Pitfalls of State and Local Taxation

The subject of state and local taxation of a law firm is usually a nonstarter. Most firms file their partnership income tax returns in their domiciliary state and maybe another state or two if they feel they enter the state enough to warrant filing. There are nonresident personal income tax filing requirements that come into play as well. Generally, that's the accepted state and local tax filing approach taken by many firms. Unfortunately, that's not the full spectrum of filings that must be considered in this new age of state and local taxation. This article covers some of the common pitfalls in this ever-evolving and aggressive area of domestic taxation.

Nexus: In General

Generally, a state has jurisdiction to tax an entity organized in another state if the out-of-state entity's contacts with the state are sufficient to create nexus. Nexus is defined as some definite link, some minimum connection, between the state and the corporation it seeks to tax. Nexus embodies the spirit that a state cannot impose a tax on persons doing business or activities that occur outside the state's borders. Various taxes may have differing threshold standards for establishing nexus. These standards are an outgrowth of the U.S. Constitution and judicial decisions that are accepted or modified as a result of legislative activity within any specific state or local taxing jurisdiction.

Historically, states have asserted that virtually any type of in-state business activity creates nexus for an out-of-state entity. The desire of state lawmakers and tax officials to basically export the local tax burden is counterbalanced
by the Due Process Clause and Commerce Clause of the U.S. Constitution, both of which limit a state's ability to impose a tax obligation on an out-of-state corporation.

The Due Process Clause states that no state shall “deprive any person of life, liberty or property, without due process of law.” The U.S. Supreme Court has interpreted this clause as prohibiting a state from taxing an out-of-state corporation unless there is a “minimal connection” between the company's interstate activities and the taxing state.

The Commerce Clause expressly authorizes Congress to “regulate Commerce ' among the several States.” The Supreme Court has interpreted the Commerce Clause as prohibiting states from enacting laws that might unduly burden or otherwise inhibit the free flow of trade among the states. More specifically, with respect to the nexus issue, the Supreme Court has interpreted the Commerce Clause as prohibiting a state from taxing an out-of-state corporation unless that company has a substantial nexus with the state.

In summary, a state cannot impose a tax obligation on an out-of-state corporation unless both the Due Process Clause minimal connection and the Commerce Clause substantial nexus requirements are satisfied. Therefore, the critical issue in the nexus arena is to determine the meaning of minimal connection and substantial nexus.

Income Tax

The landmark case with regard to minimal connection and substantial nexus is Quill v. North Dakota, 504 U.S. 298 (1992). Quill was a mail-order vendor of office supplies that solicited sales through catalogs mailed to potential customers in North Dakota and made deliveries through common carriers. Quill was incorporated in Delaware and had facilities in California, Georgia, and Illinois. Quill had no office, warehouse, retail outlet, or other facility in North Dakota, nor were any Quill employees or representatives physically present in North Dakota at any time during the year at issue. Further, during this same period, Quill made sales to roughly 3,000 North Dakota customers and was the sixth largest office supply vendor in the state.

Under North Dakota law, Quill was required to collect North Dakota sales taxes on its mail-order sales to North Dakota residents. Quill challenged the constitutionality of this tax obligation. The Supreme Court held that Quill's economic presence in North Dakota was sufficient to satisfy the Due Process Clause's “minimal connection” requirement. On the other hand, the Court ruled that an economic presence was not, by itself, sufficient to satisfy the Commerce Clause's “substantial nexus” requirement. Consistent with its ruling 25 years earlier in National Bellas Hess, Inc. v. Department of Revenue, 386 U.S. 753 (1967), the Court held that a substantial nexus exists only if a corporation has a nontrivial physical presence in a state. In other words, the Court ruled that a physical presence is an essential prerequisite to establishing constitutional nexus.

It is imperative to note, however, that Quill is a sales and use tax case, not an income tax case, and that the Supreme Court opinion did not address the issue of whether the physical presence test also applied to income taxes. This ambiguity has resulted in a significant amount of controversy, litigation and uncertainty in the income tax arena.

Each state has its own corporate nexus standards, but the foundation of all of these standards is rooted in Quill and Public Law 86-272, 15 U.S.C. 381,384 (“P.L. 86-272″).

P.L. 86-272 was enacted by Congress in 1959 at the behest of multistate corporations to provide a limited safe harbor from state income taxes. P.L. 86-272 specifically prohibits a state from imposing: 1) a “net income tax” on a corporation organized in another state if the corporation's only in-state activity is, 2) solicitation of orders by company representatives, 3) for sales of tangible personal property, 4) which orders are sent outside the state for approval or rejection, and 5) if approved, are filled by shipment or delivery from a point outside the state, 6) by common carrier. Most state tax authorities will only observe these six strictures in their most literal sense, so that companies that do business in a state that imposes, say, a gross receipts tax or an ad valorem capital tax will deny immunity under P.L. 86-272. (Please note, P.L. 86-272 does not apply to local jurisdictions, so be wary of localities with “income type” taxes like Los Angeles, New York City and Philadelphia, to name a few.)

Even with the statute, ambiguities as to its meaning have been litigated. For example, P.L. 86-272 does not define the phrase “solicitation of orders,” but the meaning of the phrase was addressed by the Supreme Court in Wisconsin Department of Revenue v. William Wrigley, Jr., Co., 505 U.S. 214 (1992). In this case, the Court held that solicitation of orders encompassed “requests for purchases” as well as “those activities that are entirely ancillary to requests for purchases ' those that serve no independent business function apart from their connection to the soliciting of orders.”

Since service activities, like professional practice and consulting, are not protected under P.L. 86-272, most states view any service activity greater than an undefined de minimis amount as sufficient to establish nexus with the state, so that tax nexus is uncertain at best. For most states, the actual number of visits to the state and the other activities of the entity within the state, if any, are important in determining whether income tax nexus exists.

Finally, in general, the nexus standard to impose corporate income tax has become the standard by which many states determine whether partnership tax return filings are required for out-of-state partnerships. Most states simply replicate the income nexus standard for corporations in their statute and regulations to determine whether an out-of-state partnership must file information returns that, in turn, require their partners to pay (or the partnership to withhold) income tax.

So what does all of this mean for your firm?

Simply put, if you are entering any state and performing any level of service in the state you may now have a partnership filing responsibility. Obviously, some attorneys will enter non-domiciliary states on a fairly regular basis so the filing requirement becomes self-evident.

But what if you only enter a state a few times a year? What if you never enter a state, but you do work for an out-of-state client? Can that trigger a filing requirement?

The short answer is: That depends. So, what does it depend on?

Under the first scenario, if you enter a state periodically to perform services, are you required to file a partnership return? First, you need to consider how often you enter the state and whether the state at issue has any de minimis standards that may exempt you from filing. Having said that, most states have veered away from these standards in the hopes of getting more partnerships, and in turn individuals, filing in their state, thereby increasing tax revenues. Therefore, the best thing to do is track how often work is actually performed in a jurisdiction, research the relevant statutes, regulations, cases and rulings in the state, and determine whether the state/local jurisdiction will indeed impose a filing requirement upon you.

That seems reasonable enough, but then how could a firm have a partnership return filing responsibility in a state if it never enters the state? That's a reasonable question, and the answer is revenue, plain and simple. As we all know, states are seeking new revenue sources, and new taxpayers mean increased revenues. Out of dire need, states have created newer and imaginative nexus standards to increase their revenue base. One of the newest and most lethal standards is the “economic nexus” standard. (Please note that there are different types of economic nexus, but we will only discuss those relevant to the taxation of your practice.)

The economic nexus standard at issue is generally financial in nature, and is usually quite diminutive from a dollar perspective, and is therefore easily cleared. Some state taxing authorities now assert that if you have only sales into our state, and the sale amounts exceed a certain threshold, then you have a filing responsibility. This standard, also sometimes referred to as a “factor standard,” requires sales of at least a certain amount, usually ranging between $250,000-$500,000 or more, into the state. Some examples of states with this type of economic nexus standard are California (2011), Oklahoma (2010), Michigan, Ohio and Washington state (June 2010).

Another of these new nexus standards is the “substantial economic presence” standard. This standard generally states that if you have a substantial economic presence in our jurisdiction, then you have a filing requirement. Of course, substantial economic presence is not defined anywhere, so saying that it's arbitrary is quite an understatement. As egregious as the factor standard is, the substantial presence standard is downright criminal. Connecticut adopted this standard in 2010. How far Connecticut will take substantial economic presence is yet to be seen.

These newer and more nebulous standards for nexus can work to result in double- or even triple-taxation, as the following example illustrates: Assume your firm does $500,000 of work for a client in Ohio from your Manhattan offices. You never enter Ohio or any other state in rendering it; all the work is done in Manhattan. Assume, further, that the work is billed from a back office billing and collection center your firm maintains in Connecticut and that your firm has other elements of “substantial economic presence” there, such as bank accounts and, perhaps, some partners who reside there.

In this scenario, it's entirely possible that Ohio might assert “factor standard” nexus and impose tax on the gross receipts your firm is paid from there; Connecticut could assert “substantial economic presence” on the same revenue billed from and received by the Connecticut billing center; and, finally, New York could assert tax on the same net income under the traditional standard of nexus based on where the services were performed. In other words, the same income would be taxed three times by three separate taxing authorities all asserting what they view as a valid “standard” for nexus.

These newer economic nexus standards are in their infancy, and their application and staying power is still up for debate. If you feel you may have some level of economic presence you should consult a state and local practitioner for a more detailed discussion.

There is one last filing requirement that needs to be briefly mentioned that is unique to partnerships. Most states will require a non-domiciliary partnership to file a partnership tax return in the state if it has resident partners, regardless of the fact that it does not conduct any business in the state. Please be sure to check with any relevant jurisdictions regarding these unique filing requirements.

Finally, in addition to the non-domiciliary partnership filing responsibilities, you must examine your personal income tax filings as a nonresident partner of your firm. There are numerous pitfalls in this area. Many states have mandatory withholding and electronic filing requirements. States will often offer you the “opportunity” to file a composite partnership return with them, as well, alleviating your separate personal income tax filing responsibility with the state. However, be wary of composite filings, since the state isn't doing you any favors. As consideration for this filing “convenience,” you will almost always pay at the highest tax rate in the state, and you will not be able to offset income from loss activities against the profits of the partnership filing the composite return, as you would if you filed in the partnership's non-domiciliary state as a non-resident individual. The withholding, composite and electronic filing rules are very confusing and change from year-to-year; so, be sure you look at them every year to ensure that you are in full compliance and are deriving the greatest tax advantage.

Sales Tax

Taxpayers often erroneously assume that P.L. 86-272 affords them some protection from all taxes. However, as we have seen, P.L. 86-272 does not apply to taxes that are measured by gross receipts or sales. Therefore, physical presence, beyond some de minimis level, triggers an obligation to collect sales and use tax.

In recent years, sales and use taxes have been expanded to tax the service sector. Thirty years ago, services made up only a small portion of the economy; however, over time the manufacturing base has shrunk and the service sector has expanded. Most states have responded to this economic change by gradually increasing the services that are subject to tax.

The first services to be taxed were those related to the sale of tangible personal property. The latest trend has been to expand the definition of taxable services to include business services (i.e., data processing) that are completely unrelated to any transfers or sales of tangible personal property. Currently, Connecticut, Hawaii, Iowa, New Mexico and South Dakota impose a sales or excise tax on a broad range of services. Obviously, the nature and extent of the services subject to sales tax varies among the states. Most other states imposing sales taxes apply the tax only to a limited number of enumerated services. Professional services, such as those performed by physicians, accountants and lawyers, typically are not among the specifically enumerated taxable services.

The laws of several states specifically provide that professional services that include the sale or rental of tangible personal property as inconsequential elements for which no separate charge is made are exempt from sales and use taxes. Few state statutes provide any clarification as to what constitutes an inconsequential element. Accordingly, contracts that are intended to be exempt service contracts, but that also include the sale or rental of tangible personal property, may be vulnerable to state and local sales taxes if it is determined that the sale or rental of tangible personal property is more than an inconsequential element of the contract.

So, law firms don't have sales tax issues, correct? Yes and no. Yes, it's true that currently your firm generally won't have to charge sales taxes for your services since they are exempt from the tax, but what about use tax? Use tax is the sister tax to sales tax. It has the same rates and is generally subject to the same rules, but it's quite often overlooked.

Use tax is generally a tax paid for “using” something in a state when no sales taxes have been paid. For example, if your New York firm buys all of its office furniture from North Carolina, and you are not charged sales taxes by the North Carolina seller because you're an out-of-state buyer, you still owe a use tax to New York. Oftentimes, use taxes will accrue over years, if not decades, and it can be quite costly if the tax hasn't been paid or no sales tax return has been filed.

Generally, professional service firms don't file sales tax returns. I have never agreed with that approach. If you haven't filed sales tax returns, then you should seriously consider it. However, be sure to analyze your back year use tax responsibility first.

The reason you file the sales/use tax returns is to start the running of the statute of limitations. Even if you file an annual zero return (no sales tax due), the statute will continue to run and the state can only audit you for the period of years allowed under the respective jurisdiction's law.

Therefore, if you haven't been filing a sales tax return in the state where your office is located, you should take a look and see if you have purchased any goods or services that were subject to tax on which no tax was paid. If this is the case, you should contact a tax professional and see about correcting the problem. One very important note of caution is warranted, however. It is never, ever, a good idea to start registering for taxes or start filing tax returns (partnership, sales, etc.) without first analyzing your back year liabilities, and developing and executing a game plan to cure those exposures. If you just file a return or register on a whim, all of the back years will be open to scrutiny, and it could become quite costly.

A little planning and foresight go a long way in alleviating unnecessary state and local tax headaches and pitfalls in your practice, which allows you to run your business and keep the tax man at bay.

John W. Sullivan III, Esq. is a Principal and the Director of State and Local Tax at Friedman LLP, Accountants and Advisors, based in New York City. A high-level tax director and consultant in public accounting and private industry for more than 13 years, Sullivan specializes in helping companies manage the complexities of state and local income, sales and use and excise taxation. Web site: www.friedmanllp.com. He can be reached at [email protected] or 212-842-7575.

The subject of state and local taxation of a law firm is usually a nonstarter. Most firms file their partnership income tax returns in their domiciliary state and maybe another state or two if they feel they enter the state enough to warrant filing. There are nonresident personal income tax filing requirements that come into play as well. Generally, that's the accepted state and local tax filing approach taken by many firms. Unfortunately, that's not the full spectrum of filings that must be considered in this new age of state and local taxation. This article covers some of the common pitfalls in this ever-evolving and aggressive area of domestic taxation.

Nexus: In General

Generally, a state has jurisdiction to tax an entity organized in another state if the out-of-state entity's contacts with the state are sufficient to create nexus. Nexus is defined as some definite link, some minimum connection, between the state and the corporation it seeks to tax. Nexus embodies the spirit that a state cannot impose a tax on persons doing business or activities that occur outside the state's borders. Various taxes may have differing threshold standards for establishing nexus. These standards are an outgrowth of the U.S. Constitution and judicial decisions that are accepted or modified as a result of legislative activity within any specific state or local taxing jurisdiction.

Historically, states have asserted that virtually any type of in-state business activity creates nexus for an out-of-state entity. The desire of state lawmakers and tax officials to basically export the local tax burden is counterbalanced
by the Due Process Clause and Commerce Clause of the U.S. Constitution, both of which limit a state's ability to impose a tax obligation on an out-of-state corporation.

The Due Process Clause states that no state shall “deprive any person of life, liberty or property, without due process of law.” The U.S. Supreme Court has interpreted this clause as prohibiting a state from taxing an out-of-state corporation unless there is a “minimal connection” between the company's interstate activities and the taxing state.

The Commerce Clause expressly authorizes Congress to “regulate Commerce ' among the several States.” The Supreme Court has interpreted the Commerce Clause as prohibiting states from enacting laws that might unduly burden or otherwise inhibit the free flow of trade among the states. More specifically, with respect to the nexus issue, the Supreme Court has interpreted the Commerce Clause as prohibiting a state from taxing an out-of-state corporation unless that company has a substantial nexus with the state.

In summary, a state cannot impose a tax obligation on an out-of-state corporation unless both the Due Process Clause minimal connection and the Commerce Clause substantial nexus requirements are satisfied. Therefore, the critical issue in the nexus arena is to determine the meaning of minimal connection and substantial nexus.

Income Tax

The landmark case with regard to minimal connection and substantial nexus is Quill v. North Dakota , 504 U.S. 298 (1992). Quill was a mail-order vendor of office supplies that solicited sales through catalogs mailed to potential customers in North Dakota and made deliveries through common carriers. Quill was incorporated in Delaware and had facilities in California, Georgia, and Illinois. Quill had no office, warehouse, retail outlet, or other facility in North Dakota, nor were any Quill employees or representatives physically present in North Dakota at any time during the year at issue. Further, during this same period, Quill made sales to roughly 3,000 North Dakota customers and was the sixth largest office supply vendor in the state.

Under North Dakota law, Quill was required to collect North Dakota sales taxes on its mail-order sales to North Dakota residents. Quill challenged the constitutionality of this tax obligation. The Supreme Court held that Quill's economic presence in North Dakota was sufficient to satisfy the Due Process Clause's “minimal connection” requirement. On the other hand, the Court ruled that an economic presence was not, by itself, sufficient to satisfy the Commerce Clause's “substantial nexus” requirement. Consistent with its ruling 25 years earlier in National Bellas Hess, Inc. v. Department of Revenue , 386 U.S. 753 (1967), the Court held that a substantial nexus exists only if a corporation has a nontrivial physical presence in a state. In other words, the Court ruled that a physical presence is an essential prerequisite to establishing constitutional nexus.

It is imperative to note, however, that Quill is a sales and use tax case, not an income tax case, and that the Supreme Court opinion did not address the issue of whether the physical presence test also applied to income taxes. This ambiguity has resulted in a significant amount of controversy, litigation and uncertainty in the income tax arena.

Each state has its own corporate nexus standards, but the foundation of all of these standards is rooted in Quill and Public Law 86-272, 15 U.S.C. 381,384 (“P.L. 86-272″).

P.L. 86-272 was enacted by Congress in 1959 at the behest of multistate corporations to provide a limited safe harbor from state income taxes. P.L. 86-272 specifically prohibits a state from imposing: 1) a “net income tax” on a corporation organized in another state if the corporation's only in-state activity is, 2) solicitation of orders by company representatives, 3) for sales of tangible personal property, 4) which orders are sent outside the state for approval or rejection, and 5) if approved, are filled by shipment or delivery from a point outside the state, 6) by common carrier. Most state tax authorities will only observe these six strictures in their most literal sense, so that companies that do business in a state that imposes, say, a gross receipts tax or an ad valorem capital tax will deny immunity under P.L. 86-272. (Please note, P.L. 86-272 does not apply to local jurisdictions, so be wary of localities with “income type” taxes like Los Angeles, New York City and Philadelphia, to name a few.)

Even with the statute, ambiguities as to its meaning have been litigated. For example, P.L. 86-272 does not define the phrase “solicitation of orders,” but the meaning of the phrase was addressed by the Supreme Court in Wisconsin Department of Revenue v. William Wrigley, Jr., Co., 505 U.S. 214 (1992). In this case, the Court held that solicitation of orders encompassed “requests for purchases” as well as “those activities that are entirely ancillary to requests for purchases ' those that serve no independent business function apart from their connection to the soliciting of orders.”

Since service activities, like professional practice and consulting, are not protected under P.L. 86-272, most states view any service activity greater than an undefined de minimis amount as sufficient to establish nexus with the state, so that tax nexus is uncertain at best. For most states, the actual number of visits to the state and the other activities of the entity within the state, if any, are important in determining whether income tax nexus exists.

Finally, in general, the nexus standard to impose corporate income tax has become the standard by which many states determine whether partnership tax return filings are required for out-of-state partnerships. Most states simply replicate the income nexus standard for corporations in their statute and regulations to determine whether an out-of-state partnership must file information returns that, in turn, require their partners to pay (or the partnership to withhold) income tax.

So what does all of this mean for your firm?

Simply put, if you are entering any state and performing any level of service in the state you may now have a partnership filing responsibility. Obviously, some attorneys will enter non-domiciliary states on a fairly regular basis so the filing requirement becomes self-evident.

But what if you only enter a state a few times a year? What if you never enter a state, but you do work for an out-of-state client? Can that trigger a filing requirement?

The short answer is: That depends. So, what does it depend on?

Under the first scenario, if you enter a state periodically to perform services, are you required to file a partnership return? First, you need to consider how often you enter the state and whether the state at issue has any de minimis standards that may exempt you from filing. Having said that, most states have veered away from these standards in the hopes of getting more partnerships, and in turn individuals, filing in their state, thereby increasing tax revenues. Therefore, the best thing to do is track how often work is actually performed in a jurisdiction, research the relevant statutes, regulations, cases and rulings in the state, and determine whether the state/local jurisdiction will indeed impose a filing requirement upon you.

That seems reasonable enough, but then how could a firm have a partnership return filing responsibility in a state if it never enters the state? That's a reasonable question, and the answer is revenue, plain and simple. As we all know, states are seeking new revenue sources, and new taxpayers mean increased revenues. Out of dire need, states have created newer and imaginative nexus standards to increase their revenue base. One of the newest and most lethal standards is the “economic nexus” standard. (Please note that there are different types of economic nexus, but we will only discuss those relevant to the taxation of your practice.)

The economic nexus standard at issue is generally financial in nature, and is usually quite diminutive from a dollar perspective, and is therefore easily cleared. Some state taxing authorities now assert that if you have only sales into our state, and the sale amounts exceed a certain threshold, then you have a filing responsibility. This standard, also sometimes referred to as a “factor standard,” requires sales of at least a certain amount, usually ranging between $250,000-$500,000 or more, into the state. Some examples of states with this type of economic nexus standard are California (2011), Oklahoma (2010), Michigan, Ohio and Washington state (June 2010).

Another of these new nexus standards is the “substantial economic presence” standard. This standard generally states that if you have a substantial economic presence in our jurisdiction, then you have a filing requirement. Of course, substantial economic presence is not defined anywhere, so saying that it's arbitrary is quite an understatement. As egregious as the factor standard is, the substantial presence standard is downright criminal. Connecticut adopted this standard in 2010. How far Connecticut will take substantial economic presence is yet to be seen.

These newer and more nebulous standards for nexus can work to result in double- or even triple-taxation, as the following example illustrates: Assume your firm does $500,000 of work for a client in Ohio from your Manhattan offices. You never enter Ohio or any other state in rendering it; all the work is done in Manhattan. Assume, further, that the work is billed from a back office billing and collection center your firm maintains in Connecticut and that your firm has other elements of “substantial economic presence” there, such as bank accounts and, perhaps, some partners who reside there.

In this scenario, it's entirely possible that Ohio might assert “factor standard” nexus and impose tax on the gross receipts your firm is paid from there; Connecticut could assert “substantial economic presence” on the same revenue billed from and received by the Connecticut billing center; and, finally, New York could assert tax on the same net income under the traditional standard of nexus based on where the services were performed. In other words, the same income would be taxed three times by three separate taxing authorities all asserting what they view as a valid “standard” for nexus.

These newer economic nexus standards are in their infancy, and their application and staying power is still up for debate. If you feel you may have some level of economic presence you should consult a state and local practitioner for a more detailed discussion.

There is one last filing requirement that needs to be briefly mentioned that is unique to partnerships. Most states will require a non-domiciliary partnership to file a partnership tax return in the state if it has resident partners, regardless of the fact that it does not conduct any business in the state. Please be sure to check with any relevant jurisdictions regarding these unique filing requirements.

Finally, in addition to the non-domiciliary partnership filing responsibilities, you must examine your personal income tax filings as a nonresident partner of your firm. There are numerous pitfalls in this area. Many states have mandatory withholding and electronic filing requirements. States will often offer you the “opportunity” to file a composite partnership return with them, as well, alleviating your separate personal income tax filing responsibility with the state. However, be wary of composite filings, since the state isn't doing you any favors. As consideration for this filing “convenience,” you will almost always pay at the highest tax rate in the state, and you will not be able to offset income from loss activities against the profits of the partnership filing the composite return, as you would if you filed in the partnership's non-domiciliary state as a non-resident individual. The withholding, composite and electronic filing rules are very confusing and change from year-to-year; so, be sure you look at them every year to ensure that you are in full compliance and are deriving the greatest tax advantage.

Sales Tax

Taxpayers often erroneously assume that P.L. 86-272 affords them some protection from all taxes. However, as we have seen, P.L. 86-272 does not apply to taxes that are measured by gross receipts or sales. Therefore, physical presence, beyond some de minimis level, triggers an obligation to collect sales and use tax.

In recent years, sales and use taxes have been expanded to tax the service sector. Thirty years ago, services made up only a small portion of the economy; however, over time the manufacturing base has shrunk and the service sector has expanded. Most states have responded to this economic change by gradually increasing the services that are subject to tax.

The first services to be taxed were those related to the sale of tangible personal property. The latest trend has been to expand the definition of taxable services to include business services (i.e., data processing) that are completely unrelated to any transfers or sales of tangible personal property. Currently, Connecticut, Hawaii, Iowa, New Mexico and South Dakota impose a sales or excise tax on a broad range of services. Obviously, the nature and extent of the services subject to sales tax varies among the states. Most other states imposing sales taxes apply the tax only to a limited number of enumerated services. Professional services, such as those performed by physicians, accountants and lawyers, typically are not among the specifically enumerated taxable services.

The laws of several states specifically provide that professional services that include the sale or rental of tangible personal property as inconsequential elements for which no separate charge is made are exempt from sales and use taxes. Few state statutes provide any clarification as to what constitutes an inconsequential element. Accordingly, contracts that are intended to be exempt service contracts, but that also include the sale or rental of tangible personal property, may be vulnerable to state and local sales taxes if it is determined that the sale or rental of tangible personal property is more than an inconsequential element of the contract.

So, law firms don't have sales tax issues, correct? Yes and no. Yes, it's true that currently your firm generally won't have to charge sales taxes for your services since they are exempt from the tax, but what about use tax? Use tax is the sister tax to sales tax. It has the same rates and is generally subject to the same rules, but it's quite often overlooked.

Use tax is generally a tax paid for “using” something in a state when no sales taxes have been paid. For example, if your New York firm buys all of its office furniture from North Carolina, and you are not charged sales taxes by the North Carolina seller because you're an out-of-state buyer, you still owe a use tax to New York. Oftentimes, use taxes will accrue over years, if not decades, and it can be quite costly if the tax hasn't been paid or no sales tax return has been filed.

Generally, professional service firms don't file sales tax returns. I have never agreed with that approach. If you haven't filed sales tax returns, then you should seriously consider it. However, be sure to analyze your back year use tax responsibility first.

The reason you file the sales/use tax returns is to start the running of the statute of limitations. Even if you file an annual zero return (no sales tax due), the statute will continue to run and the state can only audit you for the period of years allowed under the respective jurisdiction's law.

Therefore, if you haven't been filing a sales tax return in the state where your office is located, you should take a look and see if you have purchased any goods or services that were subject to tax on which no tax was paid. If this is the case, you should contact a tax professional and see about correcting the problem. One very important note of caution is warranted, however. It is never, ever, a good idea to start registering for taxes or start filing tax returns (partnership, sales, etc.) without first analyzing your back year liabilities, and developing and executing a game plan to cure those exposures. If you just file a return or register on a whim, all of the back years will be open to scrutiny, and it could become quite costly.

A little planning and foresight go a long way in alleviating unnecessary state and local tax headaches and pitfalls in your practice, which allows you to run your business and keep the tax man at bay.

John W. Sullivan III, Esq. is a Principal and the Director of State and Local Tax at Friedman LLP, Accountants and Advisors, based in New York City. A high-level tax director and consultant in public accounting and private industry for more than 13 years, Sullivan specializes in helping companies manage the complexities of state and local income, sales and use and excise taxation. Web site: www.friedmanllp.com. He can be reached at [email protected] or 212-842-7575.