Alleged Spitzer-Prostitute Liaison Raises Tax Questions

March 11, 2008

As we mentioned yesterday, the alleged paid encounter New York Gov. Eliot Spitzer had with a prostitute at the Mayflower Hotel raises (to us, at least) some interesting tax questions.

If sales tax were imposed on services, which state could tax it?

Most states do not impose sales tax on services, especially illegal services such as the one that allegedly took place here. But assuming that they did, which state would get to tax this transaction? It appears that while the services were performed here in Washington, DC (and just a few blocks from our office!), some of the money was wired to New York, and Spitzer (here in DC) allegedly negotiated with the prostitute’s service, Emperor’s Club VIP, also based in New York. Maybe they would split the difference, with the $400-$500 deposit taxed by New York, and the remainder of the $2,721 he paid taxed by DC.

To which state would Emperor’s Club VIP pay income tax?

So that’s sales tax, but what about income tax, which must be paid even on illegal income? Emperor’s Club VIP earned a hefty amount of the 2-1/2 hour transaction, but to which state would they have to pay income tax-DC or New York? While on her way to and from the transaction, “Kristen” took the train, passing through the states of New Jersey, Pennsylvania, Delaware, and Maryland, and perhaps each of those states might try to get in on the action?

Determining whether a state can constitutionally tax income is a process known as determining nexus: is the transaction, or the company involved, sufficiently related to the state to justify their taxing it? Nexus rules are a mess, primarily because states are moving away from a physical presence standard, which says that a state can only tax a business if that business has employees or offices in the state. Under a physical presence standard, only New York could tax Emperor’s Club VIP’s income since that’s where it had offices and employees.

Interestingly, Gov. Spitzer has been a leading advocate of rejecting the physical presence rule in favor of economic nexus, a nebulous and dangerous standard which would subject businesses to taxation by essentially any state where it has customers. There are lots of horror stories of small businesses making one sale through the mail to one customer in some state, and being hit with hefty registration fees and income tax demands. It also represents a serious threat of Internet commerce. A bill (BATSA) is pending in Congress to prevent these shakedowns.

Under economic nexus, which state could tax the income earned from the Spitzer-Kristen transaction? Probably all of them could, although states have de minimis (minimum) rules that exclude activity of brief duration. Most would consider 2-1/2 hours brief, but DC might try to tax it anyway.

Depreciation of Human Capital

Most businesses can deduct “depreciation,” which is the wearing out of capital assets, according to schedules in the Internal Revenue Code. The recent stimulus package even provides for “bonus depreciation,” which is an accelerated deduction for a few years on the purchase of eligible equipment. However, barring new revelations about the encounter, it’s unlikely that either Emperor’s Club VIP or Kristen can deduct the depreciation of their assets due to use by clients, as courts have consistently ruled that there is no tax basis in human capital. “[T]he earnings of the human brain and hand when unaided by capital…are commonly dealt with in legislation as income.” Stratton’s Independence, Ltd. v. Howbert, 231 U.S. 399, 415 (1913). The same would be the case for the human body.

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