State and Local Taxes: Hidden Risks and Opportunities

Understanding the complexities of state and local taxes is challenging and requires patience and attention to detail. Consequently, many entities fail to fully analyze the nexus impacts of their operations, exposing them to non-filing risks that often surface at inopportune times: during a state audit or a potential buyer's due diligence review. 

While this aversion to potential negative outcomes is not uncommon, it can be short-sighted. A lack of understanding of an entity’s nexus footprint may result in overpaying state income taxes. Here’s how to avoid that outcome. 

What Is Nexus and Why Does It Matter? 

Nexus refers to the point at which an entity’s contacts with a state are sufficient to create various filing obligations. In general, when a business has nexus with a state, the state can assert jurisdiction. Once nexus is created, an entity must properly register with the state and is subject to numerous tax filings, including state and/or local income taxes, franchise taxes, sales taxes, and payroll taxes. 

In all tax matters, knowing whether a business has nexus is the threshold question that entities must answer. If nexus does not exist, there is seldom a need for further analysis. If nexus exists, the entity must have the various facets of the tax in question analyzed. This analysis could include factors like the appropriate tax base, sourcing, rates, taxability, exemptions, etc. 

Creating Nexus: Still Misunderstood 

How an entity creates nexus remains widely misunderstood. Many businesses mistakenly believe that nexus only arises from a brick-and-mortar presence. In reality, nexus can be triggered in various ways, and the activities that create nexus can differ not only by state but also by tax type within the same state. 

Historically, nexus was created by having a physical presence in a state, such as having in-state property or employees on payroll, even if temporary or transitory in nature. However, “physical” presence could also be deemed to exist via the use of intangibles — like patents or trademarks — in a state. For income tax purposes, the mere presence of intangibles has been sufficient to create nexus since the 1990s. 

In the 2018 Wayfair decision, the U.S. Supreme Court ruled that nexus can be established through economic contacts with a state, as evidenced by meeting certain sales thresholds (“economic nexus”). It is important to note that economic nexus provisions are in addition to other nexus provisions; they did not replace historic nexus theories, but supplemented them. 

Since this ruling, every state with a general state sales tax has implemented some economic nexus provision for sales tax purposes. Many states have also implemented bright-line economic nexus provisions for income/franchise tax and gross receipts tax purposes. 

While federal legislation known as Public Law 86-272 provides some protection against creating nexus for net income tax purposes for certain businesses, it is inapplicable to sales, gross receipts, and other types of taxes. It is also inapplicable to services and many other types of businesses. In recent years, states have also started to chip away at the protections afforded by Public Law 86-272 by expanding the types of activities that exceed the protection of the law. 

In 2022, the Multistate Tax Commission (MTC) released revised guidance related to certain internet activities that are now deemed to create nexus. This includes placing internet “cookies” on computers in a state and having people access and use a company’s “chatbot” from a state. 

Apportionment: the New Nexus Frontier 

In recent years, states have also changed their apportionment provisions to expand their taxpayer base. It began with the migration away from cost-of-performance methods to market sourcing for revenues from services and intangibles. Using a company’s customer base to source receipts from services, as opposed to the location of the company’s property and payroll, initially merely shifted existing tax burdens based on market presence. 

With the advent of economic nexus provisions, the combination of these concepts allowed states to tax additional out-of-state companies based solely on the presence of an in-state customer base. Now, states are starting to look not just to the location of the immediate customer, but to the location of the customer’s customer via a “look-through” apportionment approach. As a result, Company A can find itself having nexus with a state based not on the location of its own property or payroll, or the location of its own customer base, but based on the location of Company B’s customers. 

This often creates a nightmare scenario, as Company A may have little or no knowledge of where Company B’s customers are located. When this is the case, states will often use some form of “approximation” technique, such as census data. 

This also puts companies in the daunting position of having to examine the nexus provisions of every state, regardless of their footprint. While there are several constitutional concerns with these approaches, winning such a case at the state level is unlikely, and fighting in federal court is costly and time-consuming. 

Common Pitfalls and Misconceptions 

A common misconception is the belief that states cannot impose nexus under unique theories. In reality, states often do — and will continue to do so — until successfully challenged. 

Another misconception is that economic nexus provisions replaced the prior concepts of physical presence. Thus, if you don’t meet a state’s economic nexus threshold, you don’t have to worry about nexus. Unfortunately, economic nexus supplements other nexus concepts, and is merely one of several ways that nexus is created. 

A third misunderstanding is that nexus and sourcing concepts are the same across states and/or different tax types. Each state has its own unique nexus provisions, and what creates nexus in one state may not create nexus in another. Furthermore, nexus can vary for different types of taxes, even within the same state. 

Waiting to evaluate nexus exposures until they are 1) audited or 2) considered a sales transaction is the most prevalent cause of headaches for companies. This reactive approach often results in significant monetary loss. If under audit, the company is left playing catch-up and misses potential planning opportunities and/or the opportunity to collect sales tax from its customers, in addition to penalties and interest. When a potential acquirer has concerns about a target’s nexus, possible outcomes include a large escrow, reduction in valuation/purchase price, or the possible termination of the transaction. 

What Are the Implications of Having Nexus with a State? 

The expansion of nexus-creating activities has increased the filing burdens and overall tax complexities for most companies — including compliance costs and audit risk. However, nexus is often just the starting point of analysis. Once a company determines it has nexus in a state, it still needs to look at details such as taxability and exemptions if sales tax is at issue, or apportionment and filing methods if income tax is at issue. 

When it comes to issues such as the right to apportion and throwback, nexus can even be advantageous at times. For example, establishing nexus in a low-tax-rate state with a high number of sales can minimize throwback to a high-tax-rate state, lowering the overall state tax liability. Likewise, creating the right to apportion income out of a high tax rate state into multiple lower tax rate states can also lower a company’s overall state tax liability. 

How Can EisnerAmper Help Reduce Risk and Identify Opportunities? 

We take a holistic, risk-based approach to nexus studies. As every business situation is different, our multi-phased approach provides flexibility and allows us to tailor procedures to each client. 

Phase 1 – Nexus Overview 

We review a company’s facts and footprint and compare them to each state’s nexus provisions to determine whether each state represents a high, medium, or low risk. 

Phase 2 – Taxability Review/Revenue Sourcing Review 

Based on the results of Phase 1 and the client’s specific needs, we determine the proper sales tax treatment and/or sales factor apportionment sourcing of the client’s revenue streams. At the conclusion of this phase, we also perform a high-level exposure analysis. 

Phase 3 – Remediation 

Based on the results of Phases 1 and 2, we assist the client in determining the appropriate form of remediation, including back-filing returns and Voluntary Disclosure Agreements, as needed. We guide the client through each step of the remediation process so that prior period exposure is addressed efficiently and effectively. 

Phase 4 – Ongoing Compliance 

If needed, we can meet the prospective sales tax and/or income tax compliance needs. 

This approach provides flexibility to customize our procedures to fit our clients’ needs, both technical and budgetary. It also offers set check-in points throughout the entire process, increasing communication and avoiding surprises. 

Getting Started 

Executive teams have a fiduciary responsibility to identify and manage nexus-related tax obligations. Nexus compliance can involve a combination of internal and external resources as the varying nexus rules can be complex and continue to change. Further, as an entity’s goals and/or customers change, unexpected nexus consequences may arise. 

Executing an informed nexus strategy requires diligence but can be rewarding as entities better manage risks and identify opportunities through the process. 

Do you need help assessing nexus in your entity? Contact us below if you have questions about how nexus may impact your organization.