State Tax Nexus: It's Not Just About Physical Presence!
Nexus! If you follow the debate over state sales taxes and online businesses, you've seen that term used a lot lately.
This isn't surprising, as one of the biggest recent developments in the state tax world was the enactment and eventual repeal of California's "Amazon Law". Many of these stories centered on Amazon cutting ties with its California marketing affiliates in order to avoid "nexus" under California's new (I mean repealed) "Amazon" law.
But California's "Amazon Law" drama isn't the only reason the concept of state tax "nexus" is in the limelight. In the last few years, many states have enacted similar or equally aggressive laws in their quest to increase state revenues and close budget shortfalls.
Why nexus is more complicated than it seems
In reporting on these new developments, "nexus" -- the connection that must exist before a state can impose its tax obligations on out-of-state businesses -- is all too often described as involving an obvious physical presence in a state.
I've even seem claims such as, "opening a storefront creates nexus," as if that's the end of the story.
But nexus can be triggered by many less obvious activities. So I thought I'd be helpful to revisit the concept and illustrate how even minimal activities can subject an unsuspecting business to a state's tax, filing, and reporting requirements.
To queue up the discussion, let's look at a few different scenarios.
Scenario 1: ABC Corporation is a company headquartered in State X. The company has no physical location or resident employees in State A, but has a regional sales manager who resides in neighboring State B. Because State A is in the sales manager's territory, he frequently travels to State A to solicit sales of widgets from existing or prospective customers, but has no authority beyond solicitation.
Scenario 2: Assume the same facts as Scenario 1. In this scenario, however, the sales manager brings new-product inventory with him to each sales call and has the authority to sell the product; collect or approve payment; and turn purchased items over to his State A customers.
Scenario 3: In this next scenario we again have ABC Corporation, this time selling medical equipment, which is shipped by UPS to customers in State B. Because the equipment must be properly installed and the customer's medical staff must be trained to use it, the company sends technical personnel from corporate headquarters in State X to the customer's location in State B to install the equipment and train the medical staff.
Scenario 4: Now assume that ABC Corporation's Marketing VP signs up his company for a series of trade shows in State C. Several of ABC's sales and marketing employees travel from State X to spend three weeks attending various trade shows in State C. Although customer leads are established during the trade show, no product is sold.
Scenario 5: In the next scenario ABC Corporation is an online retailer whose entire operations are in State X. All of its sales are made over the Internet, and its merchandise is shipped by UPS. ABC has recently decided to contract with unrelated "marketing affiliates" in State D. The company's "marketing affiliate" contract requires affiliates to post a banner on their website which, if clicked, will send customers to ABC's website. Marketing affiliates will earn a commission from each sale that originates from their web link, but they will not be required to actively solicit customers for ABC.
Scenario 6: Next we have ABC Corporation hiring an engineer who is a resident of State E. Because the engineer resides over 100 miles from ABC's corporate headquarters, the company allows the engineer to telecommute full-time from his home in State E. As an engineer, this employee never meets with prospective customers nor does he hold his home out as an office of the company. Other than this one telecommuting employee, ABC Company has no connection to State E.
Scenario 7: How about this one? ABC Corporation is now a financial services company, again based exclusively in State X. ABC issues credit cards which contain ABC's logo and are used by customers in State F.
As you consider whether state tax nexus has been triggered in any of these scenarios, notice that none of these scenarios involved opening a physical location. I never mention the opening of storefront, distribution center, or other facility in any other state.
That doesn't matter. In every scenario I've described, ABC Corporation has possibly, and in some cases definitely, created state tax nexus for at least one type of state tax.
State nexus is a complex concept, but understanding how easily nexus can be triggered can save a company future headaches, as well as cash, since it's much more costly to deal with delinquent taxes, penalties, and interest than it is to proactively determine a company's state tax obligations.
As it isn't feasible to address every nuance or potential nexus creating activity, I'll at least provide a high level overview of some key points.
More articles from AllBusiness.com:
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- How Employee Stock Options Work in Startup Companies
- 11 Business Deductions Even the Smallest Business Can Claim
- Five Things SMBs Should Know About State Tax Nexus
- The Cost of Incorporating a Startup Business
Why is nexus necessary?
Here's the deal, the U.S. Constitution prohibits states from unduly burdening interstate commerce. A state's ability to tax out-of-state businesses or to require them to collect the state's sales tax is limited by the Constitution and requires more than a trivial connection to the taxing state.
You're probably wondering how states can pass laws were a simple web-link on an in-state website creates sales tax nexus for an out-of-state company. In recent years states have attempted to stretch the nexus envelope by enacting nexus expanding laws. However, many of these aggressive laws are currently being challenged in state courts as being unconstitutional.
How nexus applies to different kinds of taxes
Can nexus be created for one type of state tax but not another? Absolutely!
For instance, in the first scenario above, ABC Corporation would have sales tax nexus but not corporate income tax nexus. This is because a federal law, Public Law (P.L.) 86-272, prohibits states from imposing a tax based on net income on out-of-state corporations whose only activity is soliciting orders for sales of tangible personal property, where the sales are approved and shipped from out of state.
Because P.L. 86-272 only applies to net income based taxes, activities other than those just described, would create nexus for sales, franchise, and other non-income based business taxes.
Beware the 'nexus questionnaire'
It's probably no surprise that states are become more aggressive and sophisticated in identifying companies with nexus to their state. States are proactively viewing companies websites, using information obtained through audits of vendors or customers, and reviewing a company's filings with other state agencies, such as with the Secretary of State.
If a state has any reason to suspect that a company may have state tax nexus, a state will almost always send out a nexus questionnaire. As you'll see from these links to Texas' and Michigan's nexus questionnaire, states are looking at much more than having a physical location. Notice that these questionnaires list some of the exact activities I described in the scenarios above.
Final thoughts
State tax nexus can be triggered by so much less than an obvious physical presence. While the rules vary from state to state, and by type of tax, activities such as owning or leasing property, soliciting sales, attending trade shows, performing training, deploying employees or hiring contractors to perform services, contracting with marketing affiliates, and many more, can trigger nexus for one type of tax or another or for all taxes imposed by a state.
I often caution readers to seek the advice of a CPA, attorney or tax consultant, and this is especially the case where a company has state tax nexus concerns.
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