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

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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.

What is Economic Nexus?

The concept of economic nexus first emerged with South Carolina’s adoption of the standard in the early 1990s. Economic Nexus and MBS began gaining traction around 2011, with California and other states leading the way. With the U.S. Supreme Court’s 2018 ruling in Wayfair essentially blessing the economic nexus concept, at least within the sales tax context, the list of states employing income tax economic nexus continues to grow steadily. In general, states are constitutionally required to have a minimal connection in order to impose their taxes upon an out-of-state taxpayer. Economic nexus laws establish this minimum link via a revenue threshold which, if exceeded, is deemed enough of a connection with a jurisdiction to create a tax obligation for the out-of-state taxpayer.

Currently, all 45 sales taxing states have mandated some level of a “factor presence” threshold for purposes of establishing sales tax nexus. Additionally, about a dozen of those states also utilize a receipts threshold test for corporate income taxes (e.g., New York), and/or other tax compliance, such as partnership filings and excise taxes (e.g., California and Washington). Accordingly, determining how receipts are sourced to a state becomes critical in light of the potential for increased income tax exposure under economic nexus. This is particularly important for service providers due to the shift in state sourcing rules from the cost of performance methodology to the increasingly popular market-based sourcing approach.

State Sourcing of Service Revenue

The two primary models that states use to source service revenue for income tax purposes are: (1) cost of performance and (2) market-based sourcing.

Under the cost of performance approach, service revenue is sourced to the location from which the services are rendered, or more specifically, the place where the costs to perform the services are incurred. When services are performed in multiple jurisdictions, some states require that either the majority or greatest proportion of the services need to be performed in the state in order to source any revenue there — in essence, an all-or-nothing test. Other states divide the revenue proportionally based on the percentage of service rendered in the state compared to the overall whole of the service rendering.

For market-based sourcing, revenues are sourced to the location of the customer, or more specifically, the location where the benefit of the service is received. State regulations contain various criteria for determining the jurisdiction where the benefit is received, such as the customer’s billing address, the service delivery location, the order from location, or even a reasonable approximation based on the particular circumstances at hand.

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.