Most states follow federal law or use federal taxable income as their starting point to calculate state taxable income. Hence, if the federal tax base increases, so does the state tax base (unless a state doesn’t conform to the change). Consequently, states must pay close attention to any changes the federal government makes as they will have a direct impact on state budgets. States will have to analyze federal tax law changes and make coordinated changes to their own statutes and regulations to offset any negative impacts.
The general theme of federal tax reform is to increase jobs and investment in the United States. As businesses increase investment in the U.S., they will also be creating a larger taxable presence in specific states. As a result, when businesses investigate investment opportunities and state incentive packages, they must consider the impact that nexus will have on their state tax liabilities.
Several federal tax reform proposals include broadening or increasing the tax base while decreasing the federal income tax rate. If the final federal tax reform that is enacted contains those attributes, then state taxes may become a larger percentage of a business’ tax expense making it vital to know what states the business has nexus or a taxable presence.
Irrespective of federal tax reform, businesses are continually looking for ways to grow, whether it’s into new markets or by selling new products or services. When businesses implement changes — which may include hiring sales people or independent contractors to provide services, storing inventory in new distribution centers or selling services in addition to selling tangible property — businesses become exposed to additional state tax obligations.
To complicate things further, there are different nexus thresholds for different types of taxes (e.g., income tax, sales/use tax, gross receipts taxes, etc.). As with just about every state tax issue, there is also a lack of uniformity among the states regarding nexus, which creates complexity and confusion.
Depending on a business’ activities in a state, a business could have nexus for one tax type and not have nexus for other tax types. For example, a company that sends a salesman into a state to solicit sales of tangible personal property may have nexus for sales tax collection purposes but be protected from paying income tax due to a federal law (P.L. 86-272).
Year after year, states continue to expand nexus laws to catch taxpayers in an ever-widening net. The “nexus net” began to grow larger several years ago when states started enacting economic presence nexus standards or factor-based nexus standards to subject businesses to income tax. Due to the growth of businesses conducting transactions remotely, states are attempting to impose those same economic presence nexus standards to force businesses to collect sales tax.
Economic nexus and factor-based nexus
Economic nexus is generally described as having a taxable presence by conducting a certain amount of economic activity within the state — even if a corporation lacks a physical presence — or by simply conducting business in the state or earning or receiving income in the state. Hence, physical presence is not required.
Economic nexus began when Ohio implemented its bright-line test (or factor-based nexus standard) for its Commercial Activities Tax (CAT) in 2005. Today, approximately 41 states apply an economic presence nexus standard to impose an income tax or gross receipts tax. This includes Tennessee and states such as Arkansas, Florida, Georgia, Illinois, Kentucky, Mississippi, North Carolina and South Carolina.
Approximately eight states have factor-based nexus standards similar to the bright-line test created by Ohio. Alabama and Tennessee represent two of those states. Factor-based nexus standards generally hold that taxpayers establish bright-line substantial nexus in the state if any one of the following applies:
- The value of real and tangible personal property owned or rented and used in the state exceeds the lesser of $50,000 or 25 percent of the average value of all the taxpayer’s property;
- The amount of compensation paid in the state exceeds the lesser of $50,000 or 25 percent of total compensation paid by the taxpayer; or
- The amount of total gross receipts in the state exceeds the lesser of $500,000 or 25 percent of the taxpayer’s total receipts everywhere.
Caution: The dollar thresholds for each of the above items can vary depending on the state.
Applying economic nexus to sales tax collection
The recent trend is to impose economic nexus for sales tax collection responsibilities on remote retailers. States are trying to overturn the physical presence standard established by Quill Corp v. North Dakota, a long-standing U.S. Supreme Court case. Quill requires companies to have a physical presence in a state before the state can compel companies to collect sales and use tax.
Alabama was the first state to enact economic nexus to impose sales tax collection responsibilities on out-of-state sellers. South Dakota, Tennessee and, most recently, Wyoming, have followed suit. Both South Dakota and Alabama’s laws came under immediate scrutiny, and litigation has been ongoing. The South Dakota Sixth Judicial Circuit ruled on March 6, 2017, that the state’s economic nexus regime was unconstitutional. We will have to wait and see if the case gets to the U.S. Supreme Court.
P.L. 86-272 still provides protection
P.L. 86-272 (the Interstate Income Act of 1959), prohibits states from taxing the income of businesses that limit their in-state activities to the solicitation of orders for the sale of tangible personal property, so long as those orders are sent outside the state for acceptance and, if accepted, are fulfilled by shipment or delivery from outside the state.
The law has protected out-of-state businesses from state income taxes for decades, but it has also provided much controversy. Most of the controversy has been focused on what qualifies as solicitation or on what activities could be considered de minimis and not exceeding the protections provided by P.L. 86-272. Other areas of dispute have involved whether the law and its protections apply to activities by independent contractors or to types of taxes, such as franchise or gross receipts taxes. The types of products a company sells will determine whether the company is protected by P.L. 86-272.
Example 1: Company A manufactures widgets in state X. A sells widgets to customers in states Y and Z by sending salespeople into those states to make the sales (assume the salesperson’s activities meet all the requirements of P.L. 86-272). Even if A exceeds economic nexus thresholds or factor presence nexus thresholds in Y and Z, it will be protected from nexus in those states under P.L. 86-272.
Example 2: Company B licenses computer software to customers via the cloud. B’s physical offices and servers reside in state X. B solicits sales from customers in states Y and Z via telephone and Internet and does not physically enter Y or Z to solicit sales or perform any services. If services are provided, all services are performed in state X. Because B sells intangibles or services, P.L. 86-272 does not apply. Consequently, states Y and Z could impose economic or factor-based nexus.
Light at the end of the tunnel
Despite the continued onslaught of nexus-broadening statutes and policies, businesses can take proactive steps to comply and mitigate exposure. Qualified state and local tax professionals can walk through the analysis and determine if your business has nexus or if changes can be made to the way your business operates to eliminate nexus. These online resources can be helpful.
If your business finds it has had nexus in a state for multiple years, you may want to consider entering into a voluntary disclosure agreement. A voluntary disclosure agreement, or VDA, allows a company to come forward to a state, file a few prior year returns and obtain some penalty and/or interest relief in the process.
Please note that nexus is determined on an annual basis; just because a business doesn’t have nexus in a particular state one year, doesn’t mean it won’t this year or the next. It also means that just because a business has nexus in a state this year, the business may not have nexus in the future.
Originally printed in The Tennessean.