By Judy Vorndran and Meredith Smith
How income tax nexus led to the slippery slope of sales tax nexus for multistate businesses.
Nexus is a legal term that limits states’ ability to tax an out-of-state entity or person. For a state to assert their tax status over a business that is physically located outside of its boundaries, the state must look to how the facts adhere to the standards of nexus laws and abide by them. States are also bound by the US Constitution and Federal laws that prohibit them from overtaxing out-of-state companies so that they do not burden interstate commerce.
In other words, nexus is the legal channel states use to carve out their slice of the American income tax pie, and carve they do. Nexus today carries with it a mind-boggling number of items, each individually defined by state and local governments across the nation. With over 11,000 local taxing jurisdictions on top of the 50 states, that’s a lot of nexus definitions that might make a business liable for tax obligations.
Adding to the complexity are the many different types of nexus, such as physical, economic, factor presence, agent, affiliate and click-through. In some states, if a taxpayer is deriving income within that state, that can be enough to create nexus and a tax obligation, known as factor presence or in the case of sales taxes economic or Wayfair nexus. Other states have carved out a safe harbor for taxpayers with limited business dealings in their area. In between those two extremes are a variety of nexus laws driving up state and local tax revenues and multistate compliance for both income and sales taxes.
Let’s break down nexus and what a business needs to do when they have it.
Historically, nexus was based on physical presence. People, payroll, inventory, assets, office locations, and real estate all represent a tangible presence in a state that allowed that state to assert its taxing authority over a business or individual. When that physical connection existed, the business had to abide by that state’s income and sales tax laws.
Over time, the concept of nexus has morphed into a wholly different beast. Since the 1940s, the physical categorization for imposing an income or sales tax has changed as interstate transportation became more common. Even if a taxpayer has a minimal presence in a state, such as one remote employee working from home, this can constitute nexus if a state has not established a de minimis safe harbor.
Some states would say that if you’re deriving income in their jurisdiction, that’s enough to create nexus. Other states have de minimis standards that are either dollar amounts or numbers of transactions to give small sellers a safe harbor. While these carve outs eliminate tax obligations in some states, other state laws are silent. A de minimis standard might include a limit on the number of days people are allowed to be physically present in a state before they were subjected to income taxes or eliminating trade show nexus. A taxpayer spending, say, less than 10 days in a state in a calendar year would not need to file an income tax return in a state that explicitly created this carveout.
With the carveouts, states abandoned a bright line test for measuring when they could assert income or sales tax over out-of-state taxpayers. Few taxpayers were actually tracking the travel days and activities of their employees at a granular enough level to know when the business was exceeding the de minimis thresholds.
When a customer needed to be visiting a state, sales people went, and that visit was not put on hold if it was the 8th or 9th day the salesperson had been in the state to avoid nexus. A taxpayer does not say no to potential business just because they might have to file a tax return in that state. The subsequent evolution of nexus laws from state-to-state has now made it imperative that businesses know where their workforce is by tracking the location of each business activity and know where the business is deriving income.
The concept of nexus has worked its way into an ever-widening number of situations, giving states ample opportunity to collect taxes. Many states look at affiliate nexus, which is when a business owns or is related to another entity that is making a market on its behalf. These brother-sister or parent-child company relationships can create reciprocal tax duties across the states.
There is also a concept called agency nexus, which is when a third party is making a market on another taxpayer’s behalf, such as a distributor, value-added reseller or independent sales representative.
Click-through is another nexus concept that involves paying a blogger or other unrelated entity when a sale is made based on “clicking’ through a link that leads to a transaction. For example, a blogger writes about a gluten-free hypoallergenic mouthwash, touting its benefits. After reading the article, an individual clicks on a link and buys the product through Amazon. Amazon then pays the blogger a percentage of the sale every time someone clicks on the link from the bloggers site to complete a purchase of that mouthwash on Amazon. If those click-through commissions exceed $10,000, nexus can be triggered for Amazon or the mouthwash seller using the Amazon marketplace.
As U.S. buying patterns shifted to online marketplaces, states devised ways to tax sales of remote businesses. The 2018 U.S. Supreme Court ruling in South Dakota v. Wayfair, Inc., 585 U.S., created a new standard called economic nexus. Within two years of the decision all 45 states and the District of Columbia that have a sales tax expanded their nexus laws to include an economic threshold, to force remote sellers without a physical presence in the state to collect and remit their sales taxes.
Factor Presence Rules
By contrast to Wayfair’s economic nexus, governments had factor presence rules put in place prior to Wayfair for income tax collections. These standards were recommended by the Multistate Tax Commission (MTC), a quasi-governmental entity that attempts to create standards states can choose to adopt.
Using the MTC standard guidelines, let’s say a taxpayer has one of the following: $500,000 of sales in a state, $50,000 of payroll or $50,000 of property. If a taxpayer meets any of the three standards, it is deemed to have income tax nexus in that state. Or if sales, payroll and property are 25% or more of the taxpayer’s total business operations, that too creates nexus in a state for income tax purposes under the MTC standards.
But while the MTC recommends standards, not every state chooses to follow those standards. As a result, it is a game of high-stakes hopscotch across the nation in determining which states have instituted bright line economic nexus rules for income tax and which need to be compared to Wayfair thresholds as well as physical presence, affiliates, agent or click-through nexus in order to determine a taxpayer’s nexus footprint on a state-by-state basis.
Each year, states find more creative ways to capture revenue, and rightly so, because of the way our economy has been shifting. For example, look at the digital advertising tax proposals that have been implemented in Maryland and some other states. The digital advertising tax is a completely new type of tax, separate and apart from an income or sales tax and specifically targeted towards certain types of businesses. States are always developing savvy ways to generate revenue, and that affects taxpayers.
Taxes in the state and local tax area are so complicated, it’s a wonder if they can ever be simplified. However, the states see that they are justified in finding ways to tax you because they house the citizens that buy your goods and maintain the infrastructure (roads, bridges, airports) that allows you to make sales. They provide a court system so you can sue your delinquent customers or manufacturers for defective goods and educate your workers.
State and local taxes are necessary, and understanding nexus is key to compliance. Once you know you have nexus, figuring out what you owe the state in taxes is another thing entirely.
Reach out to the tax professionals at TaxOps.com for more guidance.
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