Economic Nexus: Trends in State Taxation


In light of recent chatter about the proposed revamping of the federal income tax law, the issue of state taxation – including income, franchise and sales taxes – is often lost in the tax discussion.

With respect to state taxes, the central question for every company lies in determining to which state or states a company has “nexus.” Nexus, also referred to as “sufficient presence,” is the determining factor of whether an out-of-state business selling products into a state is liable for taxes in that state. Sales and use taxes are transactional taxes with respect to sales of tangible personal property.

Transactional Taxes and the Physical Presence Standard

The applicability of sales taxes to out-of-state companies has been settled by two U.S. Supreme Court Cases, National Bellas Hess, Inc. v. Dept of Revenue and Quill v. North Dakota. These cases generally held that physical presence is required to create nexus for purposes of these transactional taxes. Also, the Interstate Income Act of 1959 P.L. 86-272 generally limits states’ authority to subject businesses to income tax when the only activity taking place in the state is the solicitation of sales for tangible personal property.

Because of the taxpayer favorable rulings in Bellas Hess and Quill and the existence of P.L. 86-272, many practitioners and business taxpayers believed, perhaps optimistically, that some form of physical presence was required to establish a connection with a state that would result in the application of income taxes. This view, however, is outdated and less than accurate given the current state tax environment. Many states have narrowly interpreted the case law and P.L. 86-272 to afford protection from income taxes only to sellers of tangible personal property whose activities with the state are limited to solicitation. It does not, however, afford protection to a taxpayer who solicits or performs services or sales of real property in the state. Further, it does not apply to any non-income-based taxes, such as gross receipts taxes or franchise taxes.

Economic Nexus and the Sales Factor Nexus Presence Standard

Now, almost all states having an income tax are imposing what is known as an “economic nexus” approach to taxation. These policies, which are supported by a variety of state courts and apply to income and transactions not addressed and protected by federal law, do not require a business to actually conduct activities within the state to incur an income tax obligation, but rather, only that the taxpayer has income arising from a source within that state. Additionally, some states have crafted business taxes which are not income taxes or sales taxes, but are referred to as franchise taxes, business and occupation taxes, commercial activity taxes, etc., and are based on gross receipts and not net income so as to avoid the application of the federal protection referred to above.

The economic nexus concept relies on the facts and circumstances of each case and often requires significant subjective judgement in applying terms such as “doing business in”, “actively engaged” and “deriving income from”. Because of the inherent uncertainties in applying these concepts, in 2002, a working group of states participating in the Multistate Tax Commission (MTC) developed a “factor presence nexus” concept to provide guidance to taxpayers about nexus as it relates to business activity taxes.

The underlying of the concept of factor presence nexus is that a business may have a taxable event in a state that may not be the state of its domesticity because it has an economic presence in that other state by virtue of selling its goods or services to residents of that state. Because of inconsistencies and ambiguities involved in the application of this concept, the uniform proposed law suggested by the MTC established dollar thresholds for property ($50,000), payroll ($50,000) and sales ($500,000) that if exceeded would indicate nexus in a particular state.

To date, nine states have adopted some form of a sales factor nexus presence standard: Alabama, California, Colorado, Connecticut, Michigan, New York, Ohio, Tennessee and Virginia It is believed that these states provide a “bright line test” (market-based presence) which is more easily applied by taxpayers and regulators and makes it very clear that they are aggressively pursuing revenue from those that do business with customers in their state.

In perhaps the strongest indication of support of the applicability of factor presence nexus, in November 2016, the Ohio Supreme Court issued its decision in Crutchfield Corp. v. Testa, upholding the constitutionality of the factor presence nexus standard in Ohio’s commercial activity tax. This is the highest level state court to rule on the issue and a harbinger of ramifications across the country. Crutchfield was a catalog and internet based seller of consumer electronics products, based in Virginia with no physical presence in Ohio.

Without the factor presence standard, Crutchfield would not have been subject to the commercial activity tax. Crutchfield argued unsuccessfully that the Ohio law was unconstitutional because it exceeded the physical presence standard. The court held that the Quill decision requiring physical presence for nexus did not apply to a business privilege tax but only to a transactional tax. The court held that the tax was constitutional as long as “the privilege tax is imposed with an adequate quantitative standard that ensures that the taxpayer’s nexus with the state is substantial”.

Implications for Companies in the Vacation Ownership Industry

It is important to be hyper-aware that a company’s own domicile is not the most significant factor in establishing nexus for state tax purposes. Rather, it is the activities they undertake in various states that counts the most. Typically, the nexus of most development and management companies is the same as it would be under the old physical presence standard because their activities occur where they have fixed places of business. However, many other companies such as fulfillment companies, rental companies, sales agents, affinity program companies and others, are often profiting from marketing and providing their services to customers in states other than their own state of domicile without being aware of the state tax implications. The taxes, penalties and interest that would result from a multiple year assessment to these companies would be significant.

In all cases, more than ever before, taxpayers and their advisors need to evaluate all of a company’s contacts with individual states and explore its defenses to taxation in those states.

Reprinted with permission from Developments Magazine, copyright 2018

Authors:Lena Combs, CPA, CGMA, Partner | [email protected]and Thomas V. Durkee, CPA, CGMA, Partner | [email protected]

How Can We Help?

Previous Post

Next Post