Wayfair v. South Dakota1 expanded the sales tax nexus of thousands of businesses, creating hundreds of millions of dollars of collective liability. But another repercussion that is often not addressed is the impact Wayfair had on income tax nexus.
Nexus is the qualifying criteria for a seller to be required to collect and pay taxes on sales in a state. So, income tax nexus is the way states charge businesses tax on their income. Often, this tax is based on a company’s net income, though there are exceptions.
Each state has the power to define their income nexus in a different way. While each state is unique, there are some commonalities in what they require.
The primary criteria for income tax nexus is a physical presence in the state. This can include employees, inventory, property and more. Historically, states have sought to define more indirect connections – like sales representatives and solicitations – as physical nexus, but the federal government has applied limitations to this (more on that in a bit).
Since the Wayfair decision in 2018, a few states are starting to leverage the potential of economic sales tax nexus to establish economic income nexus. Businesses that meet economic thresholds for sales in a state are eligible for income tax.
Public Law 86-2722 is an interstate commerce law Congress established to add restrictions to the way states could claim income tax nexus beyond a physical presence. This Public Law names a number of exceptions that exempt some businesses from income tax requirements.
In every state, your business can engage in the following activities without impacting your income tax nexus:
What this law ultimately does is limit the sales tax liability of many businesses that engage in these activities.
It’s important to note that PL 86-272 only applies to net income tax. This means there are ways for states to get around the law and charge you for other types of income taxes.
For example, the Ohio commercial activities tax and Texas, Missouri and North Carolina franchise taxes function as a type of income tax. But these laws are not based on net income, so 86-272 does not protect you from them. Additionally, some states like California, New York and New Jersey that do have a full-fledged income tax also have an $800 minimum tax. But because minimum tax is not based on net income, those states hold that those taxes are still due. So you may owe minimum tax in those states.
While these exceptions can cause headaches, they’re much better than the alternative of owing tens of thousands of dollars in net income if PL 86-272 wasn’t in place.
Ultimately, the only way to know if you have income tax nexus is to conduct a thorough analysis of your business and any applicable laws.
In each state where you do business, consider if you have a physical presence there. Then check if the state has economic income nexus and if you meet the thresholds.
Once you’ve addressed that baseline, you’ll then need to look for exceptions and technicalities.
For example, some states use a concept called factor presence, where you have to have more than a certain threshold of property, employees, sales and payroll in a state before you have physical nexus. Be very careful with those thresholds, because sometimes states will try to get you on physical presence of any employees.
So, be sure to conduct thorough due diligence and read all of the relevant factors to get a clear assessment of your income nexus. Because this process is complex and time-consuming, many businesses turn to sales tax consultants for help.
Looking forward, it’s likely that the landscape of income tax nexus will continue to change.
Income tax historically has been defined by the standard of physical presence. But what we’re seeing now is that more states are adding economic nexus to the way they define income tax.
States like Texas and Hawaii are basing their new legislation on the frameworks they used to establish economic sales tax nexus in the wake of Wayfair. In many cases, the income tax and sales tax economic thresholds are similar.
Another thing to keep in mind is that the physical and economic thresholds are likely to change. States have the power to set thresholds as they see fit, and it’s possible some may lower their thresholds to capture more revenue.
Given all of these potential changes, you can’t just look at your income tax nexus once and stay compliant. You’ll have to stay on top of shifting legislation and thresholds, and the ways they will impact your business.
While sales tax nexus has grabbed headlines for the last two years, income tax nexus can have an equally important impact on your business. As legislation continues to change, it’s worth conducting an income tax nexus review and getting compliant.
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