The Implications of Economic Nexus and Market-Based Sourcing for Law Firms

Law firms often overlook the complexities and risks associated with state tax obligations under Economic Nexus Standards and Market-Based Sourcing Rules. These regulations can impose significant tax liabilities on firms and their partners, even without a physical presence in the state, simply by providing services to clients based upon where the benefit of the service they provide is received.  To mitigate these risks, law firms must understand these rules, including potential pitfalls, how tax authorities detect non-compliance, and the financial and professional consequences of failing to comply.  Additionally, firms need to explore proactive compliance strategies and seek advisory consultations to minimize their exposure as state tax regulations continue to evolve.

Overview

• Economic Nexus: State tax authorities can impose taxes on businesses that generate significant revenue from clients within the state, even without a physical presence or even stepping foot within the state. For law firms, this means that providing services to clients in a state could potentially trigger tax obligations if revenue exceeds a certain threshold or other requirements are met.
• Market-Based Sourcing: States that use market-based sourcing (“MBS”) attribute income to the location where the service’s benefit is received (i.e., where the client is located or receives the benefit), rather than where the service is performed (Cost of Performance or “CoP”). The actual sourcing may vary by practice area.

• Timing: The concept of economic nexus first emerged with South Carolina’s adoption of the standard in the early 1990’s. Economic Nexus and MBS began gaining traction around 2011, with California and other states leading the way. New York joined the movement by adopting MBS in 2014 for corporations. Similarly, New Jersey adopted MBS for corporations in 2014 and recently expanded the standard in 2023 to include partnerships. Most states (and some cities) now utilize an economic nexus standard based on entity type, and about a dozen have implemented bright-line tests (an amount threshold) to quantify the requirement, providing clarity as to subjectivity.

Key Considerations for Law Firms

• Triggering Economic Nexus:
  • Nexus is often triggered by remotely providing services to clients receiving the benefit of the service located within the state (economic nexus) or by physically performing services within a state (attending meetings or appearing in court, i.e., physical nexus).
  • Revenue thresholds (brightline tests) for economic nexus vary by state (e.g., California Sales: 2024 – $735,019, 2023- $711,538). Many states also use a factor standard, such as a specific threshold or, 25% or more of a single apportionment factor, such as Sales, Payroll, or Property, Plant & Equipment (“PPE”).
  • Applies to firms providing legal and other professional services remotely.
• Market-Based Sourcing Rules:
  • Income from services is sourced to where the client receives the benefit of the service (not always the client’s location, e.g., for real estate or M&A work; the benefit may be received based upon the location of the real estate or target).
  • Complexities arise in multi-state engagements where clients are in various jurisdictions.
  • Different states have different methodologies or varying definitions of “market” location, leading to potential double taxation or allocation disputes.

Detection by Tax Authorities

• Methods of Detection (often resulting in the issuance of a Nexus Questionnaire to be answered under penalties of perjury):
  • Data Matching: States use data sharing agreements and technology to track out-of-state firms with in-state revenue.
  • Audit Programs: Regular audits, often triggered by discrepancies or high-revenue engagements, can uncover unreported nexus, e.g., comparing 1099’s from resident businesses issued to tax returns filed (or, in this case, not filed) by nonresident law firms.
  • Court Dockets: Reviewed for nonresident attorneys/firms listed on the dockets appearing pro-hac-vice and matching to tax return filings.
  • Resident Partners: Some states require the filing of a partnership return by having resident partners within the state, e.g., New Jersey and New York will match the partnership’s employer identification number (“EIN”) shown on the resident partner’s individual return to see if the firm has filed returns with the state.

How Law Firms May Create Exposure

• Risk Areas:
  • Thresholds: Ignoring economic nexus thresholds, assuming physical presence is necessary.
  • CoP vs. MBS: Incorrectly applying cost of performance (the physical provision of services) instead of market-based sourcing.
  • Record Keeping: Failing to track where the benefit is received for the services performed.
  • Consistency: Failing to apply methodologies consistently between standards and/or years.
  • Revenue Reclassing: Moving MBS revenue out of one state but failing to source it to another.

Financial and Professional Consequences for the Failure to File

• Financial:
  • Tax Liability: Significant back taxes, penalties, and interest for unreported income in states where nexus exists, which can be 6-10 years due to lack of statute of limitations.
  • Increased Compliance Costs: More robust accounting and tax procedures are needed to track and report multi-state income.
  • Potential for Double Taxation: Varying state rules may lead to income being taxed in multiple states, with partners failing to get corresponding credits on their resident state returns.
• Professional:
  • Reputational Risk: Being flagged for non-compliance can harm a firm’s reputation, especially among high-profile clients.
  • Client Relations: There is potential for strained client relationships if compliance issues affect service pricing or delivery.
  • Operational Disruption: Audits and legal disputes can divert resources and focus attention away from core business operations.
  • Other Risks: Failure to file tax returns could be deemed misconduct, potentially impacting attorney licenses under the ABA Model Rules of Professional Conduct and other states’ model rules for professional conduct. Firms/partners should seek guidance from legal professionals concerning potential consequences for the failure to file.

Mitigation Strategies

• Proactive Compliance: Regularly review state nexus rules and revenue sourcing laws.
• Advisory Consultation: Engage tax professionals like Anchin, who specialize in multi-state taxation in the legal industry.
• Technology Solutions: Implement procedures to accurately track and allocate revenue by client location (or market benefit location).
• Voluntary Disclosure Programs (VDPs): The financial impact can often be limited as most states offer VDPs, which will eliminate or reduce penalties and years to file.
• Pass-Through Entity Tax (PTET) Elections: Timely filed returns with a PTET election can further reduce overall tax liability by providing a federal deduction for the tax.

Law firms must be vigilant about their tax obligations under economic nexus and market-based sourcing rules. Failure to comply can lead to severe financial and reputational damage. Proactive management and regular consultation with tax professionals are essential to navigate the complexities of these regulations.

For more information on economic nexus and market-based sourcing, please contact Steven Lando, Tax Partner and Co-Leader of the Law Firm Group, Deborah de Vries, Partner and Co-Leader of the Law Firm and Compensation & Benefits Groups, or Alan Goldenberg, Principal and Leader of the State and Local Tax and Tax Controversy Groups.