Complications Can Consume the Credit for Taxes Paid to Other States

As I discussed in my previous article “Why Does It Hurt When I Pay?” published in the May 2012 issue of this newsletter, law firm partners are in most cases going to have to file returns in every state in which the firm is doing business. The tax impact will generally be mitigated to some degree through the resident tax credit, and the compliance impact can often be reduced by using composite or group filings made by the firm on behalf of the partners.

A situation that arises time and time again begins when a firm partner, CFO, or firm administrator gets a phone call from a business specializing in state tax credits alerting them to some attractive credits that the firm is missing out on. Further, the firm is informed that obtaining these credits won't cost anything except a percentage of any of the credits actually received. This percentage is usually one-third of the credit received. So the credit business gets permission from the firm to not only prepare the necessary documentation for the current tax year credit, but to also go back to previously filed years for which the statute of limitations for refund claims is still open.

The offer sounds good. What could possibly be the downside? Imagine how pleased the firm's senior partner will be upon learning about the tax refunds that will stream in for the past three years at no out-of-pocket cost. Often, the downside is not readily apparent; it can best be demonstrated with this simple example.

All That Glitters '

Our hypothetical law firm has offices in New York, New Jersey, Massachusetts and California. Most of the partners reside in one of these four states, but a few are residents of Connecticut.

Currently, each partner is required to file a resident return in his home state ' picking up 100% of his share of earnings from the law firm. The partner is also required to file a nonresident tax return, at the very least, in the states in which the law firm has an office. Picking up a pro rata share of income sourced to the nonresident state, the partner pays a share of nonresident tax. The partner then takes a credit on the resident state return for some or all of the nonresident taxes.

To everyone's surprise, the firm's California office is located in an Enterprise Zone. The firm decides to go ahead and have the credit business file refund claims in the Golden State so that the firm can take advantage of the California Enterprise Zone Credit. The credit business dutifully applies for a credit and obtains for the firm a large refund claim as well as a substantial current-year tax credit. With pleasure, the law firm writes the credit business a check for $333,333.33, one third of the $1 million in credits received, and everyone goes their separate ways in satisfaction.

Ah, But '

The law firm, of course, allocates the refund to the partners in the same proportion as their allocations of income in the current and prior years for which the refunds were received. And, quite correctly, the firm allocates the $333,333.33 fee paid to the credit business accordingly. Cheerfully, “Joe Partner” calls his personal accountant to tell him the great news, but is only met with a long pause. Joe's accountant is thinking over how he is going to break some unpleasant news to Joe.

You see, Joe is a New York state resident ' and he could just as easily be a resident of any state that has a personal income tax. Joe had dutifully filed his resident tax return and took a credit for taxes he paid to California. Now that Joe received a refund of some of the taxes he paid, he is required to file amended tax returns with New York reducing the amount of the credit he took for taxes paid to other states.

This could mean that for every dollar of California tax that was credited to Joe, he would need to pay an additional dollar of New York tax and interest. Joe also needs to pay his share of the fee to the credit business. So, what appeared initially to be a delightful benefit to Joe could end up costing him dearly.

The California partners may or may not end up in a better place than Joe. They will receive a dollar for dollar reduction for their portion of the credit. However, what if the amount of the credit exceeds the amount of California tax paid? The good news, at least with the California Enterprise Zone Credit, is that any unused credit may be carried forward indefinitely. So the California partners may end up with a real savings.

Take the Knowledgeable Path Forward

This sad, but all-too-common, tale is in no way designed to discourage anyone from seeking a tax credit that they are entitled to. However, those responsible for making decisions for the law firm need to be aware of any potential costs, especially where previous tax years are involved. In this very simplified scenario, even if the California credits were applied for on a timely basis, the non-California partners would likely not save any tax. This means that the firm administrator must gauge whether, as a whole, the credits are going to result in a net gain to all of the firm's partners.

Firms need to be particularly cautious and alert when the credit is one that will flow to the partners' personal income tax returns and there are a large number of partners who are nonresidents of the state where the credit is being received. Typically, there is less need for concern if a large number of partners are residents of the credit state. While, outright enthusiasm can flow if a large number or majority of partners reside in a state where there is no personal income tax.

At root, it is a number-crunching exercise, but one that is essential in advance of a decision to apply for a credit. Be aware that in cases where the credit is affecting an entity level tax on the firm itself, it will generally result in a true savings to the firm. Moreover, many jurisdictions also provide similar types of incentives against sales and use tax; again, a true savings to the firm.

To paraphrase another great sage, Forrest Gump: Tax credits are “like a box of chocolates.” Just make sure you pick ones with the sweet, rewarding, cream-filled centers.

Wayne K. Berkowitz, CPA, J.D., LL.M., is 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. He can be reached at 212-331-7465 or [email protected]. ' 2013 Berdon LLP.

The old adage, “Tax loopholes are like parking spaces. As soon as you get there, they aren't there,” has been credited to many sage “tax advisers” ' such as Milton Berle and Joey Adams. That same bit of wisdom can be applied to tax credits. While an available tax credit might seem like a great savings opportunity, as many often are, caution should be your watchword before chasing that credit.

A Shiny Opportunity

Let's look at a typical law firm with offices in multiple states.

As I discussed in my previous article “Why Does It Hurt When I Pay?” published in the May 2012 issue of this newsletter, law firm partners are in most cases going to have to file returns in every state in which the firm is doing business. The tax impact will generally be mitigated to some degree through the resident tax credit, and the compliance impact can often be reduced by using composite or group filings made by the firm on behalf of the partners.

A situation that arises time and time again begins when a firm partner, CFO, or firm administrator gets a phone call from a business specializing in state tax credits alerting them to some attractive credits that the firm is missing out on. Further, the firm is informed that obtaining these credits won't cost anything except a percentage of any of the credits actually received. This percentage is usually one-third of the credit received. So the credit business gets permission from the firm to not only prepare the necessary documentation for the current tax year credit, but to also go back to previously filed years for which the statute of limitations for refund claims is still open.

The offer sounds good. What could possibly be the downside? Imagine how pleased the firm's senior partner will be upon learning about the tax refunds that will stream in for the past three years at no out-of-pocket cost. Often, the downside is not readily apparent; it can best be demonstrated with this simple example.

All That Glitters '

Our hypothetical law firm has offices in New York, New Jersey, Massachusetts and California. Most of the partners reside in one of these four states, but a few are residents of Connecticut.

Currently, each partner is required to file a resident return in his home state ' picking up 100% of his share of earnings from the law firm. The partner is also required to file a nonresident tax return, at the very least, in the states in which the law firm has an office. Picking up a pro rata share of income sourced to the nonresident state, the partner pays a share of nonresident tax. The partner then takes a credit on the resident state return for some or all of the nonresident taxes.

To everyone's surprise, the firm's California office is located in an Enterprise Zone. The firm decides to go ahead and have the credit business file refund claims in the Golden State so that the firm can take advantage of the California Enterprise Zone Credit. The credit business dutifully applies for a credit and obtains for the firm a large refund claim as well as a substantial current-year tax credit. With pleasure, the law firm writes the credit business a check for $333,333.33, one third of the $1 million in credits received, and everyone goes their separate ways in satisfaction.

Ah, But '

The law firm, of course, allocates the refund to the partners in the same proportion as their allocations of income in the current and prior years for which the refunds were received. And, quite correctly, the firm allocates the $333,333.33 fee paid to the credit business accordingly. Cheerfully, “Joe Partner” calls his personal accountant to tell him the great news, but is only met with a long pause. Joe's accountant is thinking over how he is going to break some unpleasant news to Joe.

You see, Joe is a New York state resident ' and he could just as easily be a resident of any state that has a personal income tax. Joe had dutifully filed his resident tax return and took a credit for taxes he paid to California. Now that Joe received a refund of some of the taxes he paid, he is required to file amended tax returns with New York reducing the amount of the credit he took for taxes paid to other states.

This could mean that for every dollar of California tax that was credited to Joe, he would need to pay an additional dollar of New York tax and interest. Joe also needs to pay his share of the fee to the credit business. So, what appeared initially to be a delightful benefit to Joe could end up costing him dearly.

The California partners may or may not end up in a better place than Joe. They will receive a dollar for dollar reduction for their portion of the credit. However, what if the amount of the credit exceeds the amount of California tax paid? The good news, at least with the California Enterprise Zone Credit, is that any unused credit may be carried forward indefinitely. So the California partners may end up with a real savings.

Take the Knowledgeable Path Forward

This sad, but all-too-common, tale is in no way designed to discourage anyone from seeking a tax credit that they are entitled to. However, those responsible for making decisions for the law firm need to be aware of any potential costs, especially where previous tax years are involved. In this very simplified scenario, even if the California credits were applied for on a timely basis, the non-California partners would likely not save any tax. This means that the firm administrator must gauge whether, as a whole, the credits are going to result in a net gain to all of the firm's partners.

Firms need to be particularly cautious and alert when the credit is one that will flow to the partners' personal income tax returns and there are a large number of partners who are nonresidents of the state where the credit is being received. Typically, there is less need for concern if a large number of partners are residents of the credit state. While, outright enthusiasm can flow if a large number or majority of partners reside in a state where there is no personal income tax.

At root, it is a number-crunching exercise, but one that is essential in advance of a decision to apply for a credit. Be aware that in cases where the credit is affecting an entity level tax on the firm itself, it will generally result in a true savings to the firm. Moreover, many jurisdictions also provide similar types of incentives against sales and use tax; again, a true savings to the firm.

To paraphrase another great sage, Forrest Gump: Tax credits are “like a box of chocolates.” Just make sure you pick ones with the sweet, rewarding, cream-filled centers.

Wayne K. Berkowitz, CPA, J.D., LL.M., is 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. He can be reached at 212-331-7465 or [email protected]. ' 2013 Berdon LLP.