Many taxes imposed on businesses by states are based on the concept of “nexus,” or the presence of a business within a state. The majority of states will determine nexus based on the economic presence of a business, which can be measured by indicators such as value of a business’ sales from customers within a state. Economic presence combined with economic apportionment concepts can have a significant impact on the tax liabilities of service providers with customers in multiple states even in the absence of a physical presence within the state.
Economic nexus and apportionment are tools that states have used in response to federal case law that has limited the imposition of some state taxes. The U.S. Supreme Court ruled in Quill Corp v. North Dakota that physical presence is required for the imposition of a state’s sales tax. Many states responded by adopting a narrow interpretation of the ruling as applicable only to sales tax. Consequently, those states have turned to an economic nexus concept to impose income and franchise taxes on businesses that benefit from a state’s economic marketplace, even if the taxpayer lacks a physical presence.
Take the KFC Corp. v. Iowa Department of Revenue case as an example. KFC licensed intangibles to franchisees within Iowa, but it had no property or employees in the state. The Iowa Supreme Court sided with the Department of Revenue, ruling that the licensing of intangibles by an out-of-state holding company to franchisees located within the state constituted the substantial presence necessary to establish nexus for income tax purposes.
Licensing of intangibles offers one example of nexus based on economic benefit, but it is certainly not the only one. States can find an economic nexus based on the benefit of work received by a purchaser within the state, even if that work is performed outside the state lines. For example, say an advertising agency based in State A creates a campaign for a client based in State B. If State B imposes income tax based on work performed in State B, then the time that the agency’s employees spend on the ground at the client’s office may determine the amount of tax owed in the state. If State B taxes based on economic benefit received in the state, the agency may be subject to tax in State B even if all of its work was performed at its offices in State A.
Outcomes like these can surprise a business and create an unexpected liability exposure. For a taxpayer who has established nexus but failed to file tax returns, the statute of limitations will not begin to toll. Without a tolling statute, the state has the right to assess tax for all years in which the taxpayer has neglected to file. This can quickly result in a significant potential liability. State voluntary disclosure and similar programs may be available to reduce the amount of tax owed and avoid the imposition of non-filing penalties.
While many think of nexus as creating liability exposure, it can also create opportunity. Often, a business must establish nexus in another state in order to establish the right to apportion within its home state. Each state has created its own set of apportionment sourcing rules that vary depending on whether the taxpayer is selling a service, tangible personal property, an intangible, or some combination of all three. Depending on the apportionment rules in a business’s home state and the apportionment rules in other states in which the taxpayer does business, it’s possible for a taxpayer to have “nowhere” sales. More specifically, having the ability to exclude certain sales transactions from the numerator of every state can result in less than 100 percent of the taxpayer’s activity being taxed.
In conclusion, a business should review its activities and the rules of the states in which it operates and in which it has customers to determine where it has established nexus. If a previously unknown nexus is found, the taxpayer should determine the extent of any tax liabilities and whether a voluntary disclosure program might be available. More importantly, a business should assess opportunities for “nowhere” apportionment in the states in which it operates and has a market.
