Opening the nexus chamber of secrets
Evaluating state and local tax nexus in the wake of Wayfair — the case that shall not be named
Masha Yevzelman, Esq. | June/July 2023 Footnote
Editor's note: Updated May 30, 2023
Advising companies on where they need to file state and local tax returns used to seem easy: If a company had physical presence in a state, then it would file state income tax returns and, if applicable, sales and use tax returns.
But, in June 2018, the U.S. Supreme Court opened the nexus chamber of secrets. In
South Dakota v. Wayfair, the Court pronounced that, at least when it comes to sales and use taxes, the physical presence standard is wrong, has always been wrong, and does not govern whether a state can impose its tax obligations on an out of state taxpayer. The Court replaced the seemingly easy “physical presence” bright-line nexus standard with “economic nexus.”
Five years later, tax advisers and taxpayers are continuing to struggle with the impact of the
Wayfair decision on multistate tax compliance. This article first analyzes how
Wayfair impacted state income tax and sales tax nexus and concludes with a decision roadmap that tax advisers and taxpayers can apply when approaching state tax nexus issues.
State income tax
To understand the impact of the
Wayfair decision on state income tax nexus, it is important to remember that the physical presence nexus standard was created by sales and use tax court opinions:
National Bellas Hess (1967), holding that imposing use tax collection obligations on a seller with no physical presence in the state is unconstitutional, and
Quill (1992), upholding the physical presence rule.
Nonetheless, many functioned under the assumption that the physical presence rule announced in those cases applies to income tax. Accordingly, many companies were only filing income tax returns in states where they had physical presence — an office, employees, etc. But the U.S. Supreme Court had never held that the physical presence nexus standard governs in the income tax context.
In fact, even before
Wayfair, most states had taken the position that economic presence creates nexus for income tax purposes. Minnesota statutes, for example, have long indicated that either (1) physical presence in Minnesota or (2) economic presence (i.e., obtaining or regularly soliciting business form within Minnesota) is sufficient to constitute nexus for Minnesota’s income tax (see Minn. Stat. Sec. 290.015).
Like
National Bellas Hess and
Quill,
Wayfair was a sales tax case. It had to do with whether an out-of-state seller (
Wayfair) with no physical presence in a state (South Dakota) had an obligation to collect and remit South Dakota sales tax on sales made to customers in South Dakota. The
Wayfair decision did not directly impact or change a company’s state income tax filing obligations in those states that had economic nexus statutes. But it became clear after
Wayfair that companies relying on a “physical presence” nexus standard for income tax purposes needed to reevaluate their state income tax filing positions.
Sales and use tax
Following
Wayfair, states quickly enacted sales and use tax economic nexus thresholds, with most states settling on $100,000 in sales or 200 transactions with customers in a state. Several states have since dropped the 200 transactions threshold. But many questions remain — what constitutes a “sale” into a state? Does it include nontaxable sales (e.g., sales for resale) and/or exempt sales? What happens if thresholds are exceeded in one year but not in the next? How long after thresholds are exceeded must collection begin? What about local jurisdictions?
In addition to struggling with the nuances of what creates economic nexus, states are continuing to aggressively argue about what constitutes “physical presence” nexus. Massachusetts, for example, argued that internet cookies created physical presence, a position that was recently rejected by the Massachusetts Supreme Court. California and Pennsylvania (as well as other states) have argued, with varying degrees of success, that having inventory in a state through Fulfillment by Amazon creates nexus for the seller that is making sales through Amazon’s program.
A multistate nexus evaluation, therefore, remains a complex undertaking. But clarity (or happiness) “can be found even in the darkest of times, if only one remembers to turn on the light,” as noted by Professor Dumbledore in “Harry Potter and the Prisoner of Azkaban.”
Analytic framework for analyzing state tax nexus
- Evaluate your nexus footprint. The first step in a nexus analysis is to assess the following:
- Where does the company have employees? (Consider also whether the company has withholding tax obligations.
- Where does the company have independent contractors?
- Where does the company have property — tangible personal property (e.g., inventory) or real estate (leased or owned)?
- What are the company’s sales into each state? In evaluating sales into a state, it is important to understand the state’s sourcing provisions — how does the state determine whether the sale is made “into” the state? Using a customer’s billing address is often insufficient and state sourcing provisions vary depending on whether the business is selling property or services.
- Compare physical and economic presence in the state to that state’s nexus thresholds. Some states have enacted “factor presence” thresholds for income tax purposes (sales, property and payroll) and, as noted, economic nexus thresholds for sales and use tax purposes. These thresholds differ among tax types and vary by state.
- Evaluate applicability of nexus exceptions, like Public Law 86-272. One exception to state income tax nexus is Public Law 86-272, which is a federal law that prohibits states from imposing income tax on a company that sells tangible personal property into a state when that company’s only presence in the state is the solicitation of sales. After Wayfair, there has been a lot of discussion about Public Law 86-272 and, specifically, whether a company’s website somehow constitutes “presence” in a state that goes beyond solicitation (including in Minnesota, where the Department of Revenue has issued a draft revenue notice on the subject). If a company is seeking to rely on Public Law 86-272 in a particular state, it is important to understand that state’s positions on what constitutes “solicitation” of sales.
- Don’t forget local jurisdictions. In addition to the states, local jurisdictions (like counties, cities, parishes, etc.) often impose their own taxes and may or may not have their own nexus thresholds.
- Consider the appropriateness of voluntary disclosure programs. If it is determined that a company has had nexus in a state in which it has not been filing returns, many states have voluntary disclosure programs (with limited lookback periods and potential penalty waivers) that would allow the company to come into compliance.
- Don’t forget the attorney-client privilege. In conducting this analysis, it is important to remember that there is no accountant-client privilege in most states. Accordingly, unless an attorney is involved and without the protections of the attorney-client privilege, any nexus analysis conducted by an accounting or consulting firm may be discovered by a state if it later audits the company.
Doing the right thing
In the wake of
Wayfair, companies face a choice between what is right (doing a thorough nexus analysis and coming into compliance as appropriate) and what is easy (continuing to file only in states where they have physical presence). As is often the case, choosing to do what is right is a complex undertaking.
Masha M. Yevzelman, Esq., chairs the tax disputes and litigation practice at Fredrikson & Byron, P.A. Masha represents public and private companies, trusts, estates and high-net-worth individuals in complex tax disputes. Masha handles all stages of tax controversies, including voluntary disclosures, audits, administrates appeals, tax court, district court and appellate litigation. You may reach her at 612-492-7410 or myevzelman@fredlaw.com.
