There was a time when companies could rest comfortably in the belief that their actions did not create state income tax nexus. Companies engaged in the sale of tangible personal property were protected by a federal law commonly referred to as P.L. 86-272. The law prevented states from imposing income tax on a company whose only activity in a state was the solicitation of orders. Orders needed to be accepted outside the state and delivery made by common carrier. Any other activity or physical presence could cause companies to lose the protection of the federal law.
States referred to this law as the physical presence nexus standard. Basically, if a company selling tangible personal property in a state did not have a physical presence in that state, it did not have nexus. If nexus did not exist, the state did not have authority to impose an income based tax.
As states struggle to find revenue from new sources, even companies protected by P.L. 86-272 are not safe from increasingly narrow definitions of “solicitation” and limited protected activity. Gone are the days of substantial nexus or presence to trigger nexus for companies selling tangible personal property. Many companies may now have nexus exposure in nearly every state in which they do business; however, they are either unaware or do not want to know.
Companies engaged in a service-based business or that derive income from the licensing of intangible property need to be aware of an alternative standard – economic nexus. Economic nexus does not require substantial presence to trigger nexus. Many states that have adopted economic nexus are either inconsistent in how they define it or have not provided clear guidance on how to apply the standard. The states that have provided guidance have done so by adopting a bright line test or factor presence test, which utilizes apportionment factors to determine when nexus has been triggered.
In reality, almost any activity is sufficient to create economic nexus when a company has manipulated the market and received benefits from a state. States are engaged in a love affair of sorts with economic nexus and see it as a way to pull in more out-of-state companies. As a result, we expect to see more states adopt either gross receipts or non-income based taxes so they can apply economic nexus to all companies, including those engaged in the sale of tangible goods.
Nexus is not an easy determination. However, companies should address their nexus position on an annual basis for a number of reasons:
- State Tax Filing – If a company has nexus in a state, it will need to decide whether to file in that state. Most companies will take a practical approach to understand their exposure to the state. If the exposure is insignificant, the company might take a non-filing position but monitor the liability to make sure the exposure does not become larger.
- M&A Due Diligence – Most companies looking to acquire a business will conduct due diligence, which should include state tax nexus. If the acquirer determines that the target has an unrecorded liability for state taxes due to nexus, it might require money to be set aside from the purchase to satisfy those liabilities.
- Impact on Owners – States are becoming more aggressive in asserting nexus over shareholders and partners as a result of the economic nexus created by the pass-thru entity. If a state pursues a shareholder or a partner for non-filed returns over an extended period of time, it is possible that the period to file amended returns to claim a credit for the tax paid to the shareholder’s or partner’s resident state has passed. Accordingly, the shareholder or partner will have paid tax on the same income twice.
As these changes continue to occur, it is smart to stay informed and assess the impact on you and your business. Your best defense in the event of a surprise nexus audit is knowing where your employees are standing, how your products are getting to customers, and whether you employ independent contractors to perform services.
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