Why taxing legal services in Oklahoma should fail: Not for the reasons you might think

by Leif Swedlow

State news headlines – well, at least the ones that lawyers perk up about – say that Governor Fallin’s push for “modernization” of Oklahoma’s sales tax base may lead to changing the state tax code to require sales tax on many forms of personal and professional services, including legal services. Quite a few lawyers have already spoken out with strong opinions against taxing their profession. Let’s look at the subject objectively.

1. Is Oklahoma’s sales tax system really out of date?

Umm, perhaps not. Oklahoma is among the vanguard of states that have aggressively pursued tax collection on Internet-based purchases from out-of-state retailers. Recognizing that much of this potential tax revenue was going uncollected because consumers tend to not self-report their online purchases, in May, 2016, Governor Fallin signed into law the “Oklahoma Retail Protection Act of 2016,” expanding the ways in which the Oklahoma Tax Commission could connect the cyberspace dots so that out-of-state merchants will have to charge Oklahoma sales tax when Oklahomans make online purchases. This change notably takes aim at what has been described as the “Amazon loophole”. Going forward, if an online seller offers products of “affiliates” who are in Oklahoma – a big part of Amazon’s business model – the seller gets treated as “doing business” in Oklahoma and must therefore collect and remit sales tax, the same as any Mom-&-Pop brick and mortar store. Amazon is set to start collecting and remitting Oklahoma sales tax on March 1, 2017. And no, Oklahoma is not the last state to close the so-called “Amazon loophole”.

Those who argue that Oklahoma’s sales tax system is outdated tend to cite studies showing that Oklahoma is among the states with the lowest tax revenues from online sales, thereby “missing out” on hundreds of millions of dollars of possible tax collections. That is not so much the fault of the legislature as it is a function of federal jurisprudence. The 1992 Supreme Court case of Quill Corp. v. North Dakota held that to avoid undue double taxation in multiple states, each state could only impose sales tax remittance duties on out-of-state sellers if the seller had a sufficient “nexus” with the taxing state. In 1992 the main concern for state tax authorities was the loss local sales and tax collections due to popular mail-order catalogs (who remembers those?) The distribution networks of that time, involving physical offices, retail stores, company-owned distribution centers and other physical presence in many states allowed those states who had some part of the merchant’s physical “footprints” in their borders to close the “mail order” sales tax loophole. Now “catalogs” are largely Internet-based and delivery of the vast majority of online purchases is accomplished by common carriers (Fedex, UPS, USPS). Retailers use a much smaller number of more massive central distribution warehouses, supplemented by significant reliance on “drop-shipping” where a manufacturer or wholesaler sends retail-ordered goods directly to the consumer without the retailer ever actually handling them. Despite this evolution of the retail goods supply chain, the Quill precedent remains on the books. To understand why Oklahoma’s collection of “Internet sales” taxes lags behind many other states, consider how many popular online retailers have significant direct operations in Oklahoma. Dell Computers, perhaps, due to its Oklahoma City call center, but not many others.

The new law is not Oklahoma’s first attempt, so it seems unfair to even claim that Oklahoma is late in making its efforts. In 2010 Oklahoma sought to reap more of the potential Internet commerce sales tax harvest by requiring citizens to report their online and other out-of-state purchases and remit “use tax” with their annual income tax filings. Use tax is basically the same as sales tax, but with the remittance duty imposed on the buyer. Naturally, most consumers conveniently forget to tally up their Amazon purchases on their annual Form 511’s. Colorado adopted a similar approach to taxing Internet sales, except that Colorado’s law also required retailers to submit reports to the state tax agency on sales within Colorado that would be subject to the use tax assessment. The federal Tenth Circuit Court of Appeals held that the imposition of the reporting duty on out-of-state retailers did not run afoul of Quill. In December, 2016, the U.S. Supreme Court decided not to disturb either that decision or the underlying Quill rule.

2. Would clients flee to other states?

In fairness, probably not, for three reasons.

First, rates for legal services in Oklahoma are a bargain compared to rates elsewhere. I was chatting with an Oklahoma businessman recently about the legal fees his Internet-based company has been paying during a lengthy court case. The case is being handled by lawyers based in Phoenix, Arizona, a city of comparable size and with an overall cost of living on par with Oklahoma City. The lawyers involved have similar experience to mine, but their rates are literally double the rates of my firm and other metropolitan OKC firms – 100% more expensive per lawyer, per hour. He bemoaned the fact that he hasn’t been able to convince his business partners, who happen to be in Arizona, to change law firms. I do not believe this is an isolated example. I regularly work on cases in tandem with out-of-state lawyers, and it is rare for my firm’s rates to be higher than the out-of-state firm’s rates.

Second, to engage in the practice of law in Oklahoma, the lawyer either has to be a member of the Oklahoma Bar or teamed up with an Oklahoma Bar member for pro hac vice permission to work on a specific case in an Oklahoma court. There are lawyers with multiple state bar admissions (I maintain a Texas license, for example, which can be activated when needed), but they are a small minority.

Third, the sales tax for any significant matter would likely be small compared to the added cost of hiring an out-of-state lawyer. The expenses incurred for trips by the out-of-state lawyer to come to Oklahoma for required court appearances, or the added cost of retaining the required local counsel, would quickly exceed any perceived tax savings.

3. Has taxing lawyer fees worked elsewhere?

Hawaii, New Mexico and South Dakota currently impose a gross receipts excise tax directly on lawyers. In the 1980’s, Florida experimented with a more conventional direct sales tax on lawyer services, but repealed it, after a firestorm of lobbying by essentially the entire business community, confusion and complexity in assessing and apportioning the tax between in-state and non-taxable legal fees, and the Florida Governor’s ultimate loss of faith in the measure, encouraged by his falling popularity over the tax’s public backlash. In other states where tax on legal services has been considered, its impact on the right of access to courts has been raised. It already takes hundreds of dollars just to file a lawsuit, even before a lawyer’s fees are considered (though Oklahoma’s filing costs are not unusually high).

4. Who would really be affected?

Here is where the problems begin. Lots of people need legal services, but the consumers of legal services who can most afford to pay a tax on top of their lawyer’s bill – large corporations – will easily be able to avoid much or perhaps all of the tax they would incur simply by shifting work to salaried in-house attorneys. Individuals going through divorces, small business owners needing help with required licenses, compliance audits, or vendor disputes, and the unfortunate souls who need DUI defense – these are the people who need lawyers, and who will not have the luxury of going elsewhere or shifting to a tax-free option. Thus, the proposed taxing of legal services would be strongly regressive, imposing what is on the surface an “equal” measure of tax but having a significantly more painful impact on those who can least afford it.

5. Would it actually close the state’s budget deficit?

No, not unless Oklahoma lawyers start charging New York hourly rates (some firms there now bill over $1,000.00 per hour). The legislature has been shown a study of potential revenue collections for the 164 various categories of services that could end up subject to sales tax. It shows that dropping legal services from the list – and other professional categories such as accountants, architects and professional engineers, would not make a significant impact on the overall goal of sourcing nearly a billion dollars of new tax revenues out of Oklahoma citizens’ pockets. My review suggests that the forecasted tax collection data has been manipulated to some extent, because, for example, it divides up common construction trades such as drywall, carpentry, electricians, plumbers and masons, into at least 15 different categories, and it is hard to imagine that “general medical and surgical hospitals” in Oklahoma would have taxable gross sales of under $200 million per year. But setting aside those worries, the broad category of “Legal Services” would potentially yield between $42-$45 million per year in tax collection, before the impact of such market changes as businesses shifting their legal needs to in-house counsel. Some other areas being targeted for the addition of sales tax: Utilities for residential use is estimated to be capable of generating over $132,000,000.00 in tax revenue per year. (One may wonder, and some may complain, about why utilities for commercial and industrial use are not being considered for possible taxation.) Taxing construction trades, excluding professional architects and engineers, would potentially draw in over $145 million in tax assessments per year. Taxing Cable T.V. would generate over $65million per year (yes, that means that more money is spent on T.V. watching than the amount that gets spent on lawyers). The above-discussed 2016 tax code change that addressed the “Amazon loophole” is expected to generate over $300 million in added tax collections per year.

One final data point that puts a bit of perspective on these numbers: according to several published sources, the amount of federal money that Oklahoma turned away because of its stance on the Affordable Care Act was in excess of $1.2 billion.

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