Surprises may be great for a birthday, but rarely are they great in business. One significant, unwanted surprise when it comes to state taxation concerns the concept of nexus. Having nexus in a state—unexpectedly—often leads to costly results.

In this article, we review the concept of nexus, how it can be avoided (or obtained), and actions you can take if your company or client is faced with unexpected nexus in a state.

What Is Nexus?

Under the U.S. Constitution, a state cannot impose tax on a taxpayer without some connection between the taxpayer and the state. In brief, nexus is a sufficient connection between a state and a taxpayer that allows the state to impose its taxing jurisdiction on that taxpayer. In other words, if a taxpayer has nexus in a state, that state can require the taxpayer to collect tax and pay tax. The nexus connection is typically established in one of two ways: physical presence or economic presence.

Physical presence means a taxpayer has some physical connection in the state. For businesses, this can mean the business has property in the state (including storing tangible personal property), a location in the state, or employees in the state.

Economic presence means a taxpayer makes sales into a state or conducts other business or economic activity in that state.

For many years, the concept of nexus by economic presence alone was permitted for state income tax but not sales tax. That was overturned in the recent U.S. Supreme Court case
South Dakota v. Wayfair Inc.

Now, a state can require the payment of income tax, and the collection of sales tax, from companies that only have an economic presence in that state. Therefore, businesses should be careful about when they have a new office, new employee, or new marketing campaign that brings the business into a new state, as this may create tax liability for the business in that state.

Do Businesses Always Try to Avoid Nexus?

Given that nexus typically entails payment or collection of tax in a state, most businesses try to avoid nexus in additional states.

However, in certain circumstances, nexus in another state may be helpful. For example, to apportion income for Nebraska income tax purposes, a corporation must have nexus in at least one other state (meaning that another state can impose income tax on the corporation). A corporation may reduce its tax bill by organizing its affairs in order to have nexus in one other state, so they can apportion some or all of their income away from Nebraska.

When Can Nexus Be Created Inadvertently?

In our practice, we’ve seen a number of times where a business unexpectedly obtained nexus in a state. These arose in the following situations:

Remote Employee. As noted above, having an employee in a state generally creates nexus for a business. As employees work from home or remotely, and move to different locations, it can be easy for a company not to realize that its employee who moved to California created nexus in California for that company.

Unexpected Sales. Most states have set a minimum threshold of activity in the state before a business is required to collect sales tax in that state. However, this is generally measured on an annual basis. An unexpected amount of sales in a state can therefore trigger nexus in that state under an economic presence theory.

Travel Into a State for a Conference. Some states have taken the position that travel into their state for business purposes, including for a conference, creates nexus in that state.

Property Storage. Many businesses hire other companies to help manage and store their inventory. Sometimes those businesses do not even know where their inventory is stored. Many states have taken the position that any inventory storage in their state creates nexus—even when the company itself did not direct the inventory into the state.

Does Public Law 86-272 Provide Protection?

Public Law 86-272 is a federal law enacted to restrict a state’s ability to impose income tax on businesses engaged in interstate commerce. In short, the law protects an out-of-state business from having to pay a state’s income tax if that business’ only activity in the state is the solicitation of orders for tangible personal property, when the orders are approved and shipped from outside the state. The law lists a number of actions undertaken by businesses that will not, by statute, create taxable nexus. However, the law will not protect a business that takes an action which is not specifically listed in the statute itself.

In practice, this law was enacted in 1959 and has not been updated. Accordingly, it does not reflect the way most businesses currently operate. We have found that most businesses undertake some action that falls outside of Public Law 86-272’s protection and therefore cannot rely on it.

For example, California recently issued guidance which states that “regularly providing post-sale assistance to California customers via either electronic chat or email” constitutes an activity that exceeds the protection of Public Law 86-272. A business that undertakes this activity would thus not qualify for Public Law 86-272 protection, at least according to the state of California.

When Does Nexus Come Up?

We most often see nexus issues arise in two ways. First, a company receives correspondence from a state that tries to initiate a nexus audit or asserts tax is due without an audit. Because the statute of limitations does not start in most states until a tax return is filed, we’ve seen states go back a number of years in these letters and assert significant amounts of tax owed.

Second, buyers of a business often review potential state tax obligations when they purchase that business, as part of their due diligence. Many buyers will require businesses go back and pay state income taxes that may be due from past transactions, so they would not have to worry about past liabilities.

We work closely with CPAs in both these situations to help evaluate potential tax liabilities and advise clients on the best ways to handle nexus issues.