Law Firms: Economic Nexus May Be Heading Your Way

Perhaps your partners and associates never set foot in an economic nexus state, a state in which your firm is deriving income, so economic nexus may seem like a minor tax concern. But now it's time to check the horizon ' economic nexus statutes are sweeping across the nation. Connecticut, New Jersey, and Massachusetts already have established them, along with more than 30 other states. These statutes throw physical presence in a state as the basis for economic nexus right out the window. Instead, they generally look at whether you're getting income from the state or have a substantial economic presence there by “directing business activities” toward the state. And the law remains nebulous about what exactly directing business activities means. The consequence for law firms is that your firm may be required to file a tax return in a state which no firm member or employee has even been in.

A Chicken Story That's No Joke

Hope for getting clarity at the federal level was recently dashed. On Oct. 3, 2011, the U.S. Supreme Court denied certiorari for KFC Corporation v. Iowa Department of Revenue (KFC Corp. v. Iowa Dept. of Revenue, 792 N.W.2d 308 (2010)) ' allowing the Iowa Department of Revenue's tax assessment against KFC to stand. In KFC, the Iowa Supreme Court held that even though KFC has no tangible physical presence within the state, it did receive revenue from the use of intangible property within the state via franchisees using the KFC name. Accordingly, the court held that KFC was subject to the state's corporate income tax.

While the practice of law is a long way from selling chicken, the U.S. Supreme Court's refusal to even ruffle its feathers in this case speaks volumes to both law firms and their clients. Meanwhile, the Iowa Supreme Court stated that its ” ' function is to determine, to the best of our ability, how the United States Supreme Court would decide this case under its case law and established Dormant Commerce Clause doctrine.” While this may be true, at least as it applies to Iowa taxpayers, the U.S. Supreme Court's refusal to hear KFC not only begs Congressional action, but also emboldens the states to continue on the path of economic nexus.

The Iowa Supreme Court in its holding stated ” ' that a physical presence is not required under the Dormant Commerce Clause of the United States Constitution in order for the Iowa legislature to impose an income tax on revenue earned by an out-of-state corporation arising from the use of its intangibles by franchisees located within the State of Iowa. We hold that, by licensing franchises within Iowa, KFC has received the benefit of an orderly society within the state and, as a result, is subject to the payment of income taxes that otherwise meet the requirements of the Dormant Commerce Clause.”

As designated custodians of an “orderly society,” lawyers should be concerned for themselves and for their clients.

Gauging the Impact

In light of the KFC decision and the likelihood that more states will jump on the economic nexus bandwagon, let's get a sense of the potential impact on a law firm. Consider Connecticut where the current law provides a bright-line test to establish economic nexus. If a business has $500,000 or more in receipts that can be attributed to Connecticut sources, then the state will be looking for a tax return. Arguably, the state could hold that if a law firm has receipts from Connecticut clients, even though none of the work was performed there, these amounts would satisfy the nexus threshold and require that the firm file a return. This is addressed in the very first example on the Connecticut Department of Revenue Services' Q&A on Economic Nexus:

Midwest Bank is an out-of-state banking corporation with no office or employees in Connecticut and is not otherwise subject to Connecticut income taxation. Midwest Bank engages in active solicitation of Connecticut residents. Moreover, Midwest Bank had significant receipts attributable to Connecticut customers. Midwest Bank has economic nexus with Connecticut.

From this example it isn't difficult to make the leap to a law firm with no employees in Connecticut, engaging in active solicitation of Connecticut residents. Exactly what “active solicitation” means is far from clear, but remember that bright-line test conveniently provided by the state.

First, Some Good News '

If a firm can produce records demonstrating that the work was not performed in Connecticut, at least you're relieved of the burden of sifting through files to show where the firm is deriving income, and there would be little or no Connecticut tax liability.

While there are different sourcing rules for individuals and corporations ' which are outside the focus of this article ' Connecticut's preferred method for partnerships and similar entities is to report income from Connecticut sources using the separate books and records method. So, if a separate set of books and records accurately reflects the income, gain, loss, or deduction derived from Connecticut sources, report this amount to Connecticut.

If the books and records method doesn't accurately reflect these figures, the state resorts to the standard three-factor formula consisting of property, payroll, and gross income from sales and services. Clearly, if no office or employees are located in Connecticut, both the payroll and property factors will be zero. Even better, the state's somewhat archaic methodology for receipts sources them to Connecticut if the charges were made by employees sent out from offices located in Connecticut. So if you don't have a Connecticut office, your receipts factor will also be zero. Bottom line: While Connecticut might deem the partnership to have economic nexus, the partnership may have little or no tax liability.

' Nevertheless

While the Connecticut story may end on a positive note, it is important to recognize that allocation and apportionment rules vary widely from state to state ' even within a state by type of entity. A more common, and sensible, approach to apportioning receipts from services looks to where the services are performed, and a complete discussion of the various methods would roll on for many pages. Regardless of the method used, it is clear that the growing focus on economic nexus calls for:

• a good time and billing system capable of producing detailed records;
• location tracking of where personnel are performing services;
• being prepared with the required information ' which will go a long way toward quickly ending a state income tax audit.

Keeping Your Clients Alert

As advisers to clients, it is crucial to keep them aware of the ever-evolving economic nexus climate. While certainty may not prevail, clients must at the very least be watchful for any exposure that they might have so they can make educated decisions. In certain cases, economic nexus may not create significant additional state tax liability, but might simply shift the overall burden among different states. This is especially true in situations where the client is a flow through entity and the majority of partners already reside in high-tax-rate jurisdictions. While this may increase compliance requirements, it's important that clients know the risks of not filing and the potential for an audit. Unfortunately, in many circumstances, filings would substantially increase the overall tax burden, so a more careful analysis of the nexus requirements is warranted before making any decision.

For law firms and their clients, the situation remains fluid as different states have different standards for what constitutes a substantial economic presence. The best defense is to keep accurate records, be prepared to answer questions, and keep alert as economic nexus continues to play out.

Wayne Berkowitz, CPA, J.D., LL.M., is a partner and leader of the State and Local Tax Group of CPA and Advisory firm Berdon LLP with offices in New York City and Jericho, Long Island. He advises law firms and other businesses across a spectrum of industries and professions on the unique tax regulations of states and municipalities throughout the nation. Berkowitz can be reached at 212-331-7465 or [email protected]. ' 2011 Berdon LLP

Perhaps your partners and associates never set foot in an economic nexus state, a state in which your firm is deriving income, so economic nexus may seem like a minor tax concern. But now it's time to check the horizon ' economic nexus statutes are sweeping across the nation. Connecticut, New Jersey, and Massachusetts already have established them, along with more than 30 other states. These statutes throw physical presence in a state as the basis for economic nexus right out the window. Instead, they generally look at whether you're getting income from the state or have a substantial economic presence there by “directing business activities” toward the state. And the law remains nebulous about what exactly directing business activities means. The consequence for law firms is that your firm may be required to file a tax return in a state which no firm member or employee has even been in.

A Chicken Story That's No Joke

Hope for getting clarity at the federal level was recently dashed. On Oct. 3, 2011, the U.S. Supreme Court denied certiorari for KFC Corporation v. Iowa Department of Revenue ( KFC Corp. v. Iowa Dept. of Revenue , 792 N.W.2d 308 (2010)) ' allowing the Iowa Department of Revenue's tax assessment against KFC to stand. In KFC, the Iowa Supreme Court held that even though KFC has no tangible physical presence within the state, it did receive revenue from the use of intangible property within the state via franchisees using the KFC name. Accordingly, the court held that KFC was subject to the state's corporate income tax.

While the practice of law is a long way from selling chicken, the U.S. Supreme Court's refusal to even ruffle its feathers in this case speaks volumes to both law firms and their clients. Meanwhile, the Iowa Supreme Court stated that its ” ' function is to determine, to the best of our ability, how the United States Supreme Court would decide this case under its case law and established Dormant Commerce Clause doctrine.” While this may be true, at least as it applies to Iowa taxpayers, the U.S. Supreme Court's refusal to hear KFC not only begs Congressional action, but also emboldens the states to continue on the path of economic nexus.

The Iowa Supreme Court in its holding stated ” ' that a physical presence is not required under the Dormant Commerce Clause of the United States Constitution in order for the Iowa legislature to impose an income tax on revenue earned by an out-of-state corporation arising from the use of its intangibles by franchisees located within the State of Iowa. We hold that, by licensing franchises within Iowa, KFC has received the benefit of an orderly society within the state and, as a result, is subject to the payment of income taxes that otherwise meet the requirements of the Dormant Commerce Clause.”

As designated custodians of an “orderly society,” lawyers should be concerned for themselves and for their clients.

Gauging the Impact

In light of the KFC decision and the likelihood that more states will jump on the economic nexus bandwagon, let's get a sense of the potential impact on a law firm. Consider Connecticut where the current law provides a bright-line test to establish economic nexus. If a business has $500,000 or more in receipts that can be attributed to Connecticut sources, then the state will be looking for a tax return. Arguably, the state could hold that if a law firm has receipts from Connecticut clients, even though none of the work was performed there, these amounts would satisfy the nexus threshold and require that the firm file a return. This is addressed in the very first example on the Connecticut Department of Revenue Services' Q&A on Economic Nexus:

Midwest Bank is an out-of-state banking corporation with no office or employees in Connecticut and is not otherwise subject to Connecticut income taxation. Midwest Bank engages in active solicitation of Connecticut residents. Moreover, Midwest Bank had significant receipts attributable to Connecticut customers. Midwest Bank has economic nexus with Connecticut.

From this example it isn't difficult to make the leap to a law firm with no employees in Connecticut, engaging in active solicitation of Connecticut residents. Exactly what “active solicitation” means is far from clear, but remember that bright-line test conveniently provided by the state.

First, Some Good News '

If a firm can produce records demonstrating that the work was not performed in Connecticut, at least you're relieved of the burden of sifting through files to show where the firm is deriving income, and there would be little or no Connecticut tax liability.

While there are different sourcing rules for individuals and corporations ' which are outside the focus of this article ' Connecticut's preferred method for partnerships and similar entities is to report income from Connecticut sources using the separate books and records method. So, if a separate set of books and records accurately reflects the income, gain, loss, or deduction derived from Connecticut sources, report this amount to Connecticut.

If the books and records method doesn't accurately reflect these figures, the state resorts to the standard three-factor formula consisting of property, payroll, and gross income from sales and services. Clearly, if no office or employees are located in Connecticut, both the payroll and property factors will be zero. Even better, the state's somewhat archaic methodology for receipts sources them to Connecticut if the charges were made by employees sent out from offices located in Connecticut. So if you don't have a Connecticut office, your receipts factor will also be zero. Bottom line: While Connecticut might deem the partnership to have economic nexus, the partnership may have little or no tax liability.

' Nevertheless

While the Connecticut story may end on a positive note, it is important to recognize that allocation and apportionment rules vary widely from state to state ' even within a state by type of entity. A more common, and sensible, approach to apportioning receipts from services looks to where the services are performed, and a complete discussion of the various methods would roll on for many pages. Regardless of the method used, it is clear that the growing focus on economic nexus calls for:

• a good time and billing system capable of producing detailed records;
• location tracking of where personnel are performing services;
• being prepared with the required information ' which will go a long way toward quickly ending a state income tax audit.

Keeping Your Clients Alert

As advisers to clients, it is crucial to keep them aware of the ever-evolving economic nexus climate. While certainty may not prevail, clients must at the very least be watchful for any exposure that they might have so they can make educated decisions. In certain cases, economic nexus may not create significant additional state tax liability, but might simply shift the overall burden among different states. This is especially true in situations where the client is a flow through entity and the majority of partners already reside in high-tax-rate jurisdictions. While this may increase compliance requirements, it's important that clients know the risks of not filing and the potential for an audit. Unfortunately, in many circumstances, filings would substantially increase the overall tax burden, so a more careful analysis of the nexus requirements is warranted before making any decision.

For law firms and their clients, the situation remains fluid as different states have different standards for what constitutes a substantial economic presence. The best defense is to keep accurate records, be prepared to answer questions, and keep alert as economic nexus continues to play out.

Wayne Berkowitz, CPA, J.D., LL.M., is a partner and leader of the State and Local Tax Group of CPA and Advisory firm Berdon LLP with offices in New York City and Jericho, Long Island. He advises law firms and other businesses across a spectrum of industries and professions on the unique tax regulations of states and municipalities throughout the nation. Berkowitz can be reached at 212-331-7465 or [email protected]. ' 2011 Berdon LLP