Is levying a sales tax on legal services opening a can of worms?

By Mike Scott

Legal News

A proposal touted by Governor Jennifer Granholm in which the state's sales tax would be lowered from 6 percent to 5.5 percent but applied for the first time to a wide range of services ranging from haircuts to legal fees could have a significant impact on the legal field.

While nothing has yet been finalized, such a sales tax could be implemented on a number of professional and personal services, although it would appear as if many if not all business-to-business services would be exempted. But the biggest issues related to adding a sales tax on legal services may relate to how certain transactions would be defined by the state and the operational challenges that law firms would experience as a result.

Granholm's proposal would generate $554 million more for schools and allow business tax reductions, she has said. Recently two Democratic legislative leaders, including State House Speaker Andy Dillon (D-Redford Township), have said that Michigan voters might be asked to decide on a tax increase in August if the Legislature can't agree on other ways to avoid deep funding cuts to public schools.

A sales tax on legal fees would be a bookkeeping nightmare for firms and sole practitioners around the state, said Henry Gornbein, a partner with Gornbein, Fletcher & Smith, PLLC in Bloomfield Hills. Gornbein knows that the legal community strongly opposes such a measure.

"We'd have to pass those costs down to our clients, whether businesses or individuals," Gornbein said. "I personally think it would make more sense to have a graduated income tax structure because that would make the assessment much fairer."

Even a sales tax would have a significant impact not just on legal clients but on the firms themselves. Adding such a cost to legal services may make it more cost prohibitive, Gornbein said. That could be particularly true for lawyers that work with individuals rather than corporations.

"When you are talking another five or six percent on the legal fees that starts to add up quickly so yes I think (a sales tax) would hurt many law firms," Gornbein said. "I don't see anything positive coming out of it."

There is a pyramid challenge related to assessing a sales tax on legal services as well, said Greg Nowak, a state and local tax lawyer and principal at the Detroit law office of Miller Canfield. Nowak is also chair-elect of the Michigan Association of CPAs.

The challenge is that large companies that can afford in-house counsel would not be assessed a sales tax on the services that smaller firms might need to outsource, putting them at a significant economical disadvantage, Nowak said.

"From a practical standpoint the state would have to identify and implement what a business-to-business exemption means," Nowak said.

The reality is that many legal services include mixed transactions that benefit both a company and an individual/family. So the challenge may be defining the line of what constitutes an exemption and enforcing it. For example, the state would have to more clearly determine what expenses could be considered business deductible, Nowak said.

Such a tax on not just legal services but other professional services could put Michigan-based providers at a financial disadvantage as well, he added. The Michigan Business Tax would have to identify how taxes are assessed, such as where the service was purchased or where it was consumed.

For example, if the sales tax was enforced on where a service was purchased, it might be cheaper for residents to use legal or tax providers in neighboring states where a sales tax would not be imposed.

"You don't want to create an incentive for purchasing services outside of the state and penalizing businesses here," Nowak said.

There is little positive about a possible sales tax on legal services in the eyes of Mark Haddad, an attorney with The Law Offices of Haddad and Haddad in Clinton Township. Haddad, though, doesn't see a possible 6 percent tax on legal fees as having a major impact on the amount of business his firm obtains.

"My clients are here because they have a problem or legal need," Haddad said. "Obviously it would be a tax we would simply assess in client bills."

However, the greater burden may be on the law firm itself from an operational standpoint, Haddad said. The question would be how the state might plan to collect the sales tax. If it uses a typical sales and use tax approach, the impact might be negligible. On the other hand, if law firms would be forced to collect and report the sales tax, the result could be devastatingly costly.

"The devil is in the details. If we have to train our staff or pay our accountant to handle such transactions, that's an added hidden cost that could be substantial," Haddad said. "Running a law office is difficult enough as it is."

Nowak agreed, saying that all law firms would share the burden of proving exempt status on certain fees. That burden would be of a compliance nature, raising firm costs while simultaneously squeezing margins.

The State Bar of Michigan also could become involved in the debate if it chooses to express opposition to legal sales tax if it is determined that a sales tax on legal services would create a barrier that prevents certain individuals access to such services, Nowak said. While the legal professional is largely restricted to lobbying efforts, if access to legal services is identified, an objection from the legal community may be appropriate.

In particular, the ability of residents to have access financially to family and divorce lawyers and criminal defense attorneys could be significant.

Confidentiality also could be an issue. If Michigan Treasury agents conducted regular audits as part of the sales tax collection process that could open up what Haddad refers to as a "new can of worms."

"Many of our clients don't want a paper trail and confidentiality could become a big issue," he said.

Given the number of challenges to implementing a sales tax on legal services, Gornbein doesn't expect that such a tax is likely to be instituted in the near future. It also would be difficult to justify a sales tax of legal services on individuals even if businesses are exempt, he added.

"The odds are slim but you never know -- the state is in a (precarious) financial position, so I would imagine some taxes will be raised somewhere," he said.

The pressure of a collective lobbying effort might make it difficult for the state to justify the passing of an overhauled service tax law, Nowak said.

"It will be a lobbying free-for-all as this battle heats up and those (industries) with a strong lobbying presence have a better chance to see their services be exempt," he said.

Haddad though believes some type of tax on legal services could be possible in the future.

"It keeps rearing its ugly head because this is a topic that doesn't ever seem to go away," he said. "At some point it may be inevitable."

Published: Thu, Apr 8, 2010