Nexus Review - Navigating Multi-State Tax Issues By: Chris D. Clayton, CPA, JD, Managing Partner, Babush, Neiman, Kornman & Johnson, LLP, cclayton@bnkj.com

Growing a firm is not easy. Growing into a neighboring state may add a myriad of tax complexities. While no one would ever accuse the Federal tax law of being simple, it is nothing compared to the multi-state tax issues that law firms can face. The following is a brief discussion of the some of the issues and complexities you may face.

The Facts

Your law firm's sole office is in metro Atlanta. All partners are residents of Georgia. However, some have clients who have operations in neighboring states. Many consultations are done over the phone or e-mail. Your partners expect to occasionally meet with their clients, visit accident scenes, construction sites, or do due diligence in the neighboring states. The law firm is an LLP for federal tax purposes.

The partners are concerned about meeting any tax responsibilities that they may have in the neighboring states. The neighboring states are Alabama, Florida, North Carolina, South Carolina and Tennessee. Some of the partners are admitted to the Bar in one or more of these states.

The states bordering on Georgia have a number of different systems for taxing non-resident LLP's and non-resident partners. Each of them have certain formalities which must be met before a foreign (i.e., Georgia) entity can do business in their state. This generally involves applying for a certificate of authority and paying an entrance fee (e.g., Tennessee is $600).

Three of the states, Alabama, North Carolina, and South Carolina, have an income tax on non-resident partners and treat the entity as non-taxable. They require the entity to file an information return. Florida and Tennessee do not have a personal income tax, but Tennessee requires the entity to file a return and to pay a 6 ½% tax on profits attributable to Tennessee. Florida does not have a similar requirement.

Alabama, in addition to requiring an informational return, requires a composite return for the non-resident partners, i.e., it taxes all of their Alabama income as if it were earned by one person and requires estimated payments. North Carolina and South Carolina allow non-resident partners to file either separate returns or a composite return. Both states require withholding, however, North Carolina allows a non-resident to avoid withholding by signing an agreement subjecting him to North Carolina tax.

The states also vary in the return due dates, ranging from March 15th to April 15th for a calendar year entity. In determining taxable income, all of the states start with federal taxable income and make several modifications (which vary from state to state). The states vary as to whether they require the taxpayer's federal return to be attached to the state return and as to whether they accept the LLP's federal form K-1 or require their own equivalent form.

In order for a state to tax a non-resident, the non-resident or the pass-through entity in which he has an interest, must have a significant connection with the state. The technical term for this is "nexus". Providing more than minimal, in-state consulting services is adequate to establish nexus in all the neighboring states. (It is adequate in almost every state that has an income tax). In addition, Alabama and South Carolina take the position that listing of a tie line in the phone book is adequate to establish nexus. North Carolina and South Carolina take the position that hiring a collection agency in the state to collect from clients is adequate to establish nexus.

Assuming the Georgia LLP has nexus with a neighboring state, that state will tax some portion of the LLP's taxable income (defined as federal taxable, as modified by the particular state's adjustments). Most states use a three factor formula to apportion income to the state. The factors are sales, payroll and property. Some of the states, like Georgia, double weight the sales factor, i.e. 50% sales, 25% payroll and 25% property. The double weighting states are North Carolina, South Carolina and Tennessee. Alabama single weights the factors. If an LLP has no property or payroll in a neighboring state, double weighting the sales factor is disadvantageous to the LLP.

Assume that 1) an LLP has $1 million of collections (sales) and that $1,850,000 from Georgia, 100,000 from Alabama, and $50,000 from North Carolina, 2) its payroll is $300,000 and that $250,000 is for time in Georgia, $25,000 is for time in Alabama and $25,000 for time North Carolina, and 3) it has $350,000 of property and all of it is in Georgia. Assume also that the LLP's federal taxable income (before payments to partners) is $400,000 and that there are no state modifications. The Alabama apportionment is 100,000/1,000,000 for sales; 25,000/300,000 for payroll, and 0/350,000 for property, or 10% + 8 1/3% + 0% ÷ 3 = 6.1111% x $400,000 of income = $24,444 of apportioned income.

The North Carolina apportionment is 50/1,000,000 for sales, 25,000/300,000 for payroll, and 0/350,000 for property or (5% x 2) + 8 1/3% + 0% ÷ 4 = 4.5833 x 400,000 = $18,333 of apportioned income.

Some states allow businesses to separately account for their in-state operations. This requires keeping separate records or a worksheet for these operations. In Alabama, Tennessee and South Carolina, separate accounting requires permission from the taxation authority. North Carolina does not permit separate accounting.

Georgia allows its residents a credit for taxes paid to other states, but that credit is limited to the tax that would have been paid to Georgia had all the operations been in Georgia. This means that essentially a Georgia resident's tax cost is the higher of Georgia's or the other state's tax. The Georgia credit also means that doing business in neighboring states generally has little or no tax cost; however, there is a cost in terms of dealing with complexity and paying increased professional fees.

Advance planning will help you to minimize your overall state and local tax burden. A tax advisor with a specialty in state and local tax can leverage a variety of different tax planning strategies to accomplish this for you.

Now if you think this is complicated, just think what planning is required for an international firm!

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Editor: Debra F. Goldman (dgoldman@gmlj.com) (This publication is the property of the Atlanta Association of Legal Administrators. Reproduction or reprint without prior permission is strictly prohibited. Click here to request reprint permission.)

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