State Tax Compliance After Wayfair: Time for a Nexus Review?

In the wake of the U.S. Supreme Court’s groundbreaking decision in South Dakota v. Wayfair, states have become further emboldened to assess taxes against businesses that lack employees, property or other physical attributes within their jurisdiction. At the same time, some states still lack a clear standard for determining the level of activity within their borders that can trigger a tax assessment. Businesses need to protect themselves by identifying and mitigating potential risks. They also must be proactive in achieving compliance.

Before Wayfair the states were limited to imposing sales and use tax collection duties on a vendor that maintained a physical presence within their jurisdiction. The Wayfair decision removed the so-called physical presence requirement for purposes of sales and use tax nexus determinations. Activities such as owning property in the state or having employees work there are examples of a physical presence.

The removal of the physical presence requirement opened the doors for states to consider adopting an economic nexus standard under which tax assessments can be imposed on remote vendors, which are vendors with no physical nexus to a particular state other than its sales to customers. In Wayfair, the Supreme Court upheld a South Dakota law requiring out-of-state vendors to collect sales and use tax if they had 200 or more separate transactions in the state or delivered over $100,000 of goods and services into the state, thereby establishing an economic nexus standard.

States Adopt New Economic Nexus Threshold

As the economic nexus trend continues, businesses will need to perform a similar review of their state income and franchise tax obligations. For income and franchise taxes, the Supreme Court has never explicitly ruled that the physical presence requirement applies to nexus determinations. As a result, over the past 20 years many states have successfully enforced income or franchise tax assessments against businesses that lacked a physical presence within their jurisdiction and were not otherwise protected under Public Law 86-272. Wayfair bolsters the states’ position that they are entitled to employ a similar economic nexus standard in their imposition of income and franchise taxes. The Texas Comptroller of Public Accounts adopted amendments to Rule 3.586 in December 2019 that  impose a filing responsibility for the franchise tax on certain out-of-state entities with more than $500,000 in Texas gross receipts, even if the entity has no physical presence in Texas. The economic nexus standard applies to franchise tax reports due on or after January 1, 2020. This change will likely have the greatest impact on taxpayers filing combined returns that include members with Texas sales and no physical presence in the state. Texas law and Rule 3.586 state that Public Law 86-272 does not apply to the franchise tax.

Similarly, the Pennsylvania Department of Revenue adopted new nexus requirements for purposes of the Pennsylvania corporate net income tax effective for tax periods starting on or after January 1, 2020. The Department determined that there is no longer a physical presence standard limiting the ability of the state to impose a net income tax on an out-of-state taxpayer. Rather, out-of-state corporations are considered to be doing business in the state to the extent that they are taking advantage of the state’s economic marketplace. The Department created a rebuttable presumption that a corporation with no physical presence in Pennsylvania, but with $500,000 in Pennsylvania gross receipts, must file a Pennsylvania Corporate Tax Report. Notably, the Department recognizes that a taxpayer with or without physical presence in Pennsylvania can still claim an exemption under the provisions of Public Law 86-272.

Protection Under Public Law 86-272

Public Law 86-272 prohibits states from levying a net income tax upon an out-of-state company if the company’s activities in a state are limited to the solicitation of orders for the sale of tangible personal property and the orders are approved and filled from outside the state. It also goes on to clarify that a person shall not be considered to have engaged in business activities within a state during a taxable year merely by reason of sales of tangible personal property in such state. Public Law 86-272 does not apply to services and it also does not apply to non-income taxes such as franchise and gross receipts taxes.

Hawaii’s new income tax nexus statute (Hawaii S.B. 495) states that a person that lacks in-state physical presence is presumed to be systematically and regularly engaging in business in the state and subject to Hawaii’s income tax if they (1) engage in 200 or more business transactions in Hawaii and (2) have gross income from the state of $100,000 or more, which includes the numerator of the sales factor equaling or exceeding $100,000. The provision is effective for tax years beginning after December 31, 2019, with thresholds based on activity either in the current or preceding year. It should be noted that federal law (P.L. 86-272) still protects an out-of-state business from being subject to net income tax on its business activity in Hawaii if the entity limits its business activity to the solicitation of sales of tangible personal property.

Several other states have adopted an economic nexus standard for income or franchise taxes based on the Multistate Tax Commission’s model statute, Factor Presence Nexus Standard for Business Activity Taxes. The model statute quantifies the level of activity that constitutes economic nexus. An income or franchise tax reporting obligation is triggered under this standard only if the following thresholds are exceeded during the tax period:

• $50,000 of property,
• $50,000 of payroll,
• $500,000 of sales, or
• 25% of total property, total payroll or total sales.

Most States Lack a Quantifiable Nexus Standard

At this point, most states have yet to adopt a quantifiable nexus standard for income or franchise taxes. The result is that it is difficult for businesses to determine whether their activities in a particular state are sufficient to trigger a tax assessment. To achieve compliance, businesses must take a proactive approach to identifying and mitigating risks by performing a nexus study with an experienced state and local tax advisor. A nexus study analyzes the level of business activity in each jurisdiction and considers factors such as:

• the activities of employees, independent sales representatives, agents and/or affiliates soliciting sales and/or performing services on their behalf,
• not registering for income or franchise tax where they are collecting sales and use tax, or
• multistate tax exposure as a result of a recent acquisition.

If potential liabilities are identified a business can limit their exposure by participating in a state’s voluntary disclosure program. Most programs offer reduced penalties and limit the periods for which tax liabilities can be assessed.

The Takeaway

Wayfair significantly changed the legal standard used for determining whether a state could assess corporate income or franchise tax on an out-of-state business. By doing away with the physical presence rule, a business without any employees or property in a state can be subject to tax by virtue of the amount of sales or number of transactions in the jurisdiction. This type of economic nexus standard has already been adopted by many states.

With these changes taking place, it is important to consult a tax adviser to help you re-evaluate your tax obligations in each of the states in which you do business.