State Income Tax Nexus

Definition:

State tax nexus refers to the amount and type of business activity that must be present before the business is subject to the state’s taxing authority. State tax nexus considerations differ by tax type and jurisdiction, and there has been limited guidance from tax authorities as to when nexus conclusively exists. Various business activities could create state tax nexus for sales and use tax, income tax or franchise tax.

To begin, here are some basic concepts related to state income taxes:

An individual or company generally doesn’t get taxed by multiple states on the same income
- For individuals
  - If multiple states require the same income to be included in taxable income, the taxpayer’s resident state will generally provide a credit for taxes paid to other states.
  - The credit is limited to the lesser of the other state’s tax or the tax that would have been charged by the resident state
- For businesses
  - If it is determined a business has established Nexus in multiple states and is, therefore, required to file multiple state tax returns, the income is generally apportioned to the individual states using factors like sales by state, payroll expense by state, and property, plant, and equipment by state.
    - States may require all or some of these factors and/or apply more weight to certain factors, like a three-factor formula with double weighted sales factor in some states, for example
  - State income tax nexus is not just a business income tax issue
    - It affects individuals with passthrough income in multiple states
    - It affects individuals with W-2s that report income in multiple states
    - It affects individuals who have real estate rental activities or sale real estate in a non-resident state
    - It affects individuals who report business activities on Schedule C (sole proprietorship)
    - It may affect telecommuters
  - Seven states have no individual income tax
    - Alaska, Washington, Nevada, Wyoming, South Dakota, Texas, Florida
    - Tennessee and New Hampshire only tax interest and dividends
    - You must live and work exclusively in these states in order to completely avoid state income taxes
      - Some people erroneously think forming their business in a state without an income tax will mean they won’t pay state income taxes on the income derived by the business
      - If a business operates in a state without an income tax but has owners and/or employees that live and/or work in states with an income tax, those owners and/or employees will owe income taxes to those states.
      - If an individual lives and/or works in a state that doesn’t have an income tax but has business income (passthrough or Schedule C) in a state that does have an income tax, the individual will pay income tax based on the income attributed to that state
    - These states derive their needed revenue from other sources, like sales tax or property tax, so the overall tax impact may not be so dissimilar to states that have a state income tax
  - Telecommuters
    - If an employer allows its employees to telecommute, it may unwittingly establish a business presence (Nexus) in a state in which there was previously no business presence
    - Many states have relief from this potential issue during the COVID-19 Pandemic where employees telecommuting from that state during the health emergency does not create nexus or require additional withholding.

A federal law created in the 1950s called the Interstate Income Act, or PL 86-272, protects some companies from paying state income tax in a state where there is no “substantial nexus”. According to this law, if the company’s only activity in the state is soliciting orders for sales of property, where the orders will be approved and shipped from outside the state, PL 86-272 protects the company and its employees/independent contractors from being subject to income tax in that state. This is a very strict definition and only applies if the sole business activity in the state is the solicitation of sales. Any other business activity could potentially create Nexus in the state, subjecting the company and its employees/independent contractors to an income tax obligation in the state.

State income tax nexus has become an important issue, especially since the Supreme Court, in 2018, upheld the right of South Dakota to collect sales tax on Wayfair and other out-of-state sellers that had no physical presence in the state. Prior to this decision, the Supreme Court interpreted the laws governing discrimination against interstate commerce (Commerce Clause) in a way that protected entities from state taxation if the entity didn’t have either employees or a “brick and mortar” presence in the state.

Since the 2018 Wayfair decision, which was related to the ability of states to collect sales tax from entities that established an economic presence, the “physical presence” standard has been replaced by most states with an “economic presence” standard. Some states have adapted this ruling as it applies to income taxes and have established certain thresholds to determine economic presence, such as the following as adopted by Alabama, Colorado, Ohio, Tennessee:

Business activity creates nexus if any of following thresholds is exceeded during tax period:

$50,000 of property;
$50,000 of payroll;
$500,000 of sales; or
25% of total property, total payroll, or total sales.

Thresholds are subject to adjustment for inflation.

Determining state income tax nexus can be complicated. Be sure to contact us to assist in your efforts to determine state nexus and avoid costly state audits due to noncompliance.

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State Income Tax Nexus

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