In recent years there have been significant changes to the State and Local Tax Nexus rules. Historic physical presence nexus standards are long past. Today, almost all states employ economic nexus concepts, whereby merely having sales sourced to a state generally result in a filing imposition even without a physical presence. The Wayfair case validated economic nexus for sales tax purposes and amplified economic nexus for income tax purposes, signaling to all states that economic nexus is sound law.
Economic nexus presents risk and opportunity for service providers. States across the nation use different sourcing rules and methodologies to assign sales to a state. Although many businesses might be subject to nexus, with proper planning, income tax burdens can be alleviated or reduced with sales-sourcing analysis. As states continue to shift to using the sales factor as the sole measure of apportionment, and market- sourcing continues to be prevalent in sourcing sales, businesses are actively reconsidering their sales sourcing approaches to potentially reduce state taxes.
Your business should be considering an Income Tax Nexus and Sales Sourcing Assessment, if:
- Service revenue streams are derived from multi-state customers/clients;
- Business’s receipts per state would vary based on possible different sourcing rules, such as:
- location where services benefit the customer,
- location of customer’s billing address,
- location of customer’s headquarters,
- location of customer’s primary interaction/contacts with the business,
- location of customer’s order location,
- location of the customer’s customer (i.e., ultimate customer), or
- other metrics (e.g., IP address analysis) that could result in a varied sourcing approach;
- Sales would be subject to special industry sourcing rules, such as financial services, technology (e.g., SaaS, etc.), advertising, transportation; or
- It has significant tax in any respective out-of-state jurisdiction.
State and Local Tax Workarounds
One of the centerpiece provisions of the 2017 Tax Cuts and Jobs Act (TCJA) was the limitation imposed on state and local taxes (SALT). The TCJA imposed a $10,000 limitation on the amount of SALT that individuals (or pass-through business owners) may deduct for federal income tax purposes. The SALT limitation profoundly impacted many businesses.
Several states responded by enacting various workaround bills to mitigate the impact of the SALT limitation. Some of the SALT workarounds we have seen to date include charitable deductions, payroll tax expense, and pass-through entity taxes. While some of the initial workarounds had their shortcomings, the pass-through entity tax workarounds have gained steam recently. In 2021, over a dozen states enacted pass-through entity taxes. While some state pass-through entity taxes are mandatory, most are elective.
Prior to making a pass-through entity election, there are several key issues that businesses need to consider:
- IRS Approval: The IRS has indicated in a notice that they intend to allow the workarounds. However, more authorization guidance is still forthcoming.
- Nonresident Credits: Nonresident partners/shareholders of an entity subject to an entity-level tax may not receive a credit in their home states for the entity tax paid, resulting in possible double state income taxation.
- Dual Estimate Payment Requirements: In some states, the legislation might not alter existing non-resident withholding requirements; thus, overlapping payment requirements may be necessary if individual non-resident taxpayers are subject to both regimes. This applies to estimated payments, not the actual tax itself.
- Other Considerations: Business owners should keep in mind that the election to pay tax at the entity level is subject to each business’s facts and circumstances and may vary depending on specific state provisions.
As COVID-19 continues to disrupt the global economy and transform workforces, widespread telecommuting and state budget shortfalls have increased the focus on state taxes. Although telecommuting raises many concerns, some of these central issues put into focus are:
- Income and sales tax nexus;
- Income tax apportionment; and
- State payroll withholding.
Nexus in respect to telecommuting is generally straightforward; an employee’s presence in a state result in nexus unless a state provides specific COVID-19 relief for such presence – and many state COVID-19 relief provisions have expired in 2021 and the remainder will likely expire in 2022. For income tax apportionment, in some states, the consequence of an employee working from a different state could affect sales sourcing and the payroll apportionment factor. For example, the New York City UBT (for non-corporate entities) uses cost-of-performance sourcing, which can lower taxes if employees leave New York to telework in nearby states. Such sourcing is generally determined based on the place where the services are performed.
Payroll withholding also presents challenges. Most states source employee wages to the state where the employee performs the services; however, with “Office of Convenience” rules, such as those in Massachusetts and New York, there is added complexity. These rules, some of which preceded the pandemic, essentially require non-resident wages to be sourced to the state’s office where the employee is assigned.
This could result in double withholding requirements for the employer. Some of the key issues impacting payroll withholding decisions include:
- Temporary versus permanent employee relocations
- COVID-19 payroll tax relief measures
- States that employ reciprocity agreements
- States with convenience of employer rules
Employee mobility and telecommuting are here to stay, and businesses must adapt and plan for the many tax issues that arise.
Considerations for Changing Residency
Now that you can work from home, are you considering a move to another state? Perhaps to a low-tax or no-tax state? If so, you’re not alone, and here are some of the things you should be considering.
Your move may change your domicile if you intend to permanently leave your home to establish a new, fixed, and permanent home somewhere else. Individuals domiciled in a state are subject to that state’s taxing authority on all their income. Domicile is the place you regard as your permanent home—the place to which you intend to return after a period of absence (e.g., a vacation, a short-term business relocation, educational leave). As a practical matter, you can only have one domicile at any point in time, although you may have multiple residences. Once established, domicile continues until you affirmatively establish a new domicile. Individuals establish a new domicile by moving to a new location with the concurrent intent to establish a fixed and permanent home there. However, moving to a new location, even for a substantial period of time (e.g., a multi-year work assignment), does not change your domicile if you do not intend to remain in the new location permanently. Individuals who moved out of their primary homes during the pandemic with the ultimate intention of moving back generally remain domiciled in their original home states. Individuals who maintain a second residence in another state may also find that they are statutory residents of the states where they temporarily resided if they spent substantial time at this other residence.
Determining where an individual is domiciled requires a subjective analysis of several factors, including, but not limited to:
- The individual’s home (considering the size, nature, and use of the residence) when an individual maintains more than one home)
- Active involvement in a trade or business
- Where did the individual spend the majority of their time
- Location of “near and dear” possessions
- Family connections
Additional factors demonstrating your intent to permanently move include registering to vote, obtaining a driver’s license and vehicle registration in the new state. The burden of proof is upon the person asserting a change of domicile. They must show an intention to abandon their previous domicile and establish a fixed and permanent home in a new one. Proper planning and understanding of their current home states’ residency rules are imperative if contemplating a domicile change.
Additional considerations when planning a change of domicile include:
- Whether an individual will remain subject to tax on their wages in the state they left pursuant to an Office of Convenience rule
- Modeling potential tax savings by relocating to a low or no tax state
- Implementation of proper domicile planning, considering the facts and circumstances, documentation requirements, and other rules when putting in place a plan to mitigate audit risks
- State Tax Authorities are aggressively examining taxpayers’ claims that they broke their domicile. Failing to prepare for a tax examination at the outset of a move jeopardizes the ability to ultimately prevail at the audit. Failing to plan = planning to fail.
Recent Nexus Developments
With economic nexus the law of the land, the concepts of state tax have been turned upside down. Now, businesses are first required to consider whether it has sales sourced to a state in order to determine if it has nexus. Best practices include examining a taxpayer’s sales tax nexus footprint at least annually. With sales tax, the issues of taxability review, the use of marketplace facilitators, and exemption certificate management have garnered more analysis in a post-Wayfair world.
In the aftermath of Wayfair, the Multistate Tax Commission (MTC) has targeted one of the remaining lifelines businesses have to shield them from income tax economic nexus; P.L. 86-272.
On August 4, 2021, the MTC voted to adopt a revision to its “Statement of Information”, whereby a business could lose P.L. 86-272 protection, by solely engaging with customers through the internet. The loss of P.L. 86-272 protection, may result in income tax filing impositions for many businesses. The federal law known as P.L. 86-272, was passed over 60 years ago, and it prohibits a state from imposing income tax on businesses that only sell tangible personal property (“TPP”) AND its activities in a respective state do not exceed the solicitation of orders. For many years, even preceding the Wayfair case, for income tax, it has been generally accepted that economic nexus has been the law of the land, unless a business was otherwise protected by satisfying P.L. 86-272. MTC’s guidance provides examples of when the use of an interactive website will tarnish P.L. 86-272 protection, which activities include:
- Providing post-sale customer assistance via an electronic chat or website email
- A career or employment page that accepts applications for non-sales positions
- The use of “cookies” on a customer’s device to gather information on shopping trends or to track inventory
- Transmission of remote product patches, upgrades or updates via the internet
- The offering of extended warranty plans
- Use of marketplace facilitators, such as the fulfillment center which maintains inventory
- Other interactive internet related activities
The MTC’s revised statement adoption could result in significant income tax liabilities for many remote businesses, as many of these businesses use a website or app to interact with its customers. Even if businesses have performed nexus or P.L. 86-272 review in the past, they should consider having such studies refreshed, considering many of the recent developments the last several years.
Item’s to consider:
- Review existing and pre-Wayfair Nexus footprint, including inventory held by marketplace facilitators
- Assess post-Wayfair filing obligations
- Evaluate income tax, sales and use tax, and other indirect tax nexus
- Determine potential tax exposure for prior periods
- Consider options to limit exposure (e.g., Voluntary Disclosure Agreements, amnesty, etc.)
- Assist with communication to stakeholders in the organization
- Review product and service mix
- Analyze sales sourcing on a state basis for determining income tax nexus
- Develop nexus and tax matrix
- Take advantage of current exemptions
- Review and consider automation needs
- Prepare and file registrations as necessary
- Develop SALT processes to meet compliance requirements
- Prepare for tax audits
- Address changes in the organization (e.g., new lines of business, modified sales force activity, marketplace facilitator/provider inventory locations, etc.)
- Continue to monitor changes to economic nexus and tax laws
No action should be taken without advice from a member of Withum’s State and Local Tax Services Team because tax law changes frequently, which can have a significant impact on your specific planning possibilities. Reach out to discuss your individual situation as year-end approaches.