With tax season now upon us, we’d like to focus on income tax nexus—what it is; what it means to companies that transact business in multiple states; and what some of the key considerations are when trying to understand the extent to which you may or may not have nexus with particular states. We’ll state this up front: Income tax nexus is complex. Tax professionals specialize in it, so rather than leading you down a path of near-endless detail, we think a high-level overview of the key issues will best help you understand how your company may be impacted.
What is Income Tax Nexus?
‘Nexus’ is a legal term for the extent to which a state can tax a business. More specifically, think of it as a connection between a specific taxpayer (e.g., a corporation or partnership) and a taxing jurisdiction (e.g., the state of Nebraska) that constitutionally and statutorily is adequate enough for that jurisdiction to levy either a tax (e.g., income tax) or an obligation to collect a tax (e.g., sales tax) on that taxpayer.
Is Your Business Affected By Income Tax Nexus?
Historically, a state can only tax a taxpayer (i.e., corporation or partnership) if said taxpayer maintains employees or property in that particular state (subject to limitations which will be discussed later). This is widely known as ‘physical presence.’ Yet, in recent years, some states have sought to expand their taxing power to affect businesses operating in states where the business doesn’t have a physical presence. For sales tax nexus, physical presence remains the primary criteria (for now); if a taxpayer is physically present in a given jurisdiction, then that jurisdiction can impose a tax. For income tax, the rules are a bit different. At Lutz, we use physical presence as a starting point for determining income tax nexus for clients with multistate business operations. If your business has a physical presence in a given jurisdiction, it may be subject to tax. But things can get complicated from there due to two primary factors. We’ll provide a quick rundown of each one.
You may be protected from nexus and the associated taxation thanks to the federal statutory nexus threshold and Public Law (P.L.) 86-272.
Under the Commerce Clause (and specifically, P.L. 86-272), Congress may exercise its powers to limit states’ authority to impose income taxes. P.L. 86-272 prohibits a taxing jurisdiction from imposing an income tax on a taxpayer, so long as its only business activities in that jurisdiction are solicitation activities for sales of tangible personal property. In other words, if the taxpayer/business has a presence in the state, but that presence is limited to solicitation activities for sales of tangible personal property, then it’s not subject to income tax. It may be subject to sales tax or another type of tax, but not income tax. It’s important to note that P.L. 86-272
does not apply to service providers with presence in a given jurisdiction. Service providers may deal in intangibles, royalties or other offerings; but again, P.L. 86-272 applies to taxpayers that sell tangible personal property. Also note that orders from customers and prospects for tangible personal property must be approved and filled from out of state.
Even if you think you’re sheltered from nexus and the associated taxation because you’re not physically present in a state, you may, in fact, not be due to economic nexus and factor threshold nexus.
Say you as a service-providing taxpayer (again, just to be clear, we’re referring here to corporations, partnerships or other formal business entities) are not physically present in a state, yet you derive revenues from customers or clients in that state. You may think that the lack of physical presence in the state protects you from taxation. That may be true. Or,
it may not be true, for as mentioned earlier, some states have begun to expand their taxing power to affect taxpayers operating in other states, be they product or service providers. Today, some states are taking the position that nexus can be based on more than just physical presence. Specifically, it can also include economic nexus, which means directing activities at customers in that given state. As an example, an out-of-state bank issuing credit cards to residents could have nexus with that state. States are also enacting factor threshold nexus statutes that seek to establish nexus if a taxpayer’s property, payroll or sales exceed the stated statutory threshold—expressed either as a dollar amount or as a sales factor/percentage. In California, for example, that threshold is $500,000 in sales. So hypothetically, your Nebraska company may never establish any physical presence in California; yet if it exceeds $500,000 in California-derived sales, then California could claim nexus with it (a company may still have P.L. 86-272 protection from income tax, but a state can still require the filing of a return and payment of minimum taxes or franchise taxes)
The nexus rabbit hole gets deeper. What to do?
Again, nexus issues are complicated, rules vary by state, and potentially new statutes are an ever-present reality. If your company conducts business in a particular state or multiple states, you should be aware of nexus as a broad issue and understand that you may have filing obligations. Overall, we believe it’s best to consult on all nexus matters with a qualified and experienced tax professional. At Lutz, we help clients navigate the complex nexus landscape every day by closely evaluating all their interstate activities as they relate to the latest nexus statutes. By clarifying specifically where you have nexus, and how that nexus applies to your unique business, we can uncover significant potential savings opportunities and also help you avoid unnecessary taxation, today and down the road.
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