U.S. Supreme Court building in Washington, D.C. (Photo: Diego M. Radzinschi)

A tax nightmare could face big law firms and other multistate service providers if the U.S. Supreme Court this term requires retailers to collect sales taxes in states where the business has no physical presence.

The justices will hear arguments on April 17 in the case South Dakota v. Wayfair. South Dakota and its supporters urge the high court to overrule its 1992 decision that said only retailers with a physical presence within a state can be required to collect that state's sales tax. Numerous state and local governments say a ruling for South Dakota could mean billions of additional dollars for cash-hungry government budgets.

Tax attorney David Fruchtman, chair of the state and local taxation practice at New York's Rimon, filed an amicus brief on his own behalf and in support of neither party in the case. He takes no position on whether the 1992 decision Quill v. North Dakota—central to the dispute facing the court—should be cast aside. Instead, he urges the justices to keep the physical presence rule for sales taxes on service providers.

From defining “legal services” to locating the delivery point of cloud computing access, “sourcing and apportioning of sales of services presents a series of complications unparalleled in sales of tangible personal property,” Fruchtman argued in his brief.

At large, the briefs in the Wayfair case focus on the collection of sales taxes by remote web retailers of tangible personal property. A ruling for South Dakota, however, could also apply to remote providers of a broad range of services, such as legal and accounting advice.

Three states—South Dakota, Hawaii and New Mexico—impose sales taxes on a spectrum of in-state services, although with exceptions. Enticed by a largely untapped and huge source of new revenue, “the states are actively looking for opportunities to expand their sales taxes to cover a broad-base of services, including services performed in other states,” according to Fruchtman.

“Of the 45 states that impose sales taxes, few have considered in any depth the issues raised by requiring retailers of interstate services to collect sales taxes,” Fruchtman wrote in his brief.

Fruchtman sees two major problems, among others, for law firms serving clients in their home states or across state lines: “pyramiding” of taxes and sourcing issues.

The pyramiding problem for fees from local counsel or experts may occur this way, he hypothesizes in an email to The National Law Journal:

A law firm engages an antitrust expert to assist on litigation. The expert bills the law firm for his services, which the law firm includes in its bill to the client. The client receives a bill from the law firm for $40,000 ($30K for legal services plus $10K for expert services) and pays taxes on that $40K. The law firm in turn pays the expert the $10K for expert services. Unless the state permits the use of resale certificate with purchases of services, the law firm will have to pay sales taxes on the $10K, and the total amount taxed will be $50K. Had the expert billed and been paid by the client, the client would have had a sales tax bill of $40,000 ($30K in legal fees, $10K in expert fees).

“The complexity increases if the law firm, client, and expert are located in different states, as it is possible (and perhaps likely), that the states will use differing approaches for sourcing expert fees,” Fruchtman wrote.

And the sourcing of legal fees problem:

A law firm bills a client $10,000 for advice involving the proper sales tax characterization of the client's sales of a medical device in California. Since the advice related to California taxation, one might reasonably expect that legal fees will be sourced to and taxed by California.

But now suppose the law firm advises the client on how to avoid creating tax presence in California. Since, as before, the advice related to California taxation, one might reasonably expect that legal fees will be sourced to and taxed by California—except that the client does not have tax presence in California. Another state might argue that the sale must be allocated to the client's legal domicile, or to the client's commercial domicile, or on some other basis.

And what if the law firm provides federal tax advice? “Where is the sale taxable?” Fruchtman writes in his amicus brief. “At the client's legal domicile, to the client's commercial domicile, or among the states where the client has sales, or where the client has property and payroll?”

Challenges to taxing professional services

The states, Fruchtman said, “do not know how to tax many services” and he points to the quick repeals of the attempts by Florida, Massachusetts and Michigan, to impose broad-based sales taxes on the services sector. Retaining the physical presence requirement would allow states to continue to experiment and learn how to tax services with a smaller, more manageable number of providers, he argued.

Tax partner David Brunori in the Washington office of Quarles & Brady said he sees little threat to professional service providers.

“No state has successfully expanded its sales tax base to professional services in 30-40 years,” Brunori said. “There've been lots of attempts but none successful and the reason is professional service providers tend to be lawyers, doctors, accountants, real estate agents—people with lots of political clout in state legislatures.”

When taxes on professional service providers are proposed, Brunori said, “the bar association goes in and kills it. It takes out a bunch of ads and say: 'Governor Smith wants to destroy the foundation of constitutional law!' Or real estate agents will take out ads and say: 'They want to destroy the American dream of home ownership.'”

Brunori said it's “open season” on “tattoo parlors, landscapers, dog walkers” and other nonprofessional service providers—most of whom do not cross state lines.

The Quill physical presence test will always be “unloved,” said Fruchtman, because it is “inflexible” and “looks and feels arbitrary.” But, he argued, it works. “Where services are concerned, I recommend that the states leave well enough alone,” he said.

 

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