What you need to know about tax nexus

ARTICLE | April 27, 2023

Nexus is a legal term that refers to the level of connection a business or individual has to a municipality, state, or country. In the United States, tax nexus determines whether a company is required to collect and remit certain taxes and/or is subject to state income taxes. For instance, a business may have to remit sales taxes in a state other than where it is headquartered if it conducts business in that state. 

While the requirements for establishing nexus vary between jurisdictions, business taxpayers need to be aware of the concept to comply with all relevant tax obligations. This article will provide some examples of situations that create tax nexus; however, nexus is determined on a case-by-case basis and should always be discussed with a tax expert. 

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Background

Historically, it was easy to determine where a business had to remit taxes. Their physical presence was generally enough to dictate where there was a tax liability. For example, a company located, selling products, and employing individuals in California was subject to California taxes. 

Public Law 86-272, unchanged since the 1950s, prevented a state from imposing state income tax outside of a business's home state as long as: 

1. The only activity within the state by the taxpayer was for the solicitation of orders of tangible personal property,
2. The orders received were then sent outside of the state for approval or rejection, and
3. The approved orders were fulfilled by shipment or delivery from outside the state. 

However, mass internet adoption has led to major changes in how we do business. A business might be physically located in one state, sell products or services in other states, and employ individuals in different states. Or, a business might be entirely online. As a result, the concept of tax nexus has expanded (exponentially) to keep up with the changing business environment. Today, there are many modifications and exceptions to the physical presence rule that affect businesses of all shapes and sizes. 

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Types of Nexus

In 1986, the Multistate Tax Commission (MTC) issued a statement to assist taxpayers with compliance under PL 86-272. Due to numerous court decisions interpreting the physical presence standard and updated guidance on several key elements, MTC's statement has been revised at least four times since 1986. In addition to physical presence, tax nexus can now be established by economic activity and agency, among other more narrow factors. 

Physical presence

Physical presence is no longer as cut and dry as it may appear. As business practices have changed, so has the definition of physical presence. Naturally, a business must file and remit taxes in the jurisdiction where it is physically located. But now, a business can be required to pay taxes in a jurisdiction where a subsidiary corporation is located - as affiliated companies can create reciprocal tax duties across state lines. In some circles, this is referred to as "affiliate nexus." 

Likewise, if a business has employees working from home in another state, that could potentially be enough to create a tax nexus in that employee's state of residence. Drop-shipping, another modern phenomenon, could also establish nexus outside a business's home state. For instance, if a Nevada business sells or delivers products from a drop-shipping location in North Dakota, it could potentially be subject to North Dakota sales tax. 

Economic activity

Sufficient economic activity within a state can also be enough to create nexus. In other words, if you're selling products or services to customers in a different state, you could be subject to sales tax in the customers' states. This is particularly relevant in today's business environment, where many sales take place online. 

The issue made its way to the Supreme Court in 2018 in the case of South Dakota v. Wayfair, Inc. The case revolved around whether states have the right to tax products sold online to residents of the state, even if the seller does not have a physical presence in the state. In its ruling, the Supreme Court found that states do have this right, and as a result, online sellers are now required to collect sales tax on purchases made by residents of states where the seller has nexus. As a general rule, this means businesses must remit sales tax wherever they engage in economic activity. However, each state has different thresholds for economic activity that establish economic nexus - which complicates matters further.  

Factor presence 

Taxation can also be required based on the presence of certain factors. For instance, a state may say that an out-of-state company must pay in-state taxes if they have more than $100,000 in sales, $25,000 in payroll, or $50,000 of property in the state. If the entity meets any of these factors, nexus could be established. Other states may find nexus if in-state sales, payroll, or property exceed a certain percentage (e.g., 30%) of the company's total revenue. 

Agency

Working with a third party in another state can also establish nexus. For instance, a business based in Maryland working with a distributor in Pennsylvania could have nexus in Pennsylvania. The same is true for independent contractors, sales representatives, suppliers, manufacturers, and possibly even employees working from home. 

Remote workers and tax nexus

Today's on-demand workforce adds an extra layer of complexity to nexus. If a business employs a remote worker that telecommutes regularly from another state - that could be enough to establish nexus (for income taxes) in the remote worker's state of residence. 

Different types of tax

Different types of tax also have different triggers for nexus. For instance, a business could be subject to sales tax in a state but not to payroll or income tax. Again, the triggers for these different types of tax will vary by jurisdiction. 

Importance of understanding nexus

It's critical to understand nexus so your business can meet its tax obligations. Failure to comply could result in penalties and interest. Plus, by understanding your tax obligations in advance, you can make informed decisions that minimize your tax liability. Moreover, a business in the process of a sale, merger, or acquisition could be at significant risk if it isn't aware of nexus-related tax obligations that have accrued.

While this article provides an overview of nexus, it is not a substitute for speaking with one of our expert advisors. Nexus is determined on a case-by-case basis, and every jurisdiction has different rules. If you would like to discuss nexus and your company's tax obligations, please contact our office.