Navigating State Tax Nexus in the Digital Age

In today’s interconnected world, understanding state tax nexus is crucial for businesses of all sizes. The concept of nexus, the requisite connection between a business and a jurisdiction that allows that jurisdiction to impose a tax, has evolved significantly in recent years. The rise of e-commerce, the service economy, remote workforces, and evolving state laws have created a complex landscape for businesses to navigate.

What is Tax Nexus

Nexus refers to the connections of a business with a jurisdiction, sufficient nexus between a company and a jurisdiction provides the jurisdiction with the authority to levy a tax on the company. Historically, a physical presence within a state – such as having employees, owning property, or maintaining an office – was the predominant determinant of nexus. However, in order to expand the tax base and respond to changes in the economy, jurisdictions are now looking towards an entity’s economic presence as a means to establish sufficient nexus to impose a tax.

Physical Presence Nexus

Having a physical presence within a state generally creates enough nexus such that the jurisdiction can impose a tax. Physical nexus activities within a state may include:

• Employee presence (base of operations or travel)
• Presence of property (owned or rented), including inventory held at third-party locations (e.g., Amazon fulfillment centers)
• Utilization of independent contractors/agents or the actions of affiliates
• Trade show attendance
• Performance of services (e.g., warranty or repair services)

Physical presence in a state can trigger the requirement for businesses to register for and remit various types of taxes, including income tax, sales tax, net worth taxes, franchise taxes, and payroll taxes. Most U.S. states enforce strict regulations regarding physical presence nexus.

Again, in an attempt to broaden their tax bases, and in response to prior tax optimization strategies, states have expanded the physical presence nexus concept to include non-physical activities.  For example, many states have litigation and/or tax law which provide that the presence of intangible property, such as the utilization of a patent or trademark, can establish nexus.  Additionally, the Multistate Tax Commission’s Statement on P.L. 86-272 provides that a company’s interactions with the public through its website can create nexus.

Economic Nexus

Economic nexus is triggered by a business’s economic activity within a state, specifically the taxpayer’s regular and systematic use of a state’s market.  While most states have broad “doing business” standards, many states impose “bright-line” economic nexus standards such as reaching a sales or transaction threshold (e.g., $100,000 sales or 200 transactions).  Before the 2018 Supreme Court decision in South Dakota v. Wayfair, Inc., there were genuine questions as to whether or not these rules violated the Due Process and Commerce clauses of the U.S. Constitution.

The 2018 Supreme Court decision in South Dakota v. Wayfair, Inc. opened the door to allow states to require out-of-state sellers to collect and remit sales tax based on economic activity within the state, rather than physical presence.

States with a sales tax have implemented bright-line economic nexus laws as a result of Wayfair, whereby any company that exceeds the bright-line threshold (typically $100,000) is required to register and collect sales tax. However, even with the adoption of these bright-line rules, there remains disparity amongst state adoption, creating a complex regulatory environment for interstate business operators.

The Wayfair decision has emboldened states to enact laws, regulations, and administrative positions that incorporate similar economic thresholds for income, franchise, and gross receipts taxation. As a result, businesses need to be conscious of not only complying with a state’s sales tax rules but also complying with other tax types.  Many times, a state will adopt bright-line thresholds for sales tax purposes but not adopt similar rules for income tax purposes, thus creating confusion and complexity for companies trying to maintain tax compliance.

Public Law 86-272 and out-of-state businesses

The Interstate Tax Limitation Act, codified at 15 U.S.C. 381-384 and commonly referred to as Public Law 86-272, offers protection from state income taxation for businesses that engage in certain types of interstate commerce involving tangible goods. Specifically, Public Law 86-272 provides a company immunity from an income-based tax if the activity of the business in the state is limited to the solicitation of sales of tangible property, where the sales orders are sent outside the state for approval, and where the order is fulfilled from outside the state. However, Public Law 86-272 does not extend to services or intangible goods (such as software or digital products).

More importantly, Public Law 86-272 does not shield businesses from other state taxes not based on income (e.g., sales and use tax, gross receipts tax, minimum tax or non-income-based franchise tax). As such, a taxpayer claiming P.L. 86-272 may still have a filing requirement and be subject to non-income taxes.

State tax authorities are increasingly scrutinizing businesses that claim these protections, often through audits and litigation. Certain online activities and interactions may now trigger tax obligations as states adapt to the evolving digital and service-based economy.  Additionally, as companies evolve how they carry out their business, an operating model which once may have been protected by Public Law 86-272 may no longer meet the requirements for immunity.

Nexus and Remote Employees

The rise of remote work post-COVID-19 pandemic has significantly impacted state tax nexus. In many cases, remote employees can create nexus for their employers in the state where they reside.  While many states enacted emergency legislation or administrative policies around temporary remote work due to displacement caused by the COVID-19 pandemic, these policies have generally been withdrawn or expired. Businesses must carefully review state-specific rules and maintain accurate records of employee locations.

The dynamic nature of state nexus laws requires continuous monitoring and adaptation. Staying informed of evolving state tax nexus laws is crucial. Maintaining accurate records is essential for demonstrating compliance with nexus requirements. For businesses operating across multiple states, consulting with tax professionals can provide valuable guidance in navigating the complexities of state tax nexus and ensuring compliance with all applicable regulations.

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