The taxing matter of taxing legal services

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Published on 7/14/08

In the 1960s, the Beatles were all for peace and love — until they had to contend with Britain's then-draconian tax rates on the wealthy. The result was the nasty little song, "Taxman": "Be thankful I don't want it all ... /Don't ask me what I want it for/If you don't want to pay some more."

Many lawyers, of course, make a good living helping clients mitigate the impact of the taxman. But with states hard pressed for revenue, taxmen (and taxwomen) are trying to turn to an old revenue-raising staple: a tax on professional services, including those of lawyers.

To the best of my knowledge, Hawaii, New Mexico and South Dakota are the only states that collect sales tax on legal services. In recent decades, Massachusetts and Florida enacted sales taxes on services, but repealed them as unpopular and difficult to administer. States considering and rejecting service taxes include Maine, Maryland, Minnesota, Ohio, Pennsylvania and Vermont. But the issue is alive again in states from Georgia to Michigan.

In my home state of California, often the breeding ground of national trends, a service tax at the state's imposing 8.25 percent sales tax rate is being touted. The Los Angeles Times opined on the virtues of "focusing on a sales tax on lawyers and accountants, who presumably already have the number crunchers on staff to make sure the state gets its cut."

But a tax on legal services has strong specialized arguments against it. Here are just three:

  • States conducting tax audits could claim access to confidential client billing records, creating a serious conflict of interest for any lawyer. Also, requiring lawyers to collect sales tax from their clients could erode the attorney-client relationship and compromise the confidentiality of client communications.
  • A tax on legal services could create double or even triple taxation on some transactions. For example, during a real estate settlement in most states, the purchaser and the buyer already pay a transfer tax fee. Also, a decedent's estate is taxed during the estate administration. The addition of a sales tax would only lessen the decedent's bequest that his or her estate has passed on in accordance with the instructions in an estate document.
  • Recovery for bodily injury is not taxable under either federal or state income tax laws. A tax on legal services would erode the injury victim's recovery for such injury, thereby making it even more difficult — and potentially more expensive — for corporations and insurance companies to reach reasonable compromise settlements.

Of course, it has also been argued that a legal services tax hurts people who need financial help for some of life's toughest problems: a spouse seeking child support; an injured worker seeking compensation; a person trying to protect his or her family through the drafting of a will.

But, as the taxman might say in such instances, "Be thankful I don't want it all ..."

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