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Sales and Use Tax - Clearing the Blurry Line

Lester Rosenbaum and Jesse Cohen, J.D. 02.10.2014 | Practice Made Perfect

On the same day that Cyber Monday 2013 tallied record high online sales, the U.S. Supreme Court declined to grant a writ certiorari in two New York cases. This action could have substantial sales tax implications on ecommerce transactions and use tax implications for purchases frequently made by law firms.

The Court’s denial left New York’s “click-through” affiliate nexus law intact — with implications for Connecticut, Pennsylvania and many other states that have similar laws. The nexus law compels online businesses that work with affiliates in New York State to collect sales tax on purchases — even if the business has no physical presence in the state.

Purchases from out-of-state or online vendors are not necessarily tax free solely because the vendor is not required to collect New York State or City sales tax. These very same purchases are subject to a compensating use tax, due and payable by the purchaser.

While attorneys’ fee income and other receipts from rendering legal service are exempt from sales tax, New York State and City continue to target professional service organizations, including law firms, for examinations for potential use tax liability. New York’s persistence is driven by the perpetually growing availability of electronic practice management resources and tools from out-of-state and online vendors.

The peculiar rules on software purchases especially complicate a firm’s potential use tax obligation. Generally, purchases of prewritten or “canned” software are subject to sales and use tax, while software that is custom-designed specifically for a firm is not. However, purchases of prewritten software that was subsequently modified to fit the particular specifications of the purchasing firm may be partially taxable if the customization charge (nontaxable) is separately stated. Otherwise the entire charge is subject to sales and use tax. While these concepts may seem black and white, the difficulty lies in defining what is prewritten versus what is custom.

Moreover, as software products continue to evolve into models offered through cloud computing, such as Software as a Service (SaaS) and Platform as a Service (PaaS), the line between what is taxable and what is not blurs further. Some states liken these internet-based mediums to downloading prewritten software (taxable), while other states consider it a nontaxable service because the software is never physically transferred to the user-purchaser. New York has no specific authority on the taxability of SaaS and PaaS resulting in more uncertainty regarding potential exposure to State and City tax examinations.

Once this can is opened, all contents may be under scrutiny. When a law firm is selected for an audit, all purchases may be reviewed by the State or City auditors. This means that many other commonplace items, whose taxability may have been overlooked, become a potential source of use tax liability, for example:

  • Office supplies and other recurring-type purchases;
  • Office furniture, fixtures, and equipment; and
  • Other expenditures assumed to qualify as capital improvements and thus free of sales tax

In addition, the statute of limitations may not run on New York’s assessment of use tax. Generally, there is a three-year statute for assessing unpaid use tax from the date a sales and use tax return is filed. However, where no return has been filed — which may be the case where a law firm has no taxable receipts — no assessment limitation period applies. In these instances, the taxing authority may assess unpaid use tax for an unlimited time period — even dating back to the firm’s inception — although taxing authorities at their discretion have generally been agreeable to limit their sales and use tax examinations and any related assessments to a “reasonable” period.

To lessen the potential impact of a tax examination for future periods, law firms may formally register with the New York State Department of Taxation and Finance for sales and use tax purposes. The law firm will be required to file a quarterly sales and use tax return, and pay on a current basis any use tax due. Instead of registering, another option is to pay the tax within 20 days of each purchase. While these methods may require additional tax compliance responsibilities, they will certainly reduce the potential for surprise costs and result in diminishing the time-frame within which New York may seek to examine the firm for use tax liability to a three-year period.

Also, there are certain strategies to initiate prior to the audit to help it proceed expeditiously and to ultimately minimize any assessment. Firms that are selected for an audit, should immediately contact their tax advisors to make preparations.

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