Tax Implications of Productizing Legal Services

Converting legal services into products like self-help books and videos, assessment tools, apps or chatbots invariably raises the same perennial issues for lawyers. Some lawyers obsess about the ethics of commoditization such as whether a product sold nationally might place a lawyer in violation of unauthorized practice of law (UPL) prohibitions or give rise to an attorney-client relationship, thus triggering malpractice exposure. Other lawyers are skeptical that a business model reliant on low-cost products can really make money or believe that commoditization cheapens the value of all legal services. But in the wake of the Supreme Court’s ruling in South Dakota v. Wayfair,  No. 17-494 (U.S. Jun. 21, 2018), lawyers aiming to productize their services must consider yet another issue:  the tax implications of the sale of legal products on a national scale.

Before we dive in, here’s a 60-second primer on state sales taxes – essentially those  taxes that states impose on the sale of products to in-state consumers.  Technically speaking, the buyer is responsible for paying sales tax – but obviously, requiring consumers to pay and track sales tax paid would be infeasible for them, not to mention an enforcement nightmare. Consequently,  those states that impose sales taxes pass the burden of collection  to sellers who must collect the state sales tax tax from customers when they make a purchase and remit those taxes to the state treasury.  But with the rise of interstate commerce– railroads and Welsh Fargo wagons and the like,  out-of-state sellers entered the picture, selling products to residents through mail order catalogues. Not surprisingly, states tried to snag a cut of sales taxes from sales by out of state sellers, but  the Supreme Court said no, finding that imposing sales tax collection obligations on out of state sellers with  no physical presence in the state would unduly burden interstate commerce in violation of the Commerce Clause.  And so, for the ensuing five decades, out-of-state sellers without a physical presence in a state enjoyed a prolonged holiday from in-state sales taxes. (For detailed discussion, see generally, W. Nelson, Smith Anderson, U.S. Supreme Court Overrules Quill, But Leaves Many Unanswered Questions ).

Come the 21st century and enter stage right, Amazon and the golden age of online sales.  As online shopping increased, consumer dollars flowed away from in-state brick and mortar shops to out-of-state sellers, reducing state tax coffers.  In aneffort to capture the revenues associated with online sales in the state, South Dakota enacted a law that required retailers making more than $100,000 in sales into the state or more than 200 sales to in-state consumers during a given year to collect sales tax on sales in the state. Predictably, sellers challenged the law, arguing that it violated the physical presence rule and unduly burdened interstate commerce. In response, the Supreme Court overruled the physical presence rule, finding that it must give way to the ‘far-reaching systemic and structural changes in the economy’ and ‘many other societal dimensions’ caused by the Cyber Age.” The Court went on to explain that carrying on a business within a given jurisdiction would satisfy the substantial nexus test.  In the wake of Wayfield, many states have been revising state sales tax laws to enable them to tax sales by out-of-state businesses.

So with all of that as a backdrop, let’s drill down on how and why this new ruing impacts lawyers. First of all,  lawyers who deliver traditional legal services need not worry about  the Wayfair decision. That’s because most states do not impose sales tax on professional services and there’s no sign that Wayfair will cause states to change that practice.  Because legal services aren’t subject to state taxes anyway, the Wayfair ruling allowing states to impose sales tax on out-of-state sellers is largerly irrelevant.

But all of that changes when lawyers convert traditional legal services into hard-copy books or digital products or apps or chatbots because many states subject digital products and/ or a software-as-a-service  (e.g.,  assessment tools like this product ) to state sales taxes.  So while prior to Wayfair, lawyers selling “legal products” to consumers in-state remained liable for sales tax (depending upon the state), post-Wayfair, lawyers selling legal products and apps nationally may be responsible for collecting sales taxes in every state where they sell.  Meanwhile, lawyers who try to skirt the rules by trying to characterize their product as a legal service won’t get very far because UPL rules would then prohibit the sale entirely. (Though admittedly, no sale = no tax!).

A detailed discussion potential state sales tax liability for sellers of legal products on a national basis is way beyond the scope of this blog post but depends upon a bunch of different factors such as:

• Whether the out-of-state seller has a physical nexus to a state;
• Whether a particular legal product is subject to state sales tax — an analysis that differs state to state and depends on the product’s unique characteristics such as  whether the product is digital (and if digital, whether it’s downloadable or an ebook or video or live or recorded);
• Whether the product is an online course that is considered purely educational in purpose (as opposed to mentoring or coaching) and/or offers credits or certification.

Two great resources for further research on these questions are available at the Taxjar.com Blog  and Avalara.com website which are two programs that automate sales tax collections, reporting, and filings.

As I’ve posted here before,  productizing legal services offers a myriad of benefits to lawyers — access to a wider market, a stream of recurring and largely passive revenue once the product is developed and the ability to create affordable DIY-tools to expand access to justice. Yet once lawyers cross the rubicon from genteel professional services purveyors to vendors hawking products, they must also contend with the tax realities that any other commercial business faces.  And I see it, that’s a good thing because it forces lawyers to check our exceptionalism at the door and join the real world.

[Editor’s note: