With state governments facing sharp declines in tax revenue and increases in fiscal spending, more and more states are searching for additional revenue streams. Not surprisingly, states are testing the boundaries, in an attempt to discover just how far they can extend their ability to impose taxes. Since the United States Supreme Court has declined to hear any case addressing new state tax laws, a recent trend involving nexus has emerged.
“Nexus” means a connection. The term nexus is used to describe a situation in which a business has a sufficient connection with a state to constitutionally subject the company to taxes imposed by the state. Nexus describes the degree of business activity that must be present before a state can impose tax on a business. If a company is determined to have nexus with a particular state, it is subject to the tax of that state.
States generally attempt to impose their taxes on out-of-state corporations to the fullest extent permissible under federal law, one reason being that it is more appealing to in-state voters for their state to shift its tax burden onto out-of-state taxpayers. The U.S. Constitution, however, prohibits a state from taxing an out-of-state company unless the requirements of both the Due Process Clause and the Commerce Clause are satisfied. The Due Process Clause provides that no state shall “deprive any person of life, liberty or property, without due process of law,” while the Commerce Clause gives Congress the exclusive authority “[t]o regulate commerce with foreign Nations, and among the several States.”
Congress in 1959 enacted Public Law 86-272, which was intended to act as a framework for determining when a multistate company is subject to income tax in any particular state. The law prohibits a state from imposing a net income tax if a company’s only in-state activity is the solicitation of orders for sales of tangible personal property, which are sent outside the state for approval and are filled from outside the state. Unfortunately, Public Law 86-272’s scope is limited in application. Only taxes based on net income and sales of tangible personal property fall within its purview. Thus, transactions involving sales of intangibles or services are not protected. Nor does the statute apply to taxes that are not based on net income (e.g., capital based taxes and gross receipts based taxes).
In 1967, the U.S. Supreme Court established the principle that nexus for sales and use tax purposes requires an in-state physical presence before a state can impose its tax collection responsibility on an out-of-state company (National Bellas Hess, Inc. v. Department of Revenue, 386 U.S. 753 (1967)). The Court subsequently reaffirmed this physical presence requirement twenty-five years later in Quill Corp. v. North Dakota, 504 U.S. 298 (1992). However, the Court did not specifically address the issue of whether the physical presence requirement also applies to income tax nexus.
Many states have exploited the apparent nexus opening in the Quill decision by enacting new statutes using the concept of “economic nexus.” Economic nexus is the term used to describe the establishment of nexus by an out-of-state company based on factors aside from a physical in-state presence. States have aggressively asserted economic nexus against out-of-state companies that only have a minimal amount of in-state sales or contacts. There has been a significant amount of litigation regarding the issue of whether in-state economic presence is, by itself, sufficient to satisfy previously established nexus requirements. To date, states have been very successful in defending the newly adopted economic nexus standards.
While states have taken any number of approaches in implementing economic nexus as it relates to income, franchise, and other business privilege taxes, such as Tennessee’s nexus assertion on credit card solicitation (JC Penny National Bank v. Johnson) and Kentucky finding taxable nexus for the resale of telecommunications services (Annox v. Kentucky Revenue Cabinet), the method that has gained much state popularity is attributing nexus through “factor presence.”
Factor presence is dictated by the amount of property, payroll, or sales an out-of-state corporation has within a state. While it comes as no surprise that having a certain amount of property or payroll in a state creates nexus (see the physical presence principle of National Bellas Hess and Quill), controversy arises with the notion that a certain amount of sales made within a state, even if there is no physical presence, creates nexus.
The Multistate Tax Commission (“MTC”) first developed the idea of factor presence in 2002. The concept was meant to be a simple, certain, and equitable standard for the collection of taxes. In this proposed version of factor presence, taxable nexus is established if any of the following thresholds are exceeded: $50,000 of in-state property; $50,000 of in-state payroll; $500,000 of in-state sales; or 25% of the total property, total payroll, or total sales is sourced in-state. Therefore, even if there is no physical presence during a tax year, as long as one of these thresholds is exceeded, nexus would be established. Several states have incorporated all or part of these standards into their nexus statutes.
Ohio was the first state to impose a factor presence nexus standard for determining its commercial activities tax. Washington also adopted a slightly modified version of the MTC’s standards for its business and occupation tax. More recently, Oklahoma for its business activities tax and Michigan for its corporation income tax have enacted similar factor presence statutes. Connecticut, Colorado, California, and Kansas have also jumped on factor presence nexus for their business income and franchise taxes.
In a recent survey, 35 states reported that business activity tax nexus could be triggered by conducting a minimum amount of economic activity within their borders. While economic nexus has become the law in a minority of states, its emergence is a growing trend. Taxpayers should be aware that the statutes by which a state deems a company to be doing business within its borders, and thus subject to tax, are rapidly expanding. Proper tax planning can help avert unwanted economic nexus and permit a company to focus its efforts on its core activities.
For more information on the impact of economic nexus on your business, contact Alan Goldenberg, Manager of Tax Controversy and State and Local Tax, at firstname.lastname@example.org or 212-897-6421, or contact your engagement partner.