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Law Firms and Economic Nexus – An Evolving Struggle

Wayne Berkowitz, CPA, J.D., LL.M.
11.22.2016 | Practice Made Perfect
Law firms must remain as vigilant as ever regarding economic nexus as more and more states continue to pass legislation that often results in challenges to former year tax returns. Fighting these challenges can be both wearying and costly.

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 that will go a long way toward quickly ending a state income tax audit.

One Firm’s Odyssey

In the July 2016 issue the Journal of Multistate Taxation and Incentives, a law firm documents its run-in with the State of Minnesota.1 As only a law firm with a concentration in state and local tax could do, all practicality was rightfully thrown aside in the interests of pursuing justice.

According to the article, the law firm of Hodgson Russ LLP received “correspondence” from Minnesota demanding the filing of back tax returns since the State had information that the firm received Forms 1099 from payors with Minnesota addresses. Based on the addresses on the Forms 1099 being the only contact with Minnesota, the Department of Revenue made the generous offer of disregarding the exposure they believed dated to 2004 and requesting returns only be filed for the 2009 through 2012 tax years.

Form 1099 information is provided to the states by the IRS and it is relatively simple to match non-filers (rightfully or wrongfully) against a Form 1099 with a payor address from the state. Often with reasonable responses to a state’s queries (hence my warning to be armed with the information in advance), the inquiry will simply go away. Apparently, Minnesota must have been holding firm as it was necessary for the lawyers of Hodgson Russ to sue Minnesota in New York State Supreme Court in order to convince them to go away.

Keep those Records

The good news, as we first documented in 2011, is, if the firm can produce records demonstrating that the work was not performed in the state making the inquiry (or in some cases that clients didn’t receive the benefit of your services in that state), you’re relieved of the burden of sifting through files because the information is already in hand. Even if nexus were established, there would be little or no tax liability.

While there are different sourcing rules for individuals and corporations, many jurisdictions still prefer partnerships and similar entities report income from state 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 state sources, report this amount.

If the books and records method doesn’t accurately reflect these figures, these states resort to the standard three-factor formula consisting of property, payroll, and gross income from sales and services or a single factor formula based on gross income. Many states still use a somewhat archaic methodology for receipts that looks to whether the charges were made by employees sent out from offices located in the state.

Law firms and their clients must remain aware of the ever-evolving economic nexus climate. 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.

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.

If you have questions, contact your Berdon advisor or Wayne Berkowitz, CPA, J.D., LL.M., Berdon LLP, New York accountants

1 Hodgson v. Minnesota – A Window into the Future of Economic Nexus, Chris Doyle, Stephen Kelkenberg and Dan Kelly. (Volume 26, Number 4, July 2016)