Many law firms traditionally did not need to concern themselves with multistate income tax issues. The firm operated in a single state, and for state income tax purposes, all the work was sourced to the location where the work was physically performed.
The U.S. Constitution limits state income taxation to income derived from sources within the state seeking to impose the tax. However, states have been granted a great deal of latitude in establishing methodologies to determine whether income is derived from sources within their respective borders.
Over the past several years, many states have adopted “market based sourcing” rules which source income:
- In the case of an individual client, to the client’s home address;
- In the case of a business client, to:
- The venue of the matter,
- The office of the client that controls the engagement letter with the firm; and/or
- To the location where the client “benefits” from the law firm’s services.
Over 35 states have adopted market based sourcing rules (in whole or in part) when it comes to determining whether income was derived from sources within the state. Furthermore, each state’s income sourcing methodology exists in a vacuum. Just because one state lays claim to a dollar of revenue does not prevent another state from claiming the same dollar. Inversely, just because a state determines that a dollar of revenue was derived from sources outside the state does not obligate the other state(s) to claim that dollar of revenue. The conflict of state law in this arena can easily lead to multiple states taxing the same dollar of revenue or no state claiming an item of revenue.
Under market based sourcing rules, a local law firm representing a nonresident, individual client in state court with regards to an automobile accident may have income derived from the client’s home state. Likewise, representing a multistate business in state court may give rise to income derived from sources in another state if the engagement letter is controlled at the client’s headquarters or the client holistically “benefits” from the legal services in another state. Pursuing a matter pro hoc vice or through an affiliation arrangement with a local law firm may cause revenue to be sourced to the venue of the matter.
Once a law firm has revenue derived from sources in another state, it may be obligated to:
- File income tax information returns in states that conform to the federal tax treatment of pass-through entities
- Withhold nonresident state income tax from the nonresident owners of the firm in states that conform to the federal tax treatment of pass-through entities
- Pay entity level income taxes in states that do not conform to the federal tax treatment of pass-through entities;
- Pay entity level gross receipts taxes in states that impose a gross receipts tax (e.g., OR, TX, WA); and/or,
- Pay non-income based taxes and fees (e.g., the $800 California minimum tax and/or the California $11,790 LLC fee)
Law firms representing out-of-state clients should analyze how they need to source their revenues in both the states where they operate and the states where their respective clients reside.
For more information on this topic, please contact a member of Withum’s Law Firm Services Team.