It was the best of times, it was the worst of times… For business owners, the last few years have felt more like the worst of times than anything else. With sales down, many taxpayers have implemented innovative marketing and delivery strategies to meet their customers’ needs during the down economy. Indications are that the economy is slowly picking up and we’re starting to see more taxpayers with taxable income. The two threshold questions of state tax are: (1) does the taxpayer have nexus with a particular state? and (2) is what the taxpayer is doing/selling taxable in that state? This short article focuses on the first question. A future article will examine how the states’ definitions of taxable activities and products are changing.
In part due to the down economy, taxpayers have gotten more creative. Often taxpayers have expanded into new markets over the last few years and may not be aware that their increased “footprint” – or the geography where they do business – has created new tax and filing obligations. Add to that the fact that many states have modified the rules that govern when a taxpayer is taxable, and we’re sailing into a perfect storm of audit risk. This year, we saw a high-profile, local furniture company run afoul of the Washington Department of Revenue large number of questions from clients about their sales and activities. Therefore, I thought it would be worthwhile to go over a few of the basic rules governing state taxable nexus – defined as when a taxing jurisdiction can tax an out-of-state entity or individual.
We know from various constitutional cases in the last half of the twentieth century that a state government can only tax the economic activity of a business where there is “some definite link, some minimum connection, between a state and the person, property or transaction it seeks to tax.” A bright line test is whether or not the taxpayer has a physical presence in the jurisdiction. The case of Quill Corp. v. North Dakota confirmed that, for purposes of sales and use taxes, the taxpayer must have a physical presence in the state for the state to be able to impose its sales tax on transactions with customers inside that state.
There is a well-publicized trend for state taxing jurisdictions that have a sales tax to implement so-called “Amazon”, or affiliate nexus, laws. Several jurisdictions noted the trend for internet retailers to have in-state affiliates direct e-commerce traffic back to the retailer’s site in exchange for a commission under a contract.
These states passed laws or interpreted existing laws to hold that the physical presence of the non-employee affiliate in their taxing jurisdiction was enough to create taxable nexus for the retailer. Although Amazon, the initial entity opposing these laws, has stopped fighting in many instances, we are seeing many other retailers weigh the risks and benefits of affiliate relation-ships to market their products.
The nineteenth century saw the rise of the door-to-door salesman. These “drummers” (since they drummed up business) would go from town to town selling products. Congress decided that it wanted to encourage interstate commerce and so it created a nexus safe harbor, now known as Public Law 86-272, which says that a state may not impose a tax based on net income on sales of tangible personal property where orders are sent outside the state for approval and are fulfilled from outside of the state.
There are a lot of misconceptions about how Public Law 86-272 works. I once had a client tell me that they didn’t have tax nexus anywhere other than Oregon because of Public Law 86-272, despite the presence of a sales force on the ground in 37 states. It is important to note that this only protects taxpayers against net income taxes and only in the case of sales of tangible personal property. So, a taxpayer who is protected under this law for income tax purposes may still be liable for sales or use taxes because they have sales personnel physically going into the state. Also, the Washington business and occupation tax, similar to other states’ gross receipts or franchise taxes, is not a net income tax. Thus, taxpayers who have sales employees going into Washington may also be subject to the state business and occupation tax.
Public Law 86-272 also only protects companies that sell tangible personal property. Most service providers are excluded from this protection. The Multistate Tax Commission, an organization of state revenue authorities, has advocated for the expansion of nexus standards to “economic nexus thresholds. In 2010, the State of Washington also adopted economic nexus standards that made businesses subject to its business and occupation tax if they had $250,000 in Washington sales or more than 25 per-cent of their total sales in Washington – even where they did not have a physical presence in Washington. As an example of how this plays out, many states (including Oregon) are asserting economic nexus against taxpayers that are in the financial services industry. These companies are not usually based in Oregon, but may have substantial cardholder or depositor activity in the state. Oregon would argue that this constitutes “doing business” in the state and should subject these financial institutions to Oregon tax.
I want to conclude with two cautions for our clients. One of the most common mistakes I see is taxpayers filing tax returns only in the jurisdictions they filed in last year. Since the way businesses sell goods and services has evolved in the last few years, and since the law in this area is constantly changing, I strongly recommend that taxpayers review their taxable footprint on an annual basis and evaluate whether the taxpayer wants to begin to file in any new jurisdictions or if it makes sense to keep filing in all the historic jurisdictions. It has been my experience that it is safer, and less costly in the long run, to know where your business may be taxable than to find out in the context of an audit.
Additionally, I recommend that taxpayers who receive nexus questionnaires from state revenue authorities consult with their attorney or accountant on the best way to answer the questions. Many times the questions on these letters are ambiguously worded. An answer that creates the idea with the state revenue authorities that you are subject to tax in a jurisdiction can be very difficult to refute later in the audit or appeal process.
Valerie is passionate about adding value to her clients’ businesses and having an immediate, positive influence. When working with individual clients, she strives to improve their lives by taking complex tax situations and breaking them into manageable pieces with achievable outcomes. You can contact Valerie directly at firstname.lastname@example.org.