Tax law

The Arizona Supreme Court has ruled that it doesn't violate due process for a Connecticut law firm to face a legal malpractice lawsuit in that state even though none of the firm's lawyers are licensed to practice in Arizona. Legal experts, however, said there is little chance that facing a lawsuit in another state will lead law firms to stop the practice of issuing opinion letters to out-of-state clients on tax shelters.

I covered the case in a piece for the Connecticut Law Tribune. Here's an excerpt: 

The Arizona Supreme Court has ruled that a Connecticut law firm with no lawyers licensed to practice in Arizona can nevertheless be the target of a malpractice claim from two Grand Canyon State residents. But the ruling is not likely to curtail the practice of law firms writing opinion letters for out-of-state clients in tax matters, according to legal experts.

In exchange for a $50,000 fee, Bridgeport-based Pullman & Comley and partner D. Robert Morris prepared an opinion letter for Arizona plaintiffs Bill and Sue Beverage some 13 years ago. The letter opined that it would be legitimate under federal tax law for the Beverages to take advantage of a tax shelter known as a custom adjustable rate debt structure.

However, the Internal Revenue Service rejected the couple's tax return and their declaration of substantial losses related to the tax shelter. They ended up being assessed $3 million.

In a two-page opinion, Chief Justice Rebecca White Berch affirmed that the Connecticut defendants are subject to Arizona's specific jurisdiction—even though the firm does not have an office in Arizona and does not have any attorneys licensed to practice law there. Pullman & Comley now have to face claims of civil racketeering, fraud, breach of fiduciary duty, conspiracy, professional malpractice and negligent misrepresentation in Arizona.

Adam Chodorow, a professor who teaches tax law at Arizona State University Sandra Day O'Connor College of Law, said the Arizona Supreme Court decision won't cause firms to step away from issuing opinion letters on tax matters. Instead, he thinks firms are going to insert choice-of-forum clauses—which stipulate the court or jurisdiction in which any subsequent legal actions will take place—when they advise out-of-state clients about tax shelters.

"Any firm that wants to can insert a choice-of-forum clause in any contract with a client," Chodorow said, adding that such clauses are typically upheld by the courts. In this case, such a clause might have prevented Pullman from "getting stuck in court in Arizona."

Chodorow also said law firms that issue opinion letters are going to weigh the costs of potentially being sued by an unhappy clients in a far-off state against the benefits of the business they get from issuing opinion letters.

"I guarantee you, if the money is there, and the client base is there, they'll either accept the risk or assert the forum clauses," he said.

Stephen Utz, a professor at the University of Connecticut School of Law who teaches federal tax law and policy, said the case of Beverage v. Pullman & Comley highlights the risks involved in opinion letters.

As far as the IRS is concerned, taxpayers are still subject to tax penalties even if they have an opinion letter from a law firm stating that a certain investment, deduction or other financial maneuver is legal, Utz said.

"Some law firms don't do letters of this kind in order not to disappoint clients and not mislead them that something is going to be great" when it won't, he said.

Other law firms, however, not only give opinions on tax shelters but design them and market shelters, Utz said.

The IRS has made it more difficult for tax lawyers to give advice on tax shelters, Utz said. The agency has specific penalties for "material advisors," which may include lawyers, who don't report to the IRS when clients have consulted them about certain tax shelters, he said.

The penalties were "intended to be intimidating and to persuade some tax practitioners not to do this," Utz said.

Facing lawsuits in out-of-state jurisdictions over tax-shelter legal advice gone wrong is not what will dissuade law firms from doing this kind of legal work, Utz said. But, he added, penalties from the IRS will.

I wrote a piece for The Connecticut Law Tribune on a law professor who has gone from reforming tax codes in China, Zambia, Vietnam and Gambia to proposing changes to how taxes are divided between states in which multistate corporations do business.

A story excerpt:

Richard Pomp has drafted tax codes in China, Zambia, Vietnam and Gambia.

One lesson he learned as an academic consultant is that it's a good idea to get the business community invested in the new tax rules. Another lesson is that a smaller country's taxing powers more closely parallels the circumstances in a state like Connecticut than in a big country like the United States.

A developing country "can't control its environment, [is] really at the mercy of forces outside of its control, [is] outgunned and outmanned" by the law firms and accounting firms hired by global corporations, said Pomp, a professor at the University of Connecticut School of Law.

Because a state government faces similar challenges, Pomp decided to parlay his international tax work into studies of state taxation. He was interested in how state governments with their modest powers figure out how to fairly tax businesses that operate in their jurisdiction and in many others as well.

The professor's expertise in state taxation has proved useful as he spent 383 hours on a pro bono project as the hearing officer for the Multistate Tax Commission on proposed changes to the Multistate Tax Compact.

The compact was developed after the U.S. Supreme Court ruled that states could tax interstate commerce through state income taxes. The commission is the administrative arm of the compact.

It was a national, non-partisan association known as the Uniform Law Commission that first came up with a way to fairly divide the taxable income for multistate corporations among the states in which those corporations do business. That model law, the Uniform Division of Income for Tax Purposes Act, was developed in 1957.

According to Pomp, the act provided the states with a fair way to tax multistate corporations by using a formula based on what percentage of its property, payroll dollars and sales totals that a corporation has within any single state's borders. (Connecticut never bought into the act, Pomp said. Instead, it bases its taxes on a single factor—the percentage of a company's sales that come from Connecticut.)

However, Pomp said, the taxing model has become antiquated over the last half century, with the economic shift away from manufacturing and toward service industries, as well as the development of the Internet and the digitalization of what used to be tangible property.

As a result, many states have moved away from the Uniform Division of Income for Tax Purposes Act, and have adopted their own tax-computing formulas, often for the purpose of economic development and attracting business to their states. "As the economy gets more complicated, everyone realizes that this model act that goes back to 1957 is hardly a model anymore," Pomp says.

When the Uniform Law Commission decided against updating the model law, the Multistate Tax Commission decided to step into the breach. Pomp's report to the commission suggests changing the formula for taxing multistate businesses by allowing each state to weigh the factors of sales, payroll and property however it chooses. He does, however, suggest giving the percentage of sales a company has in a state twice the weight of the other factors.

The Multistate Tax Commission's executive committee is slated to debate Pomp's report on Dec. 12. Pomp said he hopes that some of his suggestions will provide food for thought even though he proposed changes to the commission's own recommendations. Shirley Sicilian, general counsel for the Multistate Tax Commission, said during a recent press conference on Pomp's report that the goal of the model revisions is to provide something for state legislatures to draw on as they modernize their own tax laws.