Is your law firm aware of taxes it may owe out of state? Determining whether your law firm owes income tax, franchise tax, or other business taxes in a state (or states) in which you do business but are not physically located can be complex.
If you are a law firm doing business out of state, you need to be aware of evolving nexus standards in states around the country. The term nexus, when used in connection with state taxation, is the contact that must be established with a taxing jurisdiction before it can impose a tax.
The Changing Landscape
In this era of electronic commerce and record state budget deficits, many states are facing increased fiscal pressure resulting from diminishing tax revenues. This has led a number of states to search aggressively for new revenue sources, including pushing the envelope of what constitutes nexus. The minimum link creating nexus can vary from state to state as well as from tax to tax. The three major types of state taxes that are affected by nexus are (1) sales and use taxes, (2) income taxes, and (3) taxes that are neither sales and use taxes nor income taxes but more a mix of the two, i.e., “other business activity” or “neither/nor” taxes.
Traditional Nexus Concepts
Under the US Constitution’s Commerce Clause and, to a lesser extent, the Due Process Clause, companies are required to have “substantial nexus” with a state seeking to tax them. Substantial nexus has historically been interpreted as “physical presence.” Typically, a firm’s in-state property, payroll, and gross receipts – compared to its total property, payroll, and gross receipts – are the factors used by states for apportionment of income. For law firms, physical presence in a state can easily be achieved by having the firm’s professionals participate in income-producing activities such as litigating a case in an out-of-state court room or simply taking depositions or interviewing clients in a state other than the firm’s home state.
Economic Nexus Concept
Responding to their need to increase tax revenues, many states are redefining traditional nexus concepts through their state legislatures and courts. The result is a new concept called “economic nexus,” which is defined as a state having jurisdictional authority to tax any firm or company that takes advantage of the state’s markets without regard to physical presence.
Currently, economic nexus applies only to income taxes and other business activity taxes. For example, Connecticut economic nexus statutes could possibly impose a tax on any company with gross receipts exceeding the Connecticut bright-line nexus standard of $500,000. That is, if your firm collects gross receipts in excess of $500,000 from clients located in Connecticut, economic nexus has been established and your firm may have a filing requirement and could be subject to Connecticut income taxes. Examples of other business activity taxes based on economic nexus exist in Michigan, Ohio, Texas, and Washington.
As the nexus landscape evolves, the definition of when a law firm is deemed to be doing business in a state and thus subject to state income or business activity taxes is quickly expanding. While many aspects of these new nexus standards are controversial and being challenged in state courts, the likelihood is that an increasing number of states will impose new standards until the standards’ constitutionality is determined. It is therefore essential that firms monitor their state activities. It is also highly advisable to consider engaging a tax professional to help you plan for doing business in a new state or complete any state nexus questionnaires.
Find out more by contacting one of our tax professionals in the LaPorte Law Firm Services Group.
In Louisiana, contact Jennifer Bernard or Jeanne Driscoll at 504.835.5522.
In Texas, contact Richard Morrison at 713.963.8008.