New Hampshire Law Partners Face Maine Income Tax

Originally Published on forbes.com on October 17th,2011

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Anytime anybody has brought up the idea of forming a professional corporation to hold a partnership interest in a practice, I have been underwhelmed by it.  The benefits never seemed to outweigh the risk and aggravation.  A May decision by the Supreme Judicial Court of Maine, Daniel P. Luker et al v State Tax Assessor, though, finally showed me one that seemed to be worthwhile.  Sadly, the State of Maine was able to defeat it.  Perhaps even more sadly and ironically it may have been poor execution more than anything else that caused the plan to fail.

Probably because of that “Live Free or Die License Plate”, New Hampshire has a somewhat overrated reputation as a tax haven.  New Hampshire has an interest and dividends tax, a business profits tax and business enterprise value tax.  New Hampshire treats flow through and disregarded entities in an entirely different manner than any other state.  Don’t get me started.  At any rate, some of the reputation is deserved in that it does not assess income tax on wages and proprietors and partners of operating businesses can treat some of their profits as wages.  Maine, on the other hand, has a fairly normalstate income tax based on federal adjusted gross income.  Non-residents are taxed on Maine source income.  These disparate systems presented a problem for Preti, Flaherty, Beliveau, Pachios & Haley (Preti), a Mainelaw firm that wanted to merge in a New Hampshire practice.  The new partners, Daniel P. Luker, John M. Sullivan, and Simon C. Leeming (LSL) even though they would continue to work in New Hampshire would have to pay income taxes to Maine on some of their income.

It is, of course, more complicated than that.  Preti would presumably have to pay NH business profits tax on some of its revenue, but the Maine partners would get a credit for that and the deemed compensation deduction would minimize it.  When flow through entities operate in multiple states they typically do an apportionment based on payroll, sales and property similar to what most corporations do.  The result is a percentage of income taxable in a particular state.  Each computation is different for each state so if you added up the percentages you will rarely get 100%.  This gives rise to some fascinating planning opportunities for billion dollar multinationals.  For regional professional practices it is just aggravation.  Because of the credits for taxes paid to other states it is usually not that big a deal in New England – unless you live and work in New Hampshire, but have partners in other states.  In the case of a partnership like Preti, the simple solution would seem to be to allocate its Maine income to its Maine partners and its New Hampshire income to its New Hampshire partners with one or the other group having to pick up some out of state income in order for it to balance out.  Great idea.  Only Maine doesn’t let you do that. (Neither does Rhode Island).

They came up with a different solution.  The three New Hampshire attorneys formed professional corporations which were admitted to the Maine partnership.  The case does not explain this, but I think I understand how it works.  The corporations would have Maine source income and would be required to file in Maine, which some of them did.  The corporations would, however, pay out most of their income as salaries to their principals.  So Maine would not have any corporate profit to tax and would not have any claim on the salaries since the guys were working in New Hampshire.  Not that it necessarily matters, but these guys were not really trying to get away with anything very nasty.  They lived and worked in New Hampshire.  If Preti had taken them on as employees in a New Hampshire office, they would have no exposure to Maine income tax.  The only reason they might have had Maine income tax is because they were partners rather than employees.  It is no wonder that the Maine Society of CPA’s filed an amicus brief in this case.

Maine attacked the arrangement by disregarding the existence of the corporations:

In November 2006, the Assessor sent an identical letter to each Attorney, stating that because it viewed the creation of the PCs as an attempt to evade Maine individual income taxes, it intended to disregard the PCs and treat the individual Attorneys as if they had received the partnership distributions.

I recently wrote about a dentist, who came to regret having an employment agreement with his professional corporation.  It prevented him from calling proceeds of the sale of his practice personal goodwill.  Since there was only one employee in each of the corporations and it was the same person as the shareholder, the New Hampshire attorneys did not bother with employment agreements.  Oops:

Although the Attorneys argue that the PCs’ right to control “necessarily exists” because there is an employment relationship between each of the Attorneys and his respective PC, they provided no documentation or other proof setting forth job expectations, employment terms, level of compensation, or any other evidence by which a court could conclude that the PC determined—or could determine—the manner or means by which the Attorneys provided their legal services to Preti. At summary judgment, the court noted that the PCs had presented no evidence of “any meaningful control [by the PCs] over the [Attorneys], their services, or their income.”

It is difficult to believe that the attorneys could have won this case if they had entered into agreements with themselves and did job reviews with themselves, etc,, but that is how the decision came out. One judge dissented noting: 

The issue of a written employment contract is a “red herring.” Requiring a written contract elevates form over substance. A corporation can employ individuals. New Hampshire law does not require employment contracts. Why should an employment contract be required for the attorney employee? The professional corporation is limited by the Preti Flaherty agreement to representing clients of the firm. The attorney is further limited in his work by the New Hampshire bar rules.

The dissenting judge was concerned about the implications of the decision for cross-border legal practice:

The majority opinion will force New Hampshire lawyers who are partners of Maine interstate law firms to give up their partnership status and remain employees, or face Maine income tax. This has negative ramifications for these lawyers and will inhibit Maine firms from merging with firms in other states. In order to remain associated with Maine firms, out-of-state attorneys will be forced to give up the major benefits of partnership.

 A concurring opinion expressed similar concerns:

I write separately to emphasize that our decision today should not be read to hold that persons who live and work outside the state and generate income outside the state for Maine-based businesses must have their out-of-state earnings treated as Maine income for Maine income tax purposes. Interstate businesses headquartered in Maine, whether the business is law practice, retail sales, construction, or any other activity that generates income outside the state, do not, by having their headquarters in Maine, subject all their employees who live and work outside the state to Maine income taxation on earnings generated in other states.

The reason for the result here is the litigants’ choice to focus on structuring corporations to receive income distributions, raising issues of law akin to those presented in attempts at corporate structuring for tax avoidance under federal income tax law, which presents no interstate taxation issues.  …

Luker’s original complaint included claims that (1) the New Hampshire partners’ income was not Maine source income, and thus not subject to Maine income taxation; and (2) an apportionment formula exempting most of the income from Maine income taxation should have been applied. As the Court’s opinion indicates at , those issues were removed by stipulation from the case and from this appeal. Thus, based on the parties’ litigation strategy, this opinion does not address taxation of employees of Maine-based businesses who live, work and generate income for the business from sources outside the State of Maine.

This judge seems to be indicating that an attack on the Maine statute that prevents special allocation of income based on where partners are working might have had some sympathy.  The status of a partner in a large multi-state professional partnership has elements of being an employee, a sole proprietor and the owner of a large multi-state flow through corporation.  A law firm with an “eat what you kill” compensation structure  will not be allocating much of its income based on ownership so the reality is that partners are earning the bulk of personal income in their state of practice and not really getting much benefit from what their partners earn in other states.  Maine’s statute, possibly for administrative simplicity, or, perhaps, to capture as much tax as possible from out of state partners, ignores this reality.  The work around of using New Hampshire professional corporation might still work, but clearly the files need to be better papered.