Income Tax Nexus Implications in a Post-Wayfair World

After the Wayfair decision overturned the physical presence nexus standard for sales tax purposes in the summer of 2018, companies across all industries hastily reviewed their sales tax return filings. States also reacted swiftly, with more than 40 enacting economic nexus sales tax laws since the decision was rendered.

While Wayfair specifically addressed sales tax nexus, there are significant implications when it comes to income tax nexus as well that must not be overlooked. States are already more aggressively enforcing existing income tax economic nexus statutes, revising filing thresholds and moving to market-based sourcing to capture more tax dollars from out-of-state companies. As states continue to look for ways to increase revenue, clients should review their business activities to determine where they have economic nexus for income tax purposes.

State Approaches to Economic Nexus

States seeking to gain revenue from out-of-state companies targeting customers within their borders have enacted a variety of economic nexus laws. Some states, such as California and Connecticut, use bright-line thresholds based on factor presence (the amount of payroll, property, and/or sales in a state) that, when exceeded, automatically creates income tax nexus. Somewhat similarly, New York adopted a $1 million receipt threshold for nexus with no physical presence requirement as of 2015. Alternatively, other states like New Jersey use a more broadly worded “doing business” standard, which looks to the facts and circumstances of a taxpayer’s activities directed to the state to determine whether nexus is established.

While New York City did not adopt the same $1 million receipt threshold set by New York State, it is likely that the city will look to economic activity to determine whether nexus is established.  A December 2018 ruling issued by the New York City Tax Appeals Tribunal stated that “[i]n Wayfair, the Court’s substantial nexus analysis for Commerce Clause purposes impacts other state and local taxes such as the General Corporation Tax since it follows the same rationale of constitutional taxation arising from the privileges and opportunities that the taxing jurisdiction has afforded to a taxpayer’s business entity.” In Re Goldman Sachs Pettershill Fund Offshore Holdings (Delaware) Corp, TAT(H)16-9-(GC) (12/6/2018).

Also, Pennsylvania recently issued guidance stating that for periods beginning on or after January 1, 2020 remote businesses doing business in the state will be subject to corporate income tax, asserting that “the decision in Wayfair has made certain that, at least prospectively, no physical presence standard exists for purposes of limiting the ability of a state to impose a net income tax on an out-of-state taxpayer.”

Taxpayers should be aware that if states are encouraged to enact nexus standards based solely on economic activities in the state, any additional tax and compliance costs would be a direct additional cost to the business (unlike sales tax, which is collected from the customer). This could surprise taxpayers that previously had no exposure in those states where it had sales but no other activities.

It is important to note that economic nexus does not overturn the statutory protection of the Federal Interstate Income Tax Law, known as P.L. 86-272. This law prohibits a state from imposing a net income tax on out-of-state companies whose only activity in the state is the solicitation of sales that are accepted and shipped from outside the state. Although this exemption is very limited, for sellers of tangible personal property, P.L. 86-272 will still generally protect them from creating nexus within a state or locality for purposes of a net income tax.

Market-Based Sourcing

As more states impose economic nexus, many have also moved towards market-based sourcing in order to determine how much income companies must apportion to their state. Historically, in order to avoid double taxation, businesses operating in multiple states determined where to apportion income based on property, payroll and sales using a cost-of-performance method. Yet with the rise of a service economy, e-Commerce and ever more income generated from intangible assets, movement to a market-based approach, which looks to where the benefit of a service is received, combined with single sales factor apportionment offered greater opportunities for states to tax out-of-state entities.

It is anticipated that many more states will adopt economic nexus provisions for income tax in the near future, and if history is at all indicative, there will be little to no uniformity in the state approaches.  As states continue to look for ways to increase revenue, taxpayers should continually review their businesses activities and what that means for state income tax exposure.