Why Does It Hurt When I Pay?

States subject individuals to tax in one of two ways: either as a resident, which allows the state to tax the individual's worldwide income; or as a nonresident, where the state taxes income sourced to the state. Our concern relates to the latter. For a law firm practicing in multiple jurisdictions, both resident and nonresident partners are subject to multiple taxing regimes. The issue, despite its complexities and an extensive history of litigation, simply comes down to whether a partner is truly a partner.

The partner distinction is crucial for the sole reason that employees are only subject to a state's taxing regime in a jurisdiction where they actually perform services. In contrast, partners are generally subject to tax wherever the partnership operates. In today's business climate, it is becoming more and more difficult to make this distinction. For various reasons, firms are more reluctant to make “full partners” and have established one or more levels in between that of the most senior employee and a full partner. Despite the limitations placed on the relationship between these ' let's call them “junior partners” ' and the firm, having the prestige of being a partner is helpful to both the junior partners and the firm. And let's face it; clients and prospects prefer to deal with a “partner.”

So how far can a firm carry this “junior partner” concept and not be drawn into a tax trap? In my opinion, not very far, if at all. In making this statement, I respect the fact that attorneys may want to be aggressive about this and are often successful. However, I am also mindful that firms need to take a practical approach to tax administration. It simply isn't financially healthy to get embroiled in tax litigation, especially where others before you have tried and failed.

There have been a few successful cases, notably a 1999 decision of the California State Board of Equalization (“CSBE”) [See Appeal of Frederiksen, California State Board of Equalization, Decision 98A-0162, Jan. 7, 1999.] In that matter, a “special partner,” working solely out of the Dallas office of a national law firm, was held not to have California source income, despite the fact that the firm did have significant revenue from California sources. Accordingly, he was not required to file a nonresident tax return in California. Despite receiving a K-1, which identified him as a limited partner, and reporting his earnings as guaranteed payment, the CSBE held that he was not a partner for tax purposes. The Board was persuaded by the fact that he wasn't required to contribute to capital, had no rights to share in the profits and wouldn't sustain any losses of the firm, and found his relationship was more like that of an employee. This was a bit of good news for those “junior partners” who reside and practice in no or low-income states, and are with firms with significant California source income.

The Bad News

Now for the bad news. Virtually every other jurisdiction follows the creed that a partner is a partner and will be taxed accordingly. New York has been the most active jurisdiction in this area and recently reaffirmed this position in a Tax Appeals Tribunal decision. [See Petition of Robert and Frances Tosti, NYS Division of Tax Appeals, DTA No. 822915 (2010).] In that matter, an attorney who owned a law firm and practiced exclusively in New Jersey was approached by a large law firm with offices in multiple jurisdictions, including New York, seeking to establish a relationship.

The attorney's relationship with the large firm was memorialized in a letter that stated he would be a “non-equity or limited partner as opposed to a general or capital partner.” It further stated he wouldn't be responsible for any of the firm's liabilities and would have no right, title, interest, or claim in any of the firm's assets. The attorney did not have an interest in the firm's profits, and his compensation was established by the firm's executive committee. He had no management role other than to make recommendations regarding the firm's associates, who would be assigned to him as needed. He received a K-1 reporting his earnings, and no taxes were withheld by the firm.

The Tribunal framed the issue to be decided as whether the attorney should be treated as a “glorified associate” or as a partner of the firm. After analyzing past precedents, the Tribunal held that he was in fact a partner for tax purposes and was properly subject to New York personal income taxes on his share of the firm's income allocated to New York. In the words of the Tribunal, “[h]aving chosen to become a partner ' petitioner must bear the consequences.”

While one could argue that the Tribunal's decision was incorrect and didn't recognize the needs and realities of the modern law firm [See "When Is a Partner a Partner For New York Tax Purposes," Peter L. Faber, State Tax Notes, Aug. 9, 2010], the New York precedents support this decision. The current rule in New York and most jurisdictions appears to be if you call yourself a partner and you get a K-1, you are a partner.

Lawyers have a long history of successfully butting heads with the states on their own behalf. The road is a long one, however, and as firm administrator your role is to help the firm adhere to the law as it stands and keep the firm from being placed in a compromised position in the first place.

Wayne K. Berkowitz, CPA, J.D., LL.M., is a member of this newsletter's Board of Editors and a partner and head 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]. ' 2012 Berdon LLP.

Are all those new partners lining up at your door wondering why they went from having to file personal income tax returns in one state to a multitude of 15, 20, or maybe more? As a firm administrator, you reassure them; don't worry, this won't hurt a bit. Just sign this composite return election and the firm will file a return on your behalf. You tell them that since they live in such a high-tax jurisdiction (more on that later), they will be getting virtually a full credit toward their home state's taxes. Moreover, after you take out all of the other state taxes from their distributions for the year, it really shouldn't end up costing them much more ' or does it?

At times like this you should be thankful if your firm is based in a high-tax-rate state like New York, California, or Massachusetts. Partners in these states are already accustomed to paying high income taxes, and they should be paying more than enough home state taxes to offset the expense of all these other state tax obligations. But what about the partners from your offices in Florida, Texas, Nevada, South Dakota, and other states where there is no personal income tax? They have no resident state tax to credit against the other state tax obligations, so any out-of-state tax translates to an out-of-pocket expense to them. Too often, these partners were not aware of other state tax obligations before they signed their partnership agreements, so you may have a lot of explaining to do. The following information may help.

The Partner Distinction

States subject individuals to tax in one of two ways: either as a resident, which allows the state to tax the individual's worldwide income; or as a nonresident, where the state taxes income sourced to the state. Our concern relates to the latter. For a law firm practicing in multiple jurisdictions, both resident and nonresident partners are subject to multiple taxing regimes. The issue, despite its complexities and an extensive history of litigation, simply comes down to whether a partner is truly a partner.

The partner distinction is crucial for the sole reason that employees are only subject to a state's taxing regime in a jurisdiction where they actually perform services. In contrast, partners are generally subject to tax wherever the partnership operates. In today's business climate, it is becoming more and more difficult to make this distinction. For various reasons, firms are more reluctant to make “full partners” and have established one or more levels in between that of the most senior employee and a full partner. Despite the limitations placed on the relationship between these ' let's call them “junior partners” ' and the firm, having the prestige of being a partner is helpful to both the junior partners and the firm. And let's face it; clients and prospects prefer to deal with a “partner.”

So how far can a firm carry this “junior partner” concept and not be drawn into a tax trap? In my opinion, not very far, if at all. In making this statement, I respect the fact that attorneys may want to be aggressive about this and are often successful. However, I am also mindful that firms need to take a practical approach to tax administration. It simply isn't financially healthy to get embroiled in tax litigation, especially where others before you have tried and failed.

There have been a few successful cases, notably a 1999 decision of the California State Board of Equalization (“CSBE”) [See Appeal of Frederiksen, California State Board of Equalization, Decision 98A-0162, Jan. 7, 1999.] In that matter, a “special partner,” working solely out of the Dallas office of a national law firm, was held not to have California source income, despite the fact that the firm did have significant revenue from California sources. Accordingly, he was not required to file a nonresident tax return in California. Despite receiving a K-1, which identified him as a limited partner, and reporting his earnings as guaranteed payment, the CSBE held that he was not a partner for tax purposes. The Board was persuaded by the fact that he wasn't required to contribute to capital, had no rights to share in the profits and wouldn't sustain any losses of the firm, and found his relationship was more like that of an employee. This was a bit of good news for those “junior partners” who reside and practice in no or low-income states, and are with firms with significant California source income.

The Bad News

Now for the bad news. Virtually every other jurisdiction follows the creed that a partner is a partner and will be taxed accordingly. New York has been the most active jurisdiction in this area and recently reaffirmed this position in a Tax Appeals Tribunal decision. [See Petition of Robert and Frances Tosti, NYS Division of Tax Appeals, DTA No. 822915 (2010).] In that matter, an attorney who owned a law firm and practiced exclusively in New Jersey was approached by a large law firm with offices in multiple jurisdictions, including New York, seeking to establish a relationship.

The attorney's relationship with the large firm was memorialized in a letter that stated he would be a “non-equity or limited partner as opposed to a general or capital partner.” It further stated he wouldn't be responsible for any of the firm's liabilities and would have no right, title, interest, or claim in any of the firm's assets. The attorney did not have an interest in the firm's profits, and his compensation was established by the firm's executive committee. He had no management role other than to make recommendations regarding the firm's associates, who would be assigned to him as needed. He received a K-1 reporting his earnings, and no taxes were withheld by the firm.

The Tribunal framed the issue to be decided as whether the attorney should be treated as a “glorified associate” or as a partner of the firm. After analyzing past precedents, the Tribunal held that he was in fact a partner for tax purposes and was properly subject to New York personal income taxes on his share of the firm's income allocated to New York. In the words of the Tribunal, “[h]aving chosen to become a partner ' petitioner must bear the consequences.”

While one could argue that the Tribunal's decision was incorrect and didn't recognize the needs and realities of the modern law firm [See "When Is a Partner a Partner For New York Tax Purposes," Peter L. Faber, State Tax Notes, Aug. 9, 2010], the New York precedents support this decision. The current rule in New York and most jurisdictions appears to be if you call yourself a partner and you get a K-1, you are a partner.

Lawyers have a long history of successfully butting heads with the states on their own behalf. The road is a long one, however, and as firm administrator your role is to help the firm adhere to the law as it stands and keep the firm from being placed in a compromised position in the first place.

Wayne K. Berkowitz, CPA, J.D., LL.M., is a member of this newsletter's Board of Editors and a partner and head 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]. ' 2012 Berdon LLP.