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The recent federal tax legislation is good news for law firms and their owners. Not only were the individual marginal rate reductions accelerated in 2003, but also tax rates on long-term capital gains and most dividends have been reduced significantly. Businesses have increased incentives to invest in property, equipment, and qualified leasehold improvements through a special 30 percent, now 50 percent, bonus depreciation. In addition, in 2003 and 2004, there is a substantial increase in the amount of property purchases that can be fully expensed in the year of purchase, from $24,000 to $100,000, and a broadening of taxpayers who qualify for this deduction. State reaction to the federal legislation, however, has been less than favorable. Prior to the recent federal tax acts, an overriding philosophy of most states has been to promote simplicity and consistency in tax administration by conforming in many ways to the Internal Revenue Code. Many states are now reconsidering this approach because the cost of conformity is too great for state budgets to handle. States that were flush with surpluses from the boom days of the late 1990s have seen them vanish as tax revenues drop. Overspending in good times coupled with the slow economy and federal mandates related to homeland security have forced many states to re-evaluate how to now balance their budgets, something almost all states are constitutionally required to do. Spending cuts and tax increases are logical solutions. In addition, many states are becoming more creative and aggressive in their pursuit of revenue. GOING AFTER NONRESIDENTS State taxing authorities are enacting or proposing new legislation to increase tax revenues. Some states, including Virginia, have enacted tax amnesty programs replete with large penalty and interest waivers targeted at increasing nonfiler compliance. States are also beginning to more strictly enforce their nonresident regulations, which is politically much easier to do than taking a more aggressive position with residents. Law firms and their partners are being affected by state revenue-raising efforts in several ways: • Targeting nonresident entities and individuals. • Decoupling their laws from the Internal Revenue Code as of an effective date prior to the new federal tax legislation to prevent the accelerated depreciation permitted under federal law. This means that state deductions will more often differ from federal deductions. • Mandatory withholding at the partnership level for nonresident partners who are not participating in group returns. • Increasing and/or accelerating the payment of fees or creating new types of fees. Most law firms file tax returns in states in which they have physical offices or space rented, since they are clearly providing services in those states. But in those states where law firms provide a significant amount of services, at a client’s office or elsewhere, these firms are likely to have met state “nexus” requirements for “doing business” and will most likely be required to file and pay taxes. Many firms provide occasional or irregular services in certain states, such as attending client meetings, court hearings, or depositions. Should law firms be filing and paying taxes in every state in which they physically work? The practical answer has been no, but firms should consider their volume of activity in each state and that state’s nexus provisions, to consider the risks and understand their potential obligations to these states. Generally, states have the right to tax law firms and other professional service firms on income from services performed in their state. The mechanisms employed by a state may be based on statutes, regulations, case law, or form instructions. Some states have established de minimus thresholds of certain dollar or hour amounts, and others offer less than clear guidance. INCONSISTENT STANDARDS Proposals have been put forth both in Congress and by state taxing authorities to establish consistent and clear rules for determining whether an entity is taxable in a particular jurisdiction; however, at this time, there is no consistency among the states. As a result, the determination of whether a service provider is “doing business” in a state is based on a facts-and-circumstances test in each state. New Jersey is one of several states that have become aggressive in targeting non-residents that they claim are doing business there. New Jersey has no clear nexus rules and does not recognize de minimus hour thresholds for services performed there. In the middle of 2002, New Jersey sent notices directly to out-of-state attorneys who appeared in New Jersey courts, claiming that by appearing in court they were “doing business” in the state and must file and pay taxes. Mississippi sent out similar notices last year. When it comes to mandatory withholding and filing fees for nonresidents, certainly the most aggressive states have been New Jersey and New York. Both states have increased filing and administrative fees for firms conducting business within the state. The fees are calculated on a per-partner or per-owner basis. Both states have also accelerated the due date of these filing fees. New Jersey requires a 50 percent deposit of the fees for the next tax year with the current year return. New York now requires per-partner administrative fees to be paid within 30 days after the tax year ends, instead of with the tax return. New Jersey and New York have both enacted mandatory withholding for nonresident partners not participating in a composite return (a group filing of nonresident partners’ tax returns prepared by the law firm). Affected firms are fighting back. A class action was filed against New York arguing that the new requirements are unconstitutional and discriminatory in that nonresidents are treated differently than residents. Firms must pay on behalf of affected nonresident partners estimated New York tax on their share of firm income at the highest rate, without the benefit of any deductions or graduated rates. The suit argues that the new law creates interest-free loans to the state. For corporate partners, the result is estimated tax withheld in the current year that will likely be refunded in the next year since taxable income at the corporate level is typically reduced to zero through bonus payments to the individual shareholders. LOCAL TAX CHANGES Looking at the D.C. area, Maryland has for some time required firms to withhold nonresident individual partners’ shares of firm income. Virginia and the District do not currently have nonresident withholding requirements. The District, Maryland, and Virginia have never recognized the federal bonus depreciation. But many states that did recognize it originally have now decoupled from the federal bonus depreciation, effective with the recent increase in the bonus depreciation from 30 percent to 50 percent. This essentially means that for state tax purposes, fixed assets are depreciated at a slower rate than they are for federal tax purposes. Decoupling not only increases state taxes for law firms, but also increases their administrative burden by requiring them to depreciate the same fixed assets under different methods for federal and state tax purposes. Eventually, as assets become older, the state depreciation on an asset will be larger than the federal depreciation. Some states have sponsored amnesty programs, which usually provide a limited time frame, a few months, for relief from penalties and interest. Virginia’s current amnesty program ends today. For firms that own real estate, Maryland recently passed a regulation requiring 3 percent withholding on all nonresident contractors performing services related to real property in Maryland for contracts exceeding $500,000. In addition, Maryland passed a law that became effective Oct. 1 requiring withholding on real estate sales by nonresident business property owners. Before a sale can be recorded, 4.75 percent of the total contract sales amount for nonresident individuals � 7 percent for nonresident entities � must be remitted. New York has enacted similar withholding requirements on nonresident owners of real property sold in that state. The District of Columbia has asked Congress to lift the ban on a commuter tax law for nonresident individuals. If successful, this would increase tax filing and administration for many firms in the D.C. area, as well as having a direct effect on tax legislation in Maryland and Virginia. NEW BURDENS The biggest impact on a law firm and its partner-owners is the added administrative costs and cash-flow headaches associated with determining the withholding, meeting notification requirements, tracking separate depreciation, and potentially filing additional returns. Since most states allow an individual taxpayer to claim a credit for taxes paid to other jurisdictions, there usually will not be double tax, but partners will always pay the tax at the higher state’s rate. As an administrative convenience, many states permit nonresident partners to participate in composite nonresident returns filed by the partnership, instead of having to file individual nonresident returns. Some partners, however, choose not to participate in composite returns when the partnership has significant revenue in a particular state because it is not uncommon that a partner’s share of the tax bill on a group return is higher than it would be if the partner filed separately. In addition to focusing on improving income tax collection, many states are also exploring options for increasing compliance and collection of payroll withholding, sales and use, and property taxes. Firms may have greater exposure to state taxation when associates and other employees perform services for the firm in various states, especially those states that do not have de minimus rules, discussed above. Firms should also consider the implications of hiring employees who work from their homes in states where the firm has no office. The big question is: Will the states’ bite be as bad as their bark? States are working together to increase tax compliance. The federal government and at least 40 states and the District of Columbia have already agreed to share information regarding tax avoidance transactions that are “abusive.” As other states follow these aggressive tactics, a firm’s costs for administration and compliance with state tax laws may significantly increase over time. With a growing number of states in a budget crisis, coupled with more sophisticated tax-tracking systems, law firms will likely need to pay close attention to state tax issues, no matter where they practice. David D. Leith, CPA, is a partner in the law services group of the D.C.-based CPA firm Beers & Cutler, PLLC. He can be reached at [email protected] or at (202) 449-4201.

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