Five Things SMBs Should Know About State Tax Nexus

Ask me what one of the biggest concerns SMBs have when it comes to state taxes and I would have to answer it’s whether they have “nexus” in states other than their home state.

If you’re not familiar with the term, it’s used to describe the “connection” or “tie” that must exist before a state can tax an out-of-state company or require the business to collect its sales tax. Yep, nexus! It’s a term that being used quite often these days, especially in the debate on whether internet retailers should be required to charge sales tax on sales to customers in states in which the retailer has no “physical presence”.

Now, I get quite excited when I start talking about nexus. You see, helping businesses determine whether they have state tax nexus is a huge focus of mine!! Talking about nexus can also get me crazy—mostly because I often find myself explaining that nexus is much more complex than how it’s described in the news where it’s often referred to as simply having an obvious or direct presence in a state. But there are many activities that a business might engage in that can indeed create state tax nexus, but which aren’t always obvious.

You see, in an effort to add to their tax coffers (and close budget deficits), states are enacting laws which aggressively define what activities create nexus to their state. State tax officials are also aggressively interpreting and enforcing these laws. And because each state enacts, defines and enforces its own laws—whether a particular activity creates nexus in one state, may not mean that the same activity creates nexus in another state.

The reality is that very few businesses confine their business activity to their home state. Even brick-and-mortar businesses that might be physically located only in one state are likely to sell to customers in other states or send employees to other states for trade shows or for other business reasons. Not having at least a general understanding of nexus can literally shut a business down!!

While opening an office or a storefront in a new state is certain to subject a business to the new state's various taxes and to tax collection duties, there are many other common business practices which may not seem to create nexus, but very well could! So, here are five business activities that can create nexus for one type of state tax or another.

1. Nexus Can Be Created by Independent Sales Representatives, Non-Employees

Let’s face it – a business won’t survive unless it’s bringing in sales, which is one reason why a company’s sales function will often include independent (non-employee) sales representatives. But sending independent sales reps into a state to solicit sales almost always creates sales tax nexus. The fact that the sales rep is a non-employee, may represent multiple manufacturers, or that the company has no physical location in the state doesn’t matter. In the view of most states, independent sales reps are acting “agents” of the business they represent. In some states, having anyone, even someone who isn’t in the business of soliciting sales acting as an “agent” can create sales tax nexus. As matter of fact, several years ago, a California court held that school teachers that passed out book orders to their students were acting as “agents” of a popular out-of-state book seller, requiring the book seller to collect California sales tax. (Scholastic Book Clubs, Inc. v. State Board of Equalization (1989) 207 Cal.App.3d 734.)

2. Nexus Can be Created by Using a Third-Party Order Fulfillment Service

Another example of a situation where a third party creates nexus, in particular for internet sellers, occurs when a seller uses a third party order fulfillment service, such as Amazon’s Fulfillment By Amazon (FBA) service. When a merchant uses their FBA service, the merchant sends their product to an Amazon warehouse where it’s stored until an order for that product comes in.

Amazon then fulfills the orders on the merchant’s behalf—packaging and shipping the product to the merchant’s customer. Because the merchant continues to have legal ownership of the inventory while it sits in Amazon’s warehouse, the merchant literally has physical property in the state—a definite nexus creating activity. Not only that, many states take the position that the fulfillment service is acting as an “agent” of the seller.

3. Nexus Can Be Created by a Single Telecommuting Employee

Here’s a growing trend that’s creating nexus for many unsuspecting companies—the virtual workplace and telecommuting employees. It's logical to see how a company with a sales employee working from his home in another state would create nexus since the sales employee is likely to meet with customers in the normal course of his job and may even list his home address as a corporate location. But what about a telecommuting employee who strictly performs back-office administrative work or an engineer who works from home writing software code?

According to Bloomberg BNA's Annual Survey of State Tax Agencies, when asked whether a single telecommuting employee performing administrative work would create state tax nexus for corporate or business taxes, 33 states said “Yes.” Thirty-four states, including DC, said a single employee performing product development functions (e.g., software coding), would also create state tax nexus. Many of these states replied that their answer would be the same even if the single employee only worked part-time!

4. Nexus Can Be Created by Marketing Affiliates in States with “Amazon Laws”

The use of third-party marketing affiliates to drive customer traffic to retailer websites has grown enormously in the past few years, with the Amazon Associates program being perhaps the best known affiliate program. Many states have also passed laws which attribute sales tax nexus to out-of-state sellers that enter into marketing affiliate contracts with individuals or companies that post a web link on their in-state website that sends their website visitors to the out-of-state seller’s on-line store. The marketing affiliates are compensated generally via a commission if the “click” ends up generating a sale—which is why these laws are often referred to as “click-through” nexus laws, as well as “Amazon Laws” after their largest target.

States with these laws take the position that the in-state marketing affiliate is effectively an in-state sales rep that is effectively soliciting sales for the out-of-state seller. And even though these laws target mega-internet retailers, any business using marketing affiliates in a "click-through" nexus state may find that this arrangement has created sales tax nexus for them.

5. Nexus Can Be Created Without Ever Stepping Foot in a State

While I could go on about nexus, here’s one more that I have to mention because it demonstrates just how aggressive states have become. Some states have “economic nexus” laws which do not require any type of physical presence to assert nexus if the out-of-state company has an "economic" presence in the state.

Washington State, for example, has an "economic nexus" law that requires certain out-of-state companies to pay its Business and Occupation (B&O) tax if the business has at least $250,000 of Washington business receipts or at least 25% of its total business receipts are from Washington customers.

Other states that apply economic nexus say that there’s enough of a connection to tax an out-of-state company if the company is compensated for the use of its trademark or trade-name in the state. For this reason, franchisors are particularly vulnerable to economic nexus. Incidentally, back in 2010, the Iowa Supreme Court held that KFC Corporation, a Kentucky based company, was subject to Iowa’s corporate income tax simply because it licensed its trademark to its independently owned Iowa KFC franchisees.

State Tax Nexus Is a Concern for Many Businesses

I’ve mentioned several common business practices that can create state tax nexus but there are many other less than obvious ones too, such as leasing space on a third party server, sending employees to trade shows even if it’s just for a few days, allowing an in-state entity to accept returns or perform other duties for a related out-of-state entity, or negotiating a loan in a state.

Can nexus be created for one type of state tax but not another? Absolutely! In general, sales tax nexus is created more easily than nexus for let’s say, a state corporate income tax. One reason is because a federal law, commonly referred to as P.L. 86-272, prohibits a state from imposing its corporate income tax on a business if the company's only activity in the state is soliciting orders for sales of goods if the orders are approved out of state and shipped by common carrier. But as I point above, soliciting sales—even if it's performed by non-employee agents—can create sales tax nexus.

State tax nexus is a concern for many businesses, which is why you’ll find me revisiting this tax topic often.