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If you want to understand sales tax (and how much you owe), you’ll need to understand the difference between physical and economic nexus. Here’s how to figure it out.
There are plenty of articles that explain the difference between the two types of nexus. The problem is they’re often written in confusing legal and accounting jargon, which is ultimately unhelpful if you’re a business owner – one with a lot to worry about. To help, we created this basic overview of what each term means, how they’re different, and why knowing the difference matters – all in plain English.
You might be wondering, “Wait, what is nexus?”
“Nexus” is a legal term that refers to sufficient presence, or “connection.” States nexus with companies so they can collect sales tax from their business operations. Sales tax nexus, often just referred to as nexus, is just the minimum connection a business must have to be liable for sales tax in that state.
But here’s where it gets tricky: states use “sales tax nexus” interchangeably to refer to two different types of nexus: physical and economic.
Under National Bellas Hess v. Department of Revenue and Quill, only a physical nexus mattered in order to qualify for the sales tax requirement. This means that if a seller didn’t have a physical connection in the state, it didn’t have to worry about sales tax.
Qualifying criteria for physical nexus varies by state. Obviously, an office or a retail location will trigger physical nexus. But so can a warehouse, a remote employee or even a contractor. You could even have physical nexus as an FBA (Fulfillment by Amazon) seller if your products are stocked at an Amazon fulfillment center in a state. It all depends on the location.
Here are some examples of potential physical nexus triggers:
As you can probably already tell, online e-commerce sellers were able to dodge most of these physical qualifications. But states eventually wanted a piece of the booming e-commerce market – so, in 2018, the Supreme Court expanded the definition of nexus to include economic nexus as well.
In 2018, the landmark South Dakota v. Wayfair, Inc. expanded the definition of nexus to include economic nexus. In short, if you sell enough in a state, there’s a chance you have to register, collect and remit sales and use tax there, regardless of whether or not you have physical operations in the state. Even if your business is based out of one state, economic nexus requires businesses to pay taxes into other states if they meet or exceed that state’s economic nexus threshold.
Economic nexus is triggered by passing a certain number of total transactions in a state or exceeding a certain amount of revenue from transactions in the state. Some states require both for it to trigger. Others require only one. This means you must watch out for “and/or” language in your state’s legislation.
Identifying whether you’ve established economic nexus is easier said than done. It requires a thorough review of your operations and the laws of each state. This process is complex, so many businesses turn to sales tax specialists for help.
An important thing to remember: economic nexus applies to brick and mortar retailers who dabble in e-commerce as well as dedicated online retailers and resellers.
Don’t get it wrong: economic nexus legislature did not replace physical nexus. If you’re operating in a state, you’re going to have to register, collect and remit sales tax there. You could also have economic nexus in states where you don’t have physical nexus.
The two types of nexus are both in effect, and they impact businesses in different ways.
If you’re the owner of an online business, knowing whether you qualify for physical nexus, economic nexus or both is hugely important. If one or more states audit you and you have unpaid liability, you could have serious problems. We’ve seen this crush businesses, retirements and personal finances.
And economic thresholds vary. They can be as low as $10,000 per year in gross revenue, or as high as $500,000. A high volume of sales can also trigger economic nexus in some states.
(Not sure if you’ve triggered nexus? Visit the economic nexus state guide by the Sales Tax Institute for more information.)
For an online business owner, understanding the difference between physical and economic nexus can be confusing. But it’s still critical. So, as you acquire customers in new states, pay attention to your growing nexus exposure and changing tax rates. If you need help navigating the web of tax codes, here are a few steps to take: