The State(s) of Your Business: Understanding Income Tax Nexus for Law Firms
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We all know that state governments look for additional revenue to close their budget gaps. One method they use is to tax companies that do business in their state, even if the companies are based somewhere else.
So, how does that affect a law firm — or any other professional services firm? And what do you need to do to lower your potential tax liability?
It’s All About “Nexus”
It begins with the term “nexus.” Essentially, nexus describes the amount and degree of business activity that must be present in a state before the taxpayer (in this case, a law firm and its partners) becomes subject to the state’s taxing jurisdiction.
The key question is: Do your actions, or your firm’s actions, create nexus within other states? If they do, you might have an added tax burden to obey.
Activities that could create state income tax nexus for law firms include:
- Maintaining a satellite office
- Employees who work from home on a regular basis
- Revenue sourced to a state that exceeds a certain amount (commonly referred to as the “factor presence test”)
- Pro hac vice admission (when a lawyer performs work in a state where they’re not licensed)
- Client meetings
- Making an appearance at a deposition hearing
- Attendance at a settlement conference
It’s Not Always Clear
While some of the above activities may seem obvious for creating nexus for law firms, others may not. For example, having an office or an employee in a state almost always creates nexus. But if an attorney attends one settlement conference in a state, is that enough?
The challenging part of navigating nexus is determining how each state’s laws apply to the specific activity. It’s not an easy “yes or no” answer, as states will look at the totality of a taxpayer’s activity and make a determination based on the specific facts and circumstances.
Guidance in this area is not always clear, but look at a few examples from various states:
- Under Michigan law, a physical presence of more than one day during a tax year creates substantial nexus and tax responsibility.
- North Carolina requires an out-of-state attorney to sign a statement confirming they’ll report income to the North Carolina Department of Revenue as a part of the pro hac vice admission process. It’s the out-of-state attorney’s (or firm’s) responsibility to determine whether the income is reportable and if a tax return should be filed under North Carolina state law.
- Washington uses the factor presence nexus test for its business & occupation tax. Under its laws, nexus would be created if the law firm generated more than $267,000 in revenue attributable to the state. The issue is how to determine if revenues are attributable to Washington or some other state.
More Questions on Tax Obligations
Even if it’s determined you have nexus within a state, the fun isn’t over yet.
At this point, a law firm must understand what its filing obligations are in each state in which it has nexus. Since law firms are typically structured as pass-through entities, most states do not impose income tax liability directly on the law firm, instead requiring the partners to file and pay taxes individually.
But some states do impose a tax on the entity directly, most notably Ohio (commercial activity tax), Texas (franchise tax) and Washington (business and occupation tax).
Nevertheless, even though the law firm itself does not have an income tax liability, it may be required to withhold and remit income tax on nonresident partner earnings and/or file composite returns. The specific requirements in each state vary.
In addition, the firm must also determine how the tax base (income) for the period should be divided among the various jurisdictions in which it has nexus. These topics are beyond the scope of this article, but it’s important to be aware the analysis doesn’t stop once the question of whether you have nexus is answered.
Liability Can Be High: How to Lessen It
Ultimately, it’s important to understand and control your state exposure to avoid unexpected tax liabilities. If it’s determined a company doing business in a state has not filed tax returns, the period for assessment of tax is unlimited.
Even if it can be shown that little or no taxable income can be allocated, many states have minimum taxes or maintenance fees, which are payable regardless of taxable income. With the addition of penalties and interest to this annual tax, the cost of a few years of delinquent filing — or not filing at all — can be substantial.
Issues around state tax nexus continue to be complex and controversial for law firms — and other professional services firms as well. For a multi-state taxpayer to ensure compliance with its state tax obligations, it must first understand where those obligations exist. A CPA-based advisory firm can conduct a nexus study to determine where potential state tax exposure exists and how to mitigate it.
By identifying nexus, firms will have further clarity on their state tax obligations and, most importantly, avoid incurring unexpected exposure.