5 Things Businesses Need to Know About Tax Nexus
August 15, 2017
Businesses engaged in multistate operations must have a clear understanding of nexus rules regarding the imposition of taxes by state governments and related collection obligations. The current state of nexus provisions is the result of years of contentious back and forth among businesses and states. States have continued their quest to expand their tax bases and to impose obligations on out-of-state taxpayers, while businesses have continued to fight against such obligations. EisnerAmper SALT professionals William Gentilesco and Andria Siciliano point out five basic nexus concepts that every business should keep in mind:
1. Traditionally, the Constitution and federal law protected many connections from state reach.
Generally, federal law governs states’ abilities to tax non-resident business or impose tax collection responsibilities on such businesses. The U.S. Constitution’s Due Process and Commerce clauses are the main shields utilized by businesses, although other provisions, such as the First Amendment, have also been used.
Specifically, the U.S. Supreme Court has concluded that the Due Process Clause insulates businesses from the imposition of a state tax if the taxpayer lacks a minimum connection with the state (Mobil Oil Corp. v. Commr. of Taxes of Vermont, 445 U.S. 425, 1980). In addition, the Court has determined that the Commerce Clause does not permit states to impose any tax that unduly burdens interstate commerce (the so-called dormant Commerce Clause) and has specified that the Commerce Clause is violated if a tax is imposed on a business that lacks substantial nexus with the taxing state (Compete Auto Transit v. Brady, 430 U.S. 274, 1977).
2. The nexus rules for income tax, sales tax or franchise tax are NOT the same.
State income tax nexus usually exists when a company owns or leases property inside the state or employs personnel in the state who perform activities that go beyond those protected under federal law. While P.L. 86-272 (15 USC §§ 381-384) specifically provides that states may not impose an income tax on a business whose only activity in the state is the solicitation of orders for tangible personal property in the state that are approved and shipped from outside the state, this federal law is inapplicable to taxes other than those measured by net income. Accordingly, it does not apply to sales taxes or those measured by gross receipts or net worth.
The imposition of a sales or use tax collection obligation generally requires the business have substantial nexus with the state. While the definition of substantial nexus has been a point of contention for years, in general, it requires that a business has a physical presence in the state that is more than the slightest presence (as set forth in Quill v. North Dakota, 504 U.S. 298, 1992). However, over the years, states have continued to push the envelope regarding what these phrases mean.
3. P.L. 86-272 only goes so far in protecting businesses.
Despite the protections of P.L. 86-272, there are myriad potential pitfalls inherent in making a nexus determination. For example, while P.L. 86-272 does protect businesses whose only activity is soliciting orders for tangible personal property, it does not afford similar nexus protection for a business that solicits orders for services, real estate or intangibles.
The type and extent of a business’s activity also will be a factor in determining whether the business has protection under P.L. 86-272. Activities considered as ancillary to the solicitation of orders or strictly de minimis activities are protected, while certain types of activities fall outside the scope of the protections of federal law. The Multistate Tax Commission has compiled a specific listing of protected and unprotected activities. As noted above, since P.L. 86-272 doesn’t apply to taxes other than those based on net income, it is inapplicable to taxes such as the Washington Business & Occupation Tax and the Ohio Commercial Activities Tax.
4. What about economic nexus?
Another hotly contested topic in the nexus arena centers around states’ enactments of expanded nexus laws based on the premise that businesses may have nexus based on their economic, non-physical connection to the taxing jurisdiction. This concept, commonly referred to as economic nexus, is based on an argument that Quill, which requires physical presence for purposes of sales tax nexus, is not, by its terms, applicable to income tax nexus and that the standard for income tax nexus is a lower one.
Economic nexus was most famously validated in Geoffrey, Inc. v. South Carolina Tax Commission, 437 S.E.2d 13 (1993). Here, the South Carolina Supreme Court held that a Delaware holding company that owned only intangible trademarks used in South Carolina was subject to South Carolina income tax because the use of the marks created the minimum connection and substantial nexus required under the federal due process and commerce clauses. While Geoffrey is technically only binding in South Carolina, its reasoning has served as the basis for several state court decisions validating economic nexus as well as for various state laws that adopt Geoffrey principles. The U.S. Supreme Court has yet to hear a case based purely on economic nexus principles.
5. Agency and affiliate nexus bring in even more activities.
Agency nexus comes into play when a business has relationships in a state with third parties that are deemed to be acting as agents on their behalf; affiliate nexus is based on the activities of related parties. In such cases, state law may provide that the actions of such third parties in establishing and maintaining a market for the business may be attributed to the business for purposes of establishing nexus. Such laws assert nexus based on a relationship between an out-of-state entity and an in-state business with a physical location that is often relatively minor in nature. Click-through and Amazon nexus provisions are merely the latest extension of these agency nexus theories and have become more prevalent in the age of online retailing and marketing.
What should businesses do?
State tax nexus standards and rules are constantly evolving, and given the revenue issues states face, businesses need to understand that the states are likely to continue to expand their definitions to reach a broader tax base in the future. A related article in this issue discusses where we’re headed, but just as importantly, businesses must examine their current nexus status and continually monitor this evolving area for developments. Important areas of consideration include not only the costs of compliance but the potential exposure associated with non-compliance as well as customer relationships and market perceptions.
Business Tax Quarterly - Summer 2017