Nexus has been the buzzword for state and local tax since the 2018 U.S. Supreme Court decision in South Dakota v. Wayfair. That case ruled that economic nexus based on sales over a threshold is a constitutionally acceptable way to determine nexus for sales tax collection purposes. Another result of this decision that has not received as much attention is the impact on nexus for income/franchise taxes (hereafter referred to as income taxes).
The economic nexus story for income taxes actually begins in the early 1990s. At that time, states were pushing for economic nexus for both income and sales taxes, but the U.S. Supreme Court only ruled on the sales tax issue. In 1992, in Quill v. North Dakota, the Supreme Court stuck by an earlier decision in which they ruled that physical presence was required for sales tax nexus (now overturned by Wayfair), but they specifically stated they had “not…articulated the same physical presence requirement” for other types of taxes.
State interpretations of unclear legal guidance
Many states took this statement as an implicit blessing of economic nexus for income taxes and wrote language into their statutes that they would impose income tax on a company to the extent permitted by the U.S. Constitution for the privilege of doing business in or deriving income from the state. Several companies litigated this economic nexus language, winning the issue for taxpayers in some states, but losing in most states. Both the states and the business community hoped the U.S. Supreme Court would settle the matter once and for all, but it refused to take an income tax nexus case, leaving the final resolution uncertain.
With that uncertainty, states have been cautious about how aggressive they pursue companies based on their economic nexus statutes. For the most part, they have only pursued credit card-issuing banks and companies that generate income from licensing intangible assets to related entities. States did not want to target service providers like an architectural firm or IT consulting company, fearing that a broader reach to impose economic nexus might result in a precedent-setting court case that eliminated their ability to tax at least the big banks and intellectual property holding companies.
What’s new and next for economic nexus for income taxes
With Wayfair removing the physical presence requirement for even sales tax, it is now understood that economic nexus is viable for income taxes as well. This viable option is playing out in various ways across different states and may result in more changes down the road.
- Factor presence – This form of nexus based on sales over a certain threshold has been around for income taxes since the mid-2000s, appearing to start with the Ohio Commercial Activity Tax (a gross receipts tax). Fifteen states now have thresholds that allow them to impose their income tax against companies that aren’t protected by federal Public Law 86-272 (more on this below). Any company that has receipts from services and exceeds a factor presence threshold in a state should be prepared to file income taxes in that state. The thresholds range from $100,000 of annual sales in Hawaii and Washington to $1 million in New York.
- Pure economic nexus for service providers – Most states that don’t have factor presence thresholds do have the statutory language discussed above regarding doing business in or deriving income from a state. Thus, virtually all states have an economic nexus provision that would allow them to target any business with receipts from the state, as long as they are not protected by P.L. 86-272. This means any business that has receipts from services provided to clients in a state should at least be aware that the state could pursue them for income taxes based on economic nexus, even if the in-state receipts are minimal.
- Public Law 86-272 – This federal law from 1959 prevents states from imposing a net income tax on sellers of tangible personal property whose only business activity in a state is the solicitation of sales, with the sales orders sent outside the state for approval and fulfillment. It is a powerful, but narrow, protection. For example, if a company has service revenue from a state, it is not protected under P.L. 86-272, nor is it protected if it sends a repairperson into a state.
This effectively means that states cannot impose economic nexus against a business that qualifies for P.L. 86-272 protection. However, this law is under attack by the states who want to gut its effectiveness and take its protections away from tangible property sellers who do not physically go to a state. The states are in the process of reinterpreting P.L. 86-272 (which, remember, is a federal law) to say that its protections do not apply to most companies that do business over the internet. Many are starting to target any business with anything more than just a static webpage with only text and images. For example, states may soon consider businesses with a chat function or email button on their website to go beyond the protections of P.L. 86-272, subjecting many more businesses to income tax based on economic nexus.
Economic nexus for income/franchise taxes is the next wave we see coming for the multi-state business community. Many states are already pursuing this on a broad basis with factor presence thresholds, and we expect the next few years will see states more aggressively pursuing pure economic nexus against service providers and weakening the protections of P.L. 86-272 to apply economic nexus to sellers of tangible personal property.
Just as RKL has been there for clients through the expansion of sales tax economic nexus over the past three years, our state and local tax advisors are ready to work with you on the expansion of income/franchise tax economic nexus currently and over the next few years. Reach out to your RKL professional or use the form below to contact us.