Businesses in the professional services industry, including law firms, are no exception to the rule that it’s prudent to think ahead when it comes to taxes.
The following are common tax scenarios law firms may encounter, some examples of how they typically manifest, and some solution-oriented actions your firm could take to improve business.
Common Tax Challenges:
Nexus and Sourcing Revenue for State Income and Tax Purposes
Allocating and apportioning state and local income taxes, including franchise and gross receipts taxes, can be complex. Compliance with state and local tax laws while considering sourcing provisions to help manage tax liability is important. This includes determining the jurisdictions in which your company has nexus and how it should source its revenue.
How Does Nexus Affect Law Firms?
For a state to impose an income tax, franchise tax, or gross receipts tax on a company, the entity must have nexus in the taxing state.
Nexus is the connection between a taxing jurisdiction and a person or entity that causes that state to legally exercise tax jurisdiction over the person or entity. States may have differing nexus standards, which range from having a physical presence in a state—employees, office, inventory—to exceeding a bright-line sales or gross receipts threshold amount. This is also known as economic nexus.
An increasing number of states have adopted or are contemplating adopting economic nexus standards for income tax filing requirements. These nexus standards can range from a narrow bright-line sales factor threshold to a broader interpretation of gaining an economic benefit of doing business in the state, which can be interpreted as merely deriving receipts from sources within a state.
The application of economic nexus standards to state income taxes continue to pose significant challenges to law firms with clients located throughout the country. It’s important to understand your company’s multistate footprint to determine if your business is compliant with state tax laws.
Examples of Physical Presence Nexus
XYZ Law is headquartered in State A. During the tax year, XYZ law performs legal services for a client in State B. The legal services include sending an attorney into State B to perform client-related work, such as conducting depositions or arguing cases in court proceedings in the taxing state.
These activities would generally create a physical presence in State B, resulting in an income tax filing requirement in State B.
Another example of creating physical presence includes third parties performing services on a law firm’s behalf in a state. With the scenario above, XYZ Law contracted with a third party to conduct the client related services in State B.
Although XYZ Law wasn’t physically present in State B, the presence of a third party performing services on behalf of XYZ Law in State B will generally create a physical presence for XYZ Law, resulting in an income tax filing requirement in State B.
Example of Economic Nexus
XYZ Law, LLP, is a law firm specializing in real estate transactions. XYZ Law has offices in California, Oregon, and Utah. Additionally, XYZ Law has clients with land in several midwestern states. XYZ Law provides legal services related to land located in the Midwest, including drafting, and executing purchase and sale agreements.
XYZ Law, LLP doesn’t have a physical presence in the Midwest. However, the firm may have nexus in those states if receipts from providing services related to those states results in gross receipts sourced to the state under the jurisdiction’s sourcing provisions, exceeds the state’s economic nexus requirements.
How Are Law Firm Revenues Sourced?
Law firms are often faced with the challenge of determining where revenues are sourced for purposes of filing state tax returns. Revenue is generally sourced to a state through the use of a formula based on the law firm’s activity in a state compared to the law firm’s overall activity.
This is referred to as apportionment and applies to the business income of the law firm. To the extent a law firm has any non-business income, revenue is allocated to a state based on the type of income received.
Apportionment-Related Common Sales-Factor Sourcing Methods
Two common sales-factor sourcing methods that law firms may be subject to when determining how to source revenues to a certain state:
- Market-based sourcing
Both methods present numerous challenges to law firms. States may allow alternative sourcing methods in addition to the cost-of-performance and market-based sourcing methods, these being the two most common methods for sourcing revenues to a specific state.
Under this method, states source revenue to the location of the income-producing activity related to the service. When the income-producing activity occurs in more than one state, the receipts associated with the activity are generally based on the relative costs incurred.
Some states that have adopted this method may require a law firm to determine where the greater cost of performance occurred and source all revenues related to those costs to a single state. Other states may require a law firm to source revenue based on a proportionate basis to where the costs occurred.
Example of Cost-of-Performance Sourcing
123 Law, LLP, is located in State A, a cost-of-performance state, along with all its employees and property. The firm’s clients are located in State B, which has adopted the market-based sourcing method. Although all the firm’s clients are located in State B, State A would require that all revenue would be sourced to State A because 100% of the costs incurred in providing services are in State A.
Under this method, revenue is sourced to where the customer receives the benefit of the service. There has recently been an increased trend for states to adopt the market-based sourcing method, as approximately three-fourths of the states that impose an income tax have adopted the market-based sourcing method.
The challenge with this method is that the interpretation of where a customer receives the benefit of a service is broad and can vary by state. Some states may look to the billing address of the customer while others may look to the facts and circumstances of the matter to determine where the benefit of the service is received.
Example of Market-Based Sourcing
123 Law, LLP, and all employees and property, is in State A, which is a cost-of-performance state. 123 Law’s clients are in State B, which has adopted the market-based sourcing method. Clients receive the benefit of the firm’s services in State B. Under the market-based sourcing method, State B would require that 100% of the firm’s receipts would be sourced to State B, because the benefit of the services performed are wholly within State B.
The examples for each method demonstrate a common situation in which a company may report the same income to multiple states, especially in cases where the majority of the services are performed in the cost-of-performance state while the majority of clients are located in a state with market-based sourcing.
As an increasing number of states shift to market-based sourcing, this scenario is becoming increasingly uncommon. The reverse can also happen, where a law firm performs the majority of its services in a state with market-based sourcing but has clients in a cost-of-performance state. This fact patten, in contrast to the preceding one, can be taxpayer favorable.
State and Local Sales and Use Tax on Purchases
State and local sales and use tax imposed on purchases can be a daunting concept. State and local tax jurisdictions vary greatly on what is and isn’t subject to sales and use tax. While most purchases of tangible personal property are taxable, jurisdictions can provide exemptions.
Most purchases of services are exempt from sales and use tax, although some jurisdictions enumerate services as taxable.
Software and Digital Services
An especially tricky area about the imposition of sales and use tax is when the purchase is a digital service, such as software licenses, Software as a Service (SaaS), Infrastructure as a Service (IaaS), or Platform as a Service (PaaS).
States vary on whether such services are subject to sales and use tax. Adding to the complexity around the taxability of such purchases is the potential ability to apportion the sales and use tax based on where the users of such digital services are located.
Determining the taxability and apportionment of purchases helps to minimize surprises on audits and reduce cash outflows on exempt purchases.
Law Firm is headquartered in Washington State with satellite offices in Oregon and California. Law Firm purchases a cloud-based subscription software from Vendor A that’s used to track daily schedules, expenses, and other employee related activities.
Vendor A invoices the law firm for the subscription services and imposes Washington State sales tax on the entire amount, as the invoice is sent to the Washington State headquarters. However, the users of the subscription are located evenly throughout Washington, Oregon, and California.
Neither Oregon nor California imposes sales or use tax on cloud-based subscription services. Therefore, Law Firm may consider apportioning the tax based on the number of users in Washington with a savings potential of 66% of the sales tax.
Cost Segregation Study
Leasehold improvements to construct or remodel office space are often the largest part of a professional service firm’s capital expenditures.
Cost segregation planning for capital projects can provide immediate cash flow benefits to put back into current operations. Cost segregation is an income tax deferral strategy that can be applied to leasehold improvement project costs.
What’s a Cost Segregation Study?
A cost segregation study identifies component assets from improvements made to a building’s electrical, plumbing, heating, ventilation, and air conditioning (HVAC), and structure that can be depreciated over shorter recovery periods such as five-, seven-, or 15-year property, rather than 39 years.
It also documents assets that qualify as 15-year qualified improvement property (QIP), which is currently eligible for federal bonus depreciation. Accelerating depreciation expenses lowers current federal and state income tax liabilities, providing immediate cash flow benefits.
Example of Cost Segregation
ABC Law, LLP, spends $15 million to construct new office space in three floors it’s leasing in an office building in San Francisco. Electrical and plumbing fixtures are added to support open and enclosed office areas, meeting rooms, and break rooms throughout. HVAC systems are modified based on the office layouts. Partition walls, as well as floor, wall, and ceiling finishes are installed.
By identifying 60% of the cost as 15-year QIP and the rest as 39-year property, the firm could benefit from some federal bonus depreciation. However, a cost segregation study identifies that 30% is five- and seven- year property, 55% is QIP, and the remaining 15% is 39-year property.
The estimated additional first-year depreciation and tax-deferral benefit from doing a cost segregation study are shown below for the current year:
The data assumes a 35% federal income tax rate, a 7% discount rate for the net-present value, and that 100% bonus depreciation will be claimed.
Fixed Asset Compliance
With assets and operations often spanning multiple state and foreign jurisdictions, fixed asset and depreciation compliance needs can become overwhelming.
Tax depreciation has become more complex due to:
- Tax-specific framework guidance for expensing and capitalizing costs
- Ever-changing tax depreciation laws
- The inability of enterprise resource planning (ERP) systems and software to incorporate current depreciation rules
If these challenges sound familiar, your firm may be missing out on opportunities or creating costly compliance issues. Your tax and accounting professional may be able to assist with asset tracking for internal, tax, and other reporting needs, as well as consult on a capitalization policy.
We’re Here to Help
For questions about tax challenges affecting your law firm, please contact your Moss Adams professional. You can also visit our Tax Services page for additional resources.