States’ Arms are Getting Longer as They Attempt to Adapt to the Present and Future of Business
Chris DeRosa, Tax Senior Manager
With state governments becoming increasingly aggressive in their efforts to generate revenues and keep budgets in check, many have employed new tactics to cast a wider net over those to which taxes apply. One of the more recent trends sweeping the states is the concept of “economic nexus.” Nexus is the concept of having a taxable connection or presence in a jurisdiction. Economic nexus means having a connection that is not necessarily physical, but is instead reliant enough on a local economy to warrant a taxing obligation.
As business trends change, so do those of the tax collectors. Economic nexus is becoming an increasingly popular means of lowering the threshold for creating tax nexus, by taxing businesses that don’t have any connection to a state besides their customers.
Since the proliferation of digital communication and e-commerce, it is easier than ever for businesses, large and small, to reach customers in any corner of the world. State tax regimes were designed for the business norms of past eras, where business was done face to face, and manufacturing and development primarily took place within the United States. States and their tax laws have struggled to keep up with the speed in which businesses and the global economy have evolved.
In response to the changing trends in the way business is currently being conducted, states have experimented with unitary/combined reporting, various new and expanded tax bases (gross receipts, net worth, etc.), and lower thresholds of nexus; some of which directly challenge the Constitution and well established precedents set by historic case law. States have taken to taxing businesses that exploit the market place without creating local jobs or invest in property and facilities, and are piercing the veil of Public Law 86-272 by forcing payment of income taxes to a state. P.L. 86-272 provides taxpayers protection from taxes measured by net income if their sole activity in a state is the solicitation of tangible personal property. States argue that the traditional foundation of economics, upon which the states rely for revenue and growth is becoming outdated, and that they are handcuffed by the Public Law and various other case law that was applicable decades ago. The states have been forced to work within the tight confines of the Commerce and Due Process clauses to develop new ways of generating tax revenues that are directly tied to current economic drivers.
States believe economic nexus is a better way for determining whether a business exploits a local economy enough to warrant taxing it. Nearly every state has some form of economic nexus standard (some better defined than others), or has entertained the prospect of adopting economic nexus. Taxpayers argue that this is a highly subjective approach, which gives the states too broad of a reach, and inhibits interstate commerce by putting a significant compliance burden (and risk) on businesses, especially those in the small and middle markets.
Commonly, states will consider a business that licenses an intangible, such as a trade name or franchise right, as establishing nexus, as was illustrated in a 1993 South Carolina case; Geoffrey, Inc. v. South Carolina Tax Commission. Additionally, many states have adopted economic nexus standards that employ a series of bright-line tests that, if exceeded, establish a taxable presence in a state. These tests are typically a measurement of property, payroll, or sales sourced to a particular state. States such as California, Colorado, Connecticut, Michigan, New York, Ohio, and Washington, among others, have employed a bright-line test. Thresholds for payroll or property in a state may be as low as $50,000 or a percentage of the business’s total property or payroll. With regard to sales, the thresholds typically range in the neighborhood of $250,000 to $1,000,000. These low barriers of entry make it very easy for even the smallest businesses to fall into a multi-state filing obligation without even knowing it.
As states fight for their share of the tax pie, it is important to keep in mind that creating a taxable presence in more states does not always mean paying more tax. Ideally, income should only be taxed once by apportioning it among the states in which a taxpayer conducts its business. This may not always be true depending on various apportionment and revenue sourcing rules being employed in the states, as discussed in a January 2014 article. There is a cost, however, to complying with multiple states’ tax rules, through registration fees, software upgrades, and increased need for accountants and outside service providers.
It is also important to keep in mind that the protection of P.L. 86-272 still exists. States may not tax the income of a business when its only connection to the state is solicitation of sales of tangible personal property. They may, however, tax a business by other measures such as net worth, gross receipts, etc., which do not have the protections offered by P.L. 86-272.
As the concept of economic nexus and bright-line presence standards are relatively new to states and taxpayers alike, many states have been lenient with the enforcement of penalties and interest on taxpayers that have created nexus without knowing it. As the rules typically date back only a few years, the exposure to businesses that have not complied with these rules is generally limited to only a few open periods. It is important, however, to address the matter of non-compliance sooner, rather than later, as the grace period will eventually run out, and this issue will compound. Most states do offer remediation methods for new taxpayers in the form of Voluntary Disclosure Programs or other similar programs, as discussed in a July 2014 article.
Amidst all the controversy surrounding economic nexus, the Supreme Court has avoided giving definitive guidance on this matter. It has remained silent in the background, leaving it up to the states and their courts to decide how this struggle will play out.
If you feel that your business may have nexus in a state, or if you have any other questions regarding tax matters, please reach out to your BNN contact, Chris DeRosa or Merrill Barter at 1-800-244-7444.
Disclaimer of Liability: This publication is intended to provide general information to our clients and friends. It does not constitute accounting, tax, or legal advice; nor is it intended to convey a thorough treatment of the subject matter.
IRS CIRCULAR 230 DISCLOSURE:
Pursuant to requirements imposed by the Internal Revenue Service, any tax advice contained in this communication (including any attachment) is not intended to be used, and cannot be used, for purposes of avoiding penalties imposed under the United States Internal Revenue Code or promoting, marketing or recommending to another person any tax-related matter. Please contact us if you wish to have formal written advice on this matter.