What is State Tax Nexus?
And Why Does it Matter to My Business?
By Colleen Berndt, CPA
State tax nexus refers to the amount and type of business activity that must be present before the business is subject to the state’s taxing authority. Every state has its own set of tax laws and required filings. In recent years, the whole concept of state nexus for sales tax and income tax has dramatically changed.
Traditionally, state tax was based on more of a physical presence test. Thus, if your business did not employ people and property in a particular state, then most often the business would not be required to register or file in that state.
As with many laws, it takes time for states to address issues and make changes for how business is transacted in the modern world. How we conduct business is changing at a faster and faster pace. The COVID-19 pandemic generated unprecedented e-commerce growth in various economies across the globe and is anticipated to continue to grow at a rapid pace.
“While the Wayfair decision did not directly impact income-tax nexus, the removal of a physical presence requirement for sales-tax nexus has definitely encouraged more states to enact a sales threshold as an indicator for income-tax nexus.”
The pandemic also resulted in millions of people across the world to become remote workers, creating another major shift in how modern-day business is conducted. Remote working has become the ‘new normal,’ almost overnight.
The Wayfair case – a major shift in state taxation
On June 21, 2018, the United States Supreme Court ruled in South Dakota v. Wayfair Inc., et al, that states can require an out-of-state seller to collect and remit sales tax on sales to in-state consumers even if the seller has no physical presence in the consumer’s state.
In doing so, the court overruled 50 years of its own precedent. The decision allows states to define a sales threshold (either by dollar amount or the number of transactions) that will trigger a sales tax collection requirement.
Since the Wayfair case, Massachusetts enacted legislation to change the state’s economic thresholds to $100,000 in sales with no transaction threshold. Most states now employ a dollar and/or a number of transactions threshold for sales tax collection and remittance. The frequency in which the tax must be remitted also varies greatly from state to state.
While the Wayfair decision did not directly impact income-tax nexus, the removal of a physical presence requirement for sales-tax nexus has definitely encouraged more states to enact a sales threshold as an indicator for income-tax nexus.
The increase in states employing an economic nexus standard, combined with the change in how business is transacted, has opened the door for a migration toward market-based sourcing. Market-based sourcing is the idea of taxes being imposed on where the service is consumed, rather than the location where the service was performed.
Under Massachusetts law, “doing business” includes every act, power, right, privilege, and immunity exercised or enjoyed in the Commonwealth, as an incident or by virtue of the powers and privileges acquired by the nature of such organizations, as well as, the buying, selling or procuring of services or property. In addition, Massachusetts will presume that a business’s corporation’s virtual and economic contacts subject the corporation to the tax if the volume of the corporation’s Massachusetts sales for the taxable year exceeds five hundred thousand dollars. Again, each state has its own unique set of rules to determine nexus.
Remote employees’ impact on nexus
Generally speaking, a remote employee will create nexus for the employer for tax purposes. Many states provided relief for pandemic-related circumstances, but most of those provisions have since expired. Nexus created by remote-working employees can create significant tax liabilities in new jurisdictions, especially for income tax purposes where the company has significant receipts from the state and the state apportions using a single sales factor formula, as many do. Massachusetts still utilizes a three-factor formula (sales, payroll and property) for most businesses. Most states have transitioned to sales as a single factor to determine apportionment.
The impact on recordkeeping
In order to ensure state tax compliance, businesses must keep records that perhaps were not required in the past. Thankfully, most businesses have a computerized accounting system, however, it may require more detailed information then previously needed to determine filing requirements.
For instance, the number of transactions by state may not have been a standard reporting item in the past. Another consideration is that the invoicing state may not necessarily be the state where the product is being consumed. If that is true, then the shipping records must become integrated into the accounting records to provide accurate sales-by-state reports. Given the digital footprint left by any type of transaction, states are aggressively pursuing businesses looking for some type of economic presence requiring the business to register and pay various tax types.
Also, employers must keep track of employees who work remotely by state. This can be especially challenging for hybrid employees who may reside in a different state than which the employer is located. The record-keeping requirements and then complying with all state filings (employment, sales, income, gross receipts, and franchise taxes) can be complex, costly, and overwhelming for small businesses.
Not only can it be very complicated and costly to ensure that a business is complying with all state filing requirements, the rules are complex and subjective in nature. This is why it is always best to consult with your tax advisor.
Colleen Berndt, CPA is tax manager with Lapier, Dillon & Associates PC; (413) 732-0200.