This article is the first of a three-part series regarding the State and Local Tax consequences of doing business in multiple states. Part 1 will discuss Nexus, Part 2 will discuss Voluntary Disclosures, and Part 3 will discuss the Audit Process.
What is Nexus? In order for a state to impose an income, franchise, or gross receipts tax on a taxpayer or require a taxpayer to collect and remit sales and use taxes, the taxpayer must have nexus with the state. Nexus is some type of connection with the state. Such connection could be a physical presence in the state, an economic presence in the state (i.e., taking advantage of the market in the state (such as an intangible asset)) or some type of factor presence in the state (certain dollar amount of sales into a state).
Are there different nexus standards for Income, Franchise and Gross Receipts taxes and Sales and Use taxes? Yes.
Income, Franchise or Gross Receipts Tax Nexus Standards
Generally, to create nexus with a state for Income, Franchise, or Gross Receipts tax purposes, there must be some connection with the state. That connection can be a physical presence, economic presence, factor presence or just a registration with the Secretary of State of qualify to do business in the state.
A physical presence is having employees in the state (permanently or visiting customers), or inventory or assets in the state. An economic presence in the state could be the license of a trademark in the state, having a loan to a customer in the state, or anything else that may be considered taking advantage of the state’s market. Factor presence nexus is having a certain level of sales in the state. For example, if you have more than $500,000 of sales into California, then under California law, nexus is created with California—even though there is no physical presence in the state.
For Franchise tax nexus, registering with a state may create a filing obligation and may give rise to a minimum tax, even though you may not be doing business in the state. For example, if you register with the California Secretary of State to do business in California, it will create franchise tax nexus and you will be required to pay the minimum tax of $800, even though you may not actually be doing business in the state or have customers in the state.
In summary, generally, the standard for Income, Franchise or Gross Receipts tax nexus is either a physical presence in the state, an economic presence in the state, or a factor presence in a state.
Sales and Use Tax Nexus Standards
Generally, prior to June of 2018 (before the Wayfair decision), a taxpayer was required to have a physical presence in the state before a state could impose a sales and use tax collection and remittance requirement upon a taxpayer. But the Supreme Court of the United States’ decision in Wayfair changed that. In Wayfair, the court upheld a South Dakota law deeming a taxpayer with more than $100,000 of sales into the state or 200 transactions in the state to have nexus with South Dakota and requiring the taxpayer to collect and remit sales and use taxes to the state. This lowered the bar from a physical presence to an economic presence.
As a result of the Wayfair decision, all states that impose a sales and use tax, except Florida and Missouri, have adopted an economic nexus standard like the South Dakota law. Some states have not adopted the 200-transaction test and some states have a $500,000 or $250,000 threshold, rather than the $100,000 threshold. Note that Alaska, Delaware, New Hampshire, Oregon and Montana do not impose sales and use taxes.
In conclusion, generally, for sales and use tax purposes, nexus is established with a state if a taxpayer has a physical presence in the state or if it has met the economic standard of such state.
Why is nexus important? If a taxpayer has nexus with a state, then the taxpayer has a tax-filing obligation and may owe state income, franchise or gross receipts tax, or it must collect and remit sales and use taxes on the sale of taxable goods or services.
The Covid-19 pandemic has impacted states economically, as state tax collections have declined, and state spending has increased. States will be aggressive in enforcing their state tax laws, as states try to cope with budgetary deficits. If a taxpayer is not compliant with state tax laws, then the taxpayer may be subject to tax, interest and penalties, which may be costly to the taxpayer in the future. Such obligation may, for example, have an impact on selling a business or personal liability for the owner or officers of the company.
Taxpayers must be proactive as states get aggressive. A taxpayer must keep track of its employees if they are traveling to states to create a market for the taxpayer in the state or if they are working remotely (due to company policy or the Covid-19 pandemic) in a state in which the company does not do business in the state. Tax departments must work with its human resource departments to keep track of their employees’ locations to determine nexus and any new state tax obligations.
In conclusion, taxpayers must (we recommend on a quarterly basis) monitor where it has employees either working remotely or traveling into states to create a market for the taxpayer, and monitor their sales into a state to determine if it has triggered any nexus laws, and thus would be required to file an income, franchise or gross receipts tax return or collect and remit sales and use taxes on taxable sales of goods or services, or collect exemption certificates from customers in those states.