed of primarily to avoid or evade New York State income tax.' (Reference to the use of PCs as a 'tax abuse' is questionable, even considering the source.)

A number of issues are raised by new '632-a, and in the few months since its enactment, the New York Commissioner of Taxation has not provided any further guidance. Moreover, '632-a is not a self-operating provision. Rather, it requires a reallocation of income to cause New York source income to be attributed to the owner-employee (a New York non-resident). A description of the amendment is found in the Governor's Memorandum in Support of the Proposed Bill, which states the provision is designed to prevent non-residents from availing themselves of the loophole of forming a corporation to avoid personal income taxation by having his or her partnership distribution paid to the corporation which in turn creates an expense when it pays a salary to the individual shareholder. In contrast, a non-resident individual generally working outside New York would normally be taxed on his or her partnership distributions apportioned to New York.

The new New York law may have a chilling effect on individual service providers who are considering incorporation of their interests. A number of questions arise as to the application and scope of the new law. (For a more detailed technical analysis, see, Banoff, Shop Talk, 'Do Personal Service Corps. Generate State Tax Savings? The Empire State Strikes Back,' Journal of Taxation, Vol. 106, p. 59 (July 2007).) The state tax consequences (should New York assert jurisdiction and make adjustments with respect to source income of a non-resident PC partner) are by no means clear.

What Should Incorporated Partners Do?

What should incorporated partners do with respect to the New York
legislation? As is evident, '632-a is not self-executing. It merely gives the Commissioner of Taxation the right to reallocate income and other tax attributes from a PC to its employee-owner, if this is necessary to prevent avoidance or evasion of New York tax. Can a non-resident owner-employee of a PC that is a partner in a services firm having a New York office in good faith not file in New York if he or she performs no such services for the PC in New York? If there were an audit (which more likely would occur at the partnership level), however, the Commissioner well might reallocate income from the corporation to the individual to increase New York's tax revenues.

Fearing this result, might it be better to liquidate the PC, either in anticipation of or because of New York source recharacterization efforts? Such may not be easy to implement without costs and risks. The tax costs of liquidation of the PC (once one has entered corporate format) may cause adverse federal and state income tax results. It is not easy to form PCs for state tax savings purposes and then bail out without any consequences.

If an incorporated PC partner concludes that the New York tax savings are not worth the potential audit hassles and headaches, can the employee-owner use 'self-help' to report the income as New York source income in 2007, even prior to the New York Commissioner's audit and/or determination that the proportionate share of the individual employee's income should be sourced to New York? The New York statute does not so provide, although it stands to reason that the New York taxing authority is unlikely to challenge the reallocation, if it results in greater revenues.

Conclusion

Those considering forming PCs primarily for state tax savings purposes should take into consideration the New York statute ' and the possibility that other states might follow suit. Those non-resident attorneys who already operate as PC partners should seek counsel as to what reporting position they should take in New York (and other high tax rate states), for 2007 and beyond.

Sheldon I. Banoff, P.C. is a partner in the Chicago office of Katten Muchin Rosenman LLP. His expertise includes general tax and partnership matters, and counseling professional firms. He can be reached at 312-902-5256 or [email protected].

Last year, we informed LFPBR readers of the rediscovery by some partners in multi-state partnerships of the benefits of becoming a professional corporation ('PC') partner in their law firms, primarily to obtain state income tax savings. See, Banoff, 'To PC or Not to PC: The Rise and Fall and Rise (Again) of Professional Corporation Partners in Law Firms,' LFPBR, Vol. 12, No. 9 (Oct. 2006), p. 1. We observed that some firms have accommodated (and in some cases encouraged) some of their partners to consider the incorporation alternative. As discussed below, New York recently enacted legislation that would potentially adversely affect that strategy, including those who incorporated long before the legislation was passed, and it is unclear whether other states may follow.

Anecdotal evidence indicates a rebirth in recent years in the use of PCs for partners of profitable multi-state law partnerships, to provide aggregate (multi-state) income tax savings for some or many of the firms' highly paid partners. The PC structure is particularly useful for highly profitable law firm partnerships, limited liability partnerships ('LLPs'), and limited liability companies ('LLCs') ' taxable as partnerships that have a substantial amount of their income attributable to offices in states having high income tax rates applicable to individual partners.

In a typical favorable scenario, the firm will have at least one office located in a zero or low individual income tax rate state (e.g., Florida, Texas, or Illinois) and at least one other office in a relatively high tax bracket state (e.g., California or New York). Due to long-established rules on apportionment of a partnership's income for state income tax purposes, those partners who physically reside and practice primarily in the zero or low tax rate state nonetheless are subject to a substantial out-of-state tax liability. If a substantial portion of the firm's income is allocable to high-rate states, the problem is magnified.

The individual partners in the low tax rate states are penalized by having to pay income taxes on a substantial amount of out-of-state income taxed at high rates, and receiving only a zero or low out-of-state tax credit against their residence state's income tax liability. For example, Illinois only provides a 3% tax credit for an individual's out-of-state taxes, even if Illinois partners pay taxes at rates exceeding 9% elsewhere on their out-of-state apportioned income. Texas and Florida resident partners (who pay no home-state income taxes) face the highest tax differential on partnership income allocated to high tax rate states. (Unfortunately, the multi-state tax rules provide no offsetting income tax benefit for the law firm's other partners working or residing in high tax rate states.)

A PC structure may mitigate this multi-state tax problem for those partners residing and practicing in low or zero tax rate states. If the low tax rate state individual partner transfers his or her partnership interest to a wholly owned PC, and the corporation annually pays W-2 salary, payroll taxes, and other expenses approximately equal to the PC's net income (before compensation), then his or her compensation presumably would be deemed to be earned and received in the state in which the partner provides services (i.e., the low tax rate state). As a result, the PC (which itself would remain subject to multi-state income allocation on its net income, if any) would largely protect the attorney-shareholder from being subject to taxation in the high tax rate state.

A cost/benefit analysis is appropriate for individual partners considering incorporation. Is the state income tax savings generated by use of the PC-partner format worth the effort? Calculation of the potential tax savings is not easy and requires annual, intricate computations as to the individual's federal, state, and local tax liability, prognosticating the firm's ever-changing allocation or apportionment of its income among the various jurisdictions in which it conducts business, and several other factors. As discussed in the October 2006 LFPBR article, a number of tax and non-tax factors must be considered in making the analysis, and the choice of form of entity for lawyers is deceptively complex.

Moreover, the administrative planning and ongoing strategic and operative questions (and hassles) that arise from a partner's operating in PC form should not be understated. Many partners who have operated in PC form for a number of years can attest to the problems of doing it right. Also, the firm itself faces numerous burdens and costs, which may substantially reduce the computed tax savings, and it is recognized that the audit of one aggressive PC partner (with adjustments resulting in his or his PC owing taxes and interest) might lead to audits of the firm's other PCs (including those taking more conservative tax reporting positions) and possibly an audit of the law firm partnership itself. Even if no tax adjustments arise from such audits, the cost and hassle arising from responding to IRS and state tax agencies' information requests (and possibly mounting an audit defense) might not be worth the aggravation. Nonetheless, when the savings for individual, highly paid (and important) partners may substantially exceed $10,000 per year, it is easier for them to downplay the potential negatives of forming and operating as a PC, and the potentially formidable tax costs of the ultimate liquidation of the PC. Adopting PC status has been described as a lobster trap. See, Banoff, Shop Talk, 'Are Personal Service Corporations Back in Style?', Journal of Taxation, Vol. 105, p. 62 (July 2006).

Time Has Told

In our October 2006 LFPBR article, we asked whether high-tax states will ultimately recognize the validity of the PCs, which (this time around) are providing primarily state tax benefits (rather than pension law benefits or a personal limited liability shield). If not, then the upside of the planning will not be achieved, but the downsides may continue to exist (particularly if the PC's creation, existence, and liquidation are all given effect for federal income tax purposes!). We stated that only time will tell.

Well, time has told ' at least in New York, which has struck back with legislation that empowers the state's tax authorities to undo the desired tax benefits in New York. Moreover, it is possible that similar legislation will be enacted in one or more other states, which in turn may have unanticipated tax consequences for those law firm partners who chose the incorporation route.

As states increasingly search for sources of revenues, one could predict that the tax-favored use of PCs would come under scrutiny and, ultimately, attack. On April 9, 2007, New York Governor Eliot Spitzer signed legislation that gives the state taxing authorities the power to make adjustments to the income of PCs and their employee-owners to prevent evasion of New York taxes. Added to the New York Tax Law (Chapter 60 of the Laws of 2007) is a new '632-a, 'Personal Service Corporations and S-corporations Formed or Availed of to Avoid or Evade New York State Income Tax.' In relevant part, '632-a provides that if: 1) substantially all of the services of a PC are performed for or on behalf of another corporation, partnership, or other entity, and 2) the effect of performing or availing of such PC is the avoidance or evasion of New York income tax by reducing the income of, or, in the case of a non-resident, reducing the New York source of, or securing the benefit of any expense, deduction, credit, exclusion, or other allowance for, any employee-owner which otherwise would not be available, then the New York Commissioner of Taxation may allocate all income, deductions, credits, exclusions, and other allowances between such PC and its employee-owners, provided such allocation is necessary to prevent avoidance or evasion of New York income tax or to clearly reflect the source and the amount of the income of the PC or any of its employee-owners. The provision is effective for taxable years beginning on or after Jan. 1, 2007. The New York State Department of Taxation and Finance, Office of Tax Policy Analysis, 'Summary of Tax Provisions in SFY 2007-2008 Budget,' (April 2007), p. 3, refers to this legislation as a 'partnership tax abuse remedy' that authorizes the Tax Commissioner 'to disregard personal service or S-corporations formed or availed of primarily to avoid or evade New York State income tax.' (Reference to the use of PCs as a 'tax abuse' is questionable, even considering the source.)

A number of issues are raised by new '632-a, and in the few months since its enactment, the New York Commissioner of Taxation has not provided any further guidance. Moreover, '632-a is not a self-operating provision. Rather, it requires a reallocation of income to cause New York source income to be attributed to the owner-employee (a New York non-resident). A description of the amendment is found in the Governor's Memorandum in Support of the Proposed Bill, which states the provision is designed to prevent non-residents from availing themselves of the loophole of forming a corporation to avoid personal income taxation by having his or her partnership distribution paid to the corporation which in turn creates an expense when it pays a salary to the individual shareholder. In contrast, a non-resident individual generally working outside New York would normally be taxed on his or her partnership distributions apportioned to New York.

The new New York law may have a chilling effect on individual service providers who are considering incorporation of their interests. A number of questions arise as to the application and scope of the new law. (For a more detailed technical analysis, see, Banoff, Shop Talk, 'Do Personal Service Corps. Generate State Tax Savings? The Empire State Strikes Back,' Journal of Taxation, Vol. 106, p. 59 (July 2007).) The state tax consequences (should New York assert jurisdiction and make adjustments with respect to source income of a non-resident PC partner) are by no means clear.

What Should Incorporated Partners Do?

What should incorporated partners do with respect to the New York
legislation? As is evident, '632-a is not self-executing. It merely gives the Commissioner of Taxation the right to reallocate income and other tax attributes from a PC to its employee-owner, if this is necessary to prevent avoidance or evasion of New York tax. Can a non-resident owner-employee of a PC that is a partner in a services firm having a New York office in good faith not file in New York if he or she performs no such services for the PC in New York? If there were an audit (which more likely would occur at the partnership level), however, the Commissioner well might reallocate income from the corporation to the individual to increase New York's tax revenues.

Fearing this result, might it be better to liquidate the PC, either in anticipation of or because of New York source recharacterization efforts? Such may not be easy to implement without costs and risks. The tax costs of liquidation of the PC (once one has entered corporate format) may cause adverse federal and state income tax results. It is not easy to form PCs for state tax savings purposes and then bail out without any consequences.

If an incorporated PC partner concludes that the New York tax savings are not worth the potential audit hassles and headaches, can the employee-owner use 'self-help' to report the income as New York source income in 2007, even prior to the New York Commissioner's audit and/or determination that the proportionate share of the individual employee's income should be sourced to New York? The New York statute does not so provide, although it stands to reason that the New York taxing authority is unlikely to challenge the reallocation, if it results in greater revenues.

Conclusion

Those considering forming PCs primarily for state tax savings purposes should take into consideration the New York statute ' and the possibility that other states might follow suit. Those non-resident attorneys who already operate as PC partners should seek counsel as to what reporting position they should take in New York (and other high tax rate states), for 2007 and beyond.

Sheldon I. Banoff, P.C. is a partner in the Chicago office of Katten Muchin Rosenman LLP. His expertise includes general tax and partnership matters, and counseling professional firms. He can be reached at 312-902-5256 or [email protected].