If you are a business owner, the concept of “tax nexus” is something you need to be familiar with. Why? Because the last thing you want is a tax surprise derailing your carefully crafted business plans.
But what exactly is a tax nexus?
In this guide, we'll dive right into the details of tax nexus and explain why understanding it is crucial for your operations. We will explore the types of tax nexuses, when they arise, and what you should do once a tax nexus is established.
In the context of taxes, a nexus is a link between a taxing authority (like a state) and an entity (like your business). Essentially, a tax nexus arises between a state and a business when this link _is sufficient to warrant _the imposition of taxes on the business by the state. What does this mean?
This means that there must be a link of a certain degree (physical or economic) between the state and the business before the state can impose taxes. For instance, if a business has a retail store in Arkansas, the tax nexus arises because of the business’s physical presence in the state. Therefore, Arkansas can tax the business.
If a sufficient link (nexus) exists, the business must file returns and pay taxes in that state.
Conversely, if this link is not “sufficient” (more on how this is established later), the state cannot impose taxes.
Let’s take a quick look at the origin and evolution of the tax nexus concept.
1787 - Commerce Clause: This gives Congress the power “to regulate commerce with foreign nations, and among the several states, and with the Indian tribes.” It prevents states from imposing excessive burdens on or restricting the unrestricted flow of trade between states.
1868 - Due Process: This clause prohibits states from depriving a person of their “life, liberty, or property, without due process of law.”
How does due process come into the picture? The Supreme Court has interpreted the due process clause to apply to tax laws as well. It requires that there be a minimal connection between a business and the state in which it operates before the state can tax the business.
In 1959, Congress enacted the Interstate Income Act, also known as Public Law (P.L.) 86-272. According to P.L. 86-272, states cannot impose income tax on out-of-state corporations on their income derived from within the state if their business activities are restricted to:
- Soliciting orders for selling tangible personal property
- If these orders are approved and fulfilled from outside the state
In this case, the Supreme Court held that a tax imposed by a state is constitutional if the tax is:
- Applied to an activity that has a substantial nexus with the taxing state
- Fairly apportioned (the state cannot tax more than its share of the taxpayer’s income)
- Not discriminatory against interstate commerce
- Fairly related to the services that the state provides
What constitutes a substantial nexus?
In Quill Corp., the US Supreme Court held that a state can enforce a sales tax collection obligation on an out-of-state entity only if the entity has a physical presence within the state.
This physical presence can include:
- Offices or branches
- Other tangible assets
Merely having customers within the state (economic presence), without a physical presence, did not establish substantial nexus under the Commerce Clause to warrant the collection of sales or use tax for purchases that in-state customers made.
This was where the rules regarding tax nexus evolved drastically. _South Dakota v. Wayfair, Inc. _was a landmark Supreme Court decision that overruled the decision in Quill Corp. (which you read about previously) and redefined the rules regarding when nexus is established.
To give you a brief background of the facts surrounding the case, South Dakota had passed a law expanding its sales tax beyond sellers with a physical presence to remote sellers who sold:
- Tangible physical property
- Products transferred electronically
- Services for delivery in South Dakota
If from the sale of these products, the seller:
- Generated more than $100,000
- Had two hundred or more separate transactions
This law contradicted the “physical presence” requirement that the Supreme Court had laid down in Quill Corp. While deciding the matter, the Court revisited the “physical presence” rule established in Quill Corp. and concluded that it no longer aligned with the realities of today's business landscape, especially the booming internet-based e-commerce market.
They recognized that the old rule placed an unfair burden on states that were unable to collect sales tax from out-of-state vendors operating without a physical presence in the buyers' states. Although purchasers were technically responsible for paying a compensating use tax in their own states, many failed to do so, resulting in reduced revenue collection for the states.
Therefore, the Court adopted the stance that the widespread use of technology for interstate transactions creates a sufficient nexus to justify imposing sales tax obligations on out-of-state vendors, even if they lack a physical presence in the state where the sales occur.
There are various types of tax nexuses based on how nexus is established.
As discussed earlier, if a business has a physical presence in a state, this gives rise to nexus for the purpose of tax and gives the state the right to tax that business. The standards vary across states, but a physical nexus obligation is generally established by the following:
- Employing someone in the state
- Owning physical property in the state
- Renting or leasing physical property in the state
- Storing goods for sale in the state
- Providing goods or services to residents of the state
- Temporarily being present in the state for business purposes, like setting up a pop-up shop or attending a trade show
Economic nexus is a connection or “sufficient presence” established by a business within a state based on economic factors, such as:
- Sales revenue
- Transaction volume
- Number of customers
These thresholds are set by states (as you saw in the case of South Dakota). When a business meets the specified economic thresholds set by a state, it is deemed to have economic nexus and becomes subject to the state's tax laws and obligations, including the collection and remittance of taxes.
Let’s take an example to illustrate this. Suppose a jewelry company is based in State A. While it mainly sells jewelry within its own state, its popularity grows. It starts getting more orders from customers in neighboring State B.
Once its sales in State B reach a certain threshold set by State B's tax laws, the company must register with the state, collect sales tax from customers in State B, and submit the tax to State B's tax authorities.
This happens because the company has met the economic nexus requirement in State B by surpassing the sales threshold.
Economic nexus has gained significance in the digital era as businesses engage in online sales and expand their operations across multiple states. And as expected, considering the fact that introducing economic nexus translates to additional tax revenue, post the decision in Wayfair, most states have jumped on the bandwagon to define their economic nexus requirements.
Affiliate nexus is established when an out-of-state business entity has an affiliate in the taxing state. Many states have codified "affiliate nexus" laws, which assume the existence of a nexus obligation when there is a connection between an in-state entity and an out-of-state entity that are related, commonly owned or controlled (affiliated), and have certain shared business characteristics.
Because of the affiliation, the out-of-state entity is considered “present” in the taxing state and is required to collect and remit sales tax. Some important factors for establishing affiliate nexus are:
- Common ownership: While not the sole factor, it plays a substantial role in establishing affiliate nexus.
- Selling similar products under the same name: If the in-state affiliate sells products similar to the out-of-state entity under the same brand or name, it can contribute to establishing affiliate nexus.
- Sales-related activities: The involvement of the in-state affiliate in promoting, generating, or fulfilling sales for the out-of-state entity is an important factor in determining affiliate nexus.
- Other sales-related activities: Activities such as delivery, customer service, and maintaining a physical presence on behalf of the out-of-state entity may also be taken into account when establishing affiliate nexus.
However, it can be challenging to define a one-size-fits-all definition of affiliate nexus because each state’s definition of this threshold differs from the other.
When an out-of-state retailer lacks physical presence in a particular state, they may still be bound by sales/use tax nexus if they have an in-state affiliate and meet certain criteria.
Under click-through nexus laws, nexus can be established through an agreement with an in-state individual or business that refers or guides sales to an out-of-state online retailer in exchange for a commission or other form of consideration. This could include people or entities:
- Sharing links, codes, discount coupons, etc.
- Encouraging people to buy things by undertaking marketing or advertising programs, etc.
Simply put, if an in-state entity guides customers to an online retailer from another state using links or a website, and those customers make purchases of physical products or services, it creates a click-through nexus.
If the state where the affiliate operates has click-through nexus regulations in place, the out-of-state seller becomes responsible for gathering and remitting the relevant sales tax.
To better explain this, let's say there is a clothing brand based in State A. They have an affiliate in State B, a fashion blogger who promotes their products on her website. State B has a click-through nexus law. This means that the brand has to pay taxes in State B because of this relationship. They need to register, collect, and remit sales tax for sales made through the blogger's promotional efforts in State B (subject to State B’s thresholds in terms of revenue, customers, etc. as applicable).
As you saw earlier, a clear nexus must exist between an entity and a state before the state can impose any taxes.
When it comes to income tax, certain states (for instance, Alabama, California, Colorado, Connecticut, Michigan, New York, Tennessee, and Virginia) use a factor-presence standard to determine this nexus.
In 2002, the Multistate Tax Commission (MTC) proposed a uniform law to provide clear guidelines for when an out-of-state business establishes a nexus for business activity taxes, such as gross receipts or income taxes, in a specific state.
According to the MTC's factor-presence nexus standard, certain thresholds must be exceeded during the tax period to indicate that a company is conducting business in a state. These thresholds include property, payroll, and sales thresholds:
- Property: $50,000
- Payroll: $50,000
- Sales: $500,000
- 25% of the total property, total payroll, or total sales
States have the option to adopt this uniform law with or without modifications to suit their specific needs. These threshold amounts can be adjusted for inflation annually or through other means as outlined in the MTC's model statute.
For instance, California’s thresholds are:
- Property: $63,726
- Compensation: $63,726
- Sales: $637,252
- 25% of total property, total compensation paid, or total sales
However, it is important to note that the Interstate Income Act of 1959, which we discussed earlier, prohibits states from imposing a net income tax on a seller's business activity if it is limited to soliciting orders for sales of tangible personal property.
It's worth mentioning though that this exception does not apply to sales tax.
As of 2021, 45 states impose sales tax. Once a tax nexus is established (through the different types of nexuses we saw above), a sales tax nexus is created between a business and a state. This requires the seller to then register for the purpose of collecting and remitting sales tax. Some states require you to register and collect sales tax as soon as you hit the threshold, while some others give you some time to do this.
For instance, in North Dakota, you have to register for sales tax 60 days after the threshold is met or in the next calendar year (whichever is earlier).
Sellers operating across state borders and remote sellers must take a proactive and organized approach to documenting their business activities, which involves undertaking the following:
- Keeping thorough records of the goods, services, or digital products they sell
- Including specific details such as the quantity and specific information of each transaction
- Tracking how the sales are conducted and the locations to which they are made
- Recording relevant details about the customers involved in the transactions
If a business discovers that it owes sales tax in a state where it was previously unaware of the obligation, there are several steps it can take:
Register for sales tax: The business should promptly register with the state's tax authority to obtain a sales tax permit or license. This allows the business to legally collect and remit sales tax on its transactions.
Assess liability: The business should determine the amount of sales tax it owes for the past period of non-compliance (including checking the effective dates of statutes related to various nexuses).
This involves reviewing sales records, invoices, and other relevant documentation to calculate the correct tax liability.
Voluntary disclosure: Some states offer voluntary disclosure programs that allow businesses to come forward and voluntarily report their sales tax liability without facing penalties or interest. The business should consider participating in such a program to minimize potential penalties.
Payment of sales tax: The business should promptly pay the outstanding sales tax liability to the state's tax authority as per the deadlines provided by the tax authority.
It is important to note that specific procedures and requirements may vary by state. Also, do note that you must identify where your business might have a sales tax nexus by state (as each state has its own rules regarding this).
- Tax nexus is the link between a state and a business that warrants the imposition of taxes by the state.
- Nexus can be established through physical presence, economic factors, affiliate or agency relationships, or click-through arrangements, which means even online or remote sellers may be bound to pay taxes once certain conditions are met.
- Physical nexus is established through physical presence such as offices, employees, or property in a state.
- Economic nexus is based on economic factors like sales revenue, transaction volume, or the number of customers.
- Affiliate nexus considers the connection between an in-state and out-of-state entity that are related or have shared business characteristics.
- Click-through nexus applies when an out-of-state retailer has an in-state affiliate that guides customers to their online store through links, etc.
- Different types of tax nexuses may trigger income tax or sales tax obligations depending on a state's laws.
- Businesses should keep thorough records of their transactions, including goods, services, quantity, location, and customer details.
- If a business discovers a sales tax obligation in a new state, it should register, assess liability, consider voluntary disclosure programs, and promptly pay the outstanding tax.
- You can ensure that you navigate the state tax landscape smoothly by:
- Maintaining accurate records
- Implementing internal audit processes
- Conducting regular reviews
- Leveraging automation and technology solutions
- Staying updated on regulatory changes
Remember, understanding your tax obligations and staying compliant is essential for the sustainable growth of your business.
430 U.S. 274 (1977)
504 U.S. 298 (1992)
Dkt. No. 17-494 (U.S. Supr. Ct. June 21, 2018)
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