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In this day of tight budgets and the ability to do business electronically across state lines, states are looking more closely at how additional revenue can be generated through interstate commerce. But under the Constitution’s commerce clause, states cannot place an undue burden on the ability to do business across state lines. One type of undue burden would be taxing a business or individual who does not have some sufficient connection — or “nexus” — to that state. The definition of nexus raises some interesting questions. Does a connection or link that creates a nexus mean that a firm needs to be physically present within the state, or does it mean that the firm must merely generate significant revenue from transactions within the state? The federal courts have not yet definitively decided that issue. As a result, many states have developed different methods of defining nexus and in recent years have begun to broaden that definition so they can increase their ability to tax businesses or individuals from other states. Why is this issue so important to law firms? Many law firms have offices in multiple states and, additionally, do work for clients in states in which they do not have offices. The tax ramifications of doing business in more than one state are both complex and uncertain. The complexity and uncertainty can not only lead to a higher tax liability but may also significantly increase the costs to the firm of complying with the many different tax laws and regulations. In most states, law firms or their partners are entitled to a credit for taxes paid to nonresident states on their resident state tax return. The credit, however, is generally limited to the amount that would be due on the resident return. Because of differences in rates and the way taxable income is calculated from state to state, this can lead to higher tax liabilities for many law firms or their partners. This, in turn, creates an additional burden on the record keeping of law firms, which would have to track the information needed to comply with the various state tax laws, thereby increasing the costs of doing business. WHAT CAN LAW FIRMS DO? So what should a firm do? Here are some suggestions for how firms can make sure they comply with the tax rule requirements of the various states. First of all, firm administrators should set up a system to track the activities of the various attorneys in states where the firm has no office. Involve the administrative staff in tracking and logging the whereabouts of the attorneys who are away for business reasons. Make sure the firm’s time and billing system can sort clients by state and locality in order to determine if services are performed for clients in other states. Next, consider adding a section to the new-client form that specifies where the work is being performed, or, if it is for a specific project (such as a real estate development or construction project) or a trial, where the project or trial is located. In addition, the firm’s controller or tax manager should continually review the nexus rules in states where the law firm has meaningful business activity or high-profile legal matters. Finally, and maybe most importantly, partners should contact their representatives to let them know that they need to take action to create some consistency for doing business across the country by passing new legislation to alleviate the confusion. WHAT’S PAST IS PAST There was a time when many practitioners thought that the U.S. Supreme Court had given guidance on the issue. In Quill Corp. v. North Dakota in 1992, the Court held that a “physical presence” was required under the commerce clause in order for a state to require the collection and payment of use tax on an out-of-state company. The Court also stated that Congress has the power to resolve the issue. Even though the ruling applied a physical-presence test specifically to “use taxes,” many assumed that states would apply the same test to other business taxes. In the years following Quill, West Virginia and New Jersey, among others, assessed business taxes against companies that clearly had no “physical presence” within their states. In the fall of 2006, the highest courts of those states upheld the position of the taxing authorities for their states. These decisions were based on an “economic presence” within each state. For example, in the West Virginia case ( West Virginia Tax Commissioner v. MBNA America Bank N.A.), the company was a credit card issuer that mailed numerous offerings to potential customers within the state and then serviced the accounts of those customers who lived in the state. The company generated considerable revenue from those customers, but it had no physical presence within the state. The court stated that significant revenue was earned from within the state, which created an “economic presence” sufficient to create nexus for state tax purposes. The decision specifically cited Quill as applying only to sales and use taxes and not being applicable to other business taxes. The case shows that states are looking for additional sources of revenue in this age of e-commerce and the ability to do business across state lines without a “physical presence.” The taxpayers in both the West Virginia and the New Jersey cases filed a petition with the U.S. Supreme Court, asking it to hear the cases. Several groups then filed briefs with the Court in support of the petitions seeking review of the cases. In June, the Supreme Court decided not to hear either case, putting the burden on Congress to resolve the issue. Before the Supreme Court’s decision not to act, the Business Activity Tax Simplification Act had been introduced in the House Judiciary Committee in 2005. This bill proposed to create a bright-line test for determining when a state could levy a tax on various types of interstate commerce. The main thrust of the bill was to “forbid states from imposing a corporate tax on virtually any corporation that has no physical presence in the taxing state.” The bill defined what would be required to constitute a physical presence, using an aggregate 21 days of activity in a calendar year to create a physical presence. By June 2006, it was marked up by the full committee and the amended bill was reported to the full House. No further action was taken on the bill in the last Congress. Again, after the Supreme Court recently denied the request to hear the West Virginia and New Jersey cases, the Business Activity Tax Simplification Act of 2007 was introduced in the Senate on June 28, 2007. This bill amends Public Law 86-272, enacted almost 50 years ago, which reinforced Congress’ authority over interstate business activity. It codifies the “physical presence” standard and reinforces the notion that a tax should not be imposed by a state unless that state provides benefits or protections to the taxpayer. The act provides for a de minimis exemption from the physical-presence test. If the physical presence is for less than 15 days, then no physical presence is deemed to exist. The effective date of the act would be Jan. 1, 2008. Because the bill was just introduced and sent to committee, it could change its form before finally being enacted, if it is enacted at all. Without this new legislation, more states are taking advantage of the opening that has been provided by the courts. Two additional states passed laws in July adopting the “economic presence” test. Under the “economic presence” theory of nexus, a firm could be subject to tax in a state without ever making an appearance, so long as the client or project is in that state. This trend of states broadening their reach will certainly continue without congressional action. Firms could be faced with filing tax returns in many more states than they currently do, because of the ease of providing services that reach across state lines. Hopefully, law firms will have better guidance before they have to file their 2008 income tax returns.
Bill Apple is a director in Beers & Cutler’s law firm services group in the firm’s Tysons Corner, Va., office, providing consulting, tax planning, and compliance services.

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