By Jason Watson, CPA
Posted Sunday, December 29, 2024

In a 1992 U.S. Supreme Court case docketed as Quill Corporation v. North Dakota, the court established a physical presence test for sales tax nexus. The court did not address income tax, and since this decision states have varied quite a bit on attaching nexus to taxes other than sales and use tax.

Several appellate courts have limited the Quill case to sales and use tax nexus, and have deferred income tax nexus to economic presence rather than physical presence. According to Bloomberg’s Multi State Survey from 2015, only 7 states applied the physical presence test in determine an income tax nexus leaving 43 states to apply an economic presence test for income tax nexus. That was 2015 and prior to the Wayfair case.

Let’s consider California’s economic presence rules. A business is considered doing business in California under Revenue and Taxation Code Section 23101 (enacted in 2011) if it meets any of the following conditions-

• They have sales in California, in the amount of $500,000 or 25% of total sales, whichever is less.

• They have property in California, with a value of $50,000 or 25% of total property, whichever is less.

• They have payroll in California, in the amount of $50,000 or 25% of total payroll, whichever is less.

California’s numbers above are a bit out dated since they are annually adjusted for inflation. According to their website as of this writing, they state, “For taxable years beginning on or after 1/1/2019, the amounts are $601,967, $60,197 and $60,197, respectively.”

These hard numbers are called bright-line nexus, and are used in income tax nexus. You simply meet a numeric threshold, and you magically have nexus in that state. Several states have a preponderance of the evidence set of rules using phrases such as “businesses earning significant income.” Really!? Sounds like fun trying to defend that.

Sidebar on Nexus: Having these hard numbers is similar to driving under the influence (DUI). Let’s say your state has a 0.08% blood alcohol limit. You can still be considered driving under the influence even if you have less than 0.08%. However, if you are over 0.08% then the state automatically presumes you are driving under the influence no matter how well you walk the line or touch your nose. This is called a “bright line.” States may argue you have nexus even if you do not cross the bright line, but if you do cross the bright line then it is automatic. Does that help?

More bad news. Your business might not have income associated with California but be deemed as doing business in California. Seriously! And, in this case you would be subjected to the $800 minimum franchise tax regardless (as of the 2025 tax year). Yuck.

Here is the direct language from California’s Franchise Tax Board website-

An out-of-state taxpayer that has less than the threshold amounts of property, payroll, and sales in California may still be considered doing business in California if the taxpayer actively engages in any transaction for the purpose of financial or pecuniary gain or profit in California.

Partnership A, an out-of-state partnership, has employees who work out of their homes in California. The employees sell and provide warranty work to California customers. Partnership A’s property, payroll, and sales in California fall below the threshold amounts. Is Partnership A considered to be doing business in California?

Yes. Partnership A is considered doing business in California even if the property, payroll, and sales in California fall below the threshold amounts. Partnership A is considered doing business in California through its employees because those employees are actively engaging in transactions for profit on behalf of Partnership A.

Corporation B, an out-of-state corporation, has $100,000 in total property, $200,000 in total payroll, $1,000,000 in total sales, of which $400,000 was sales to California customers. Corporation B has no property or payroll in California. Is Corporation B doing business in California?

Yes. Although Corporation B’s California sales is less than the $500,000 threshold, Corporation B’s California sales is 40 percent of its total sales which exceeds 25 percent of the corporation’s total sales ($400,000 ÷ 1,000,000 = 40%.)

And to make matters worse, your business might be protected by Public Law 86-272 if you are simply soliciting orders for tangible personal property in California. But if you are selling services in California, even with independent contractors, there is no protection and the income will be taxed if you meet one of the three criteria above.

More direct language from California’s FTB Publication 1050–

PL 86-272 still applies to sellers of tangible personal property. As a result, if a taxpayer’s activities in California stay within the protections of PL 86-272, a taxpayer also remains protected from the imposition of those taxes that are computed based on net income, namely, the California franchise and income tax. Nevertheless, if a taxpayer is considered doing business in California either under R&TC Section 23101(a) or (b), it still has a filing requirement and will be subject to the minimum tax, because that tax is not computed based on net income and therefore is not subject to the protections of PL 86-272.

Corporation C, an out-of-state corporation, is a seller of tangible goods over the internet and qualifies for protection under PL 86-272. For taxable year 2011, Corporation C has $1,000,000 of sales but no property or payroll in California. Is Corporation C considered doing business in California?

Yes. Corporation C is considered doing business in California because it has sales of $1,000,000 in California. Therefore, Corporation C must file a California return to pay the minimum tax. However, since Corporation C is protected under PL 86-272, it will not be subject to California franchise tax.

Corporation D, an out-of-state corporation with no property or payroll in California, is a service provider that has sales of $2,000,000 to purchasers who receive the benefit of Corporation D’s services in California. Those services are from income-producing activity that is performed outside of California and Corporation D uses the four-factor formula (property, payroll, and double-weighted sales) to apportion its income to California. As a result, none of Corporation D’s income is apportioned to California. Is Corporation D considered doing business in California?

Yes. Sales of services and intangibles are sourced under R&TC 25136(b) for purposes of applying the doing business test of R&TC 23101(b) regardless of whether those sales are sourced under R&TC 25136(a) for income apportionment purposes (that is, regardless of whether taxpayer elects single sales factor apportionment). Accordingly, Corporation D is considered doing business in California because it has sales of services here of $2,000,000. Although Corporation D has no California source income, it is still liable for the minimum tax because it is doing business here. PL 86-272 does not protect the taxpayer, because it does not apply to service providers, nor does it protect against the minimum tax (because that tax is not income-based).

California is a fun state to research since they are usually on the forefront of legislative changes and updates, and there is so much economic activity. The following link is California’s FTB1050 (updated 2017) where they outline in plain language a list of protected activities and unprotected activities as they relate to Public Law 86-272 (tangible personal property).

wcginc.com/1751

As of February 28, 2020 this is the current FTB1050 from California (they require you submit a form and they email you the PDF… not sure why it just doesn’t sit on their web server. Oh well).

There are 50 other examples aside from California (including Washington DC and New York City). Please do the homework!

Some more fodder for your consideration. In two U.S. Supreme Court cases, Scripto v. Carson (1960) and Tyler Pipe v. Washington Department of Revenue (1987), the court affirmed that a third-party can create nexus. The court specifically stated what matters

“is whether the activities performed in the state on behalf of the taxpayer are significantly associated with the taxpayer’s ability to establish and maintain a market in this state for the sales.”

This third-party connection is detrimental to Amazon and eBay retailers (and the like) and discussed in more detail later.

To recap, what we are doing here is setting the stage for Wayfair. States have established numbers from a sales, property and payroll perspective to say, “hey, based on math alone you have substantial presence in our state and as such you must pay income tax.” Keep this in mind as we shift back to sales tax.

By Jason Watson, CPA
Posted Monday, October 18, 2021

We attempted to provide several angles and concepts to the state taxation issue. There are very few hard and fast solutions. There are tax attorneys and consulting firms who do nothing but argue and litigate state nexus issues.

If there is nexus, is there allocation? If there is allocation, who gets what? If there is a sales tax obligation is there an income tax (or franchise tax or business tax) obligation? Can you have one and not the other? Are your services considered tangible personal property by some states?

Be careful. States are taking on the bigger online retailers like Wayfair, Newegg and Overstock, and now they now appear to be shifting their focus to those businesses who do not have deep pockets to fight or pay fines. If what you are doing smells wrong or keeps you up at night, it probably is worth looking into.

Our philosophy at WCG is not popular among online retailers, but we believe our position is solid. We are 100% in favor of capitalism and free markets. We are also 100% in favor of fair competition. If another tax and business consulting firm “beats us” then we learn and move along. But if a competitor beats another player in the market because the playing field is not level, then that is not winning… it’s cheating.

Selling the same stuff as Best Buy but not charging a sales tax to make yourself look more attractive is not fair competition. Sure, the responsibility is ultimately on the consumer to pay sales tax, Yes, we get it. But a consumer cannot get out of Best Buy without paying a sales tax, and to make matters even worse Best Buy has to collect sales tax even on internet orders. What bugs us the most is the resistance from Amazon and other big online retailers.

Times are changing. Sure, the small retailer might get squeezed, but that’s life. Survival of the fittest. Eat or get eaten.

By Jason Watson, CPA
Posted Monday, October 18, 2021

Fulfillment By Amazon (FBA) and other fulfillment services add a new dimension to the nexus conversation. States are scrambling to figure it out so tax revenue can keep up with population growth and resource use.

Avalara is a consultation business who specializes in sales tax issues, and they re-printed a wonderful article on FBA and what it means to you. It was originally written by Michael Fleming of Peisner Johnson & Company and it is a bit outdated since it was the voice before Wayfair, but it provides excellent backdrop of the issues. We will attempt to paraphrase some of the concepts here, but if you want the full details use the following link-

wcginc.com/5858

The first concept is nexus, which we’ve beaten to death. But here is a different spin for those selling products online. There are four common nexus creating activities-

• Your Location

• Inventory

• Warehouse Use, and

• Fulfillment Services

The common theme to these four activities is Where is your stuff? More importantly, is your stuff in a state that ships within the state, and if so, does that state have a sales tax obligation? In other words, if a competitor located in the same state that you are selling your tangible personal property (TPP) through an online channel is collecting sales tax, then you probably have a similar obligation. Location. Location. Location.

There is guilt by association as well. If the distributor, warehouse, fulfillment center, storage facility, or whatever else you want to call it stores and ships your stuff, then you also have nexus by the fact of their physical presence. The essence of the facility argument for a state is that the facility is helping you create a marketplace for your goods.

There are some fine lines with who holds title and when does title transfer. For most online retailers and sellers, title arguments probably won’t do much good unless there is a lot at stake and you have a war chest to spend on attorney fees.

The next concern is materiality. If you’ve determined that you have nexus and are required to collect sales tax, is the obligation material? If you sold $200 worth of stuff to a Colorado Springs consumer, is the $16 in tax worth the headaches? Remember, if you do not collect sales tax from a consumer, he or she is still obligated to pay sales tax on his or her individual state income tax return. Unless, of course, your nexus and materiality tips the scale, and you have the responsibility to collect sales tax on behalf of the consumer.

States can spend some time on going after the head of snake, such a medium-sized online retailers or states can spend a lot of time going after the consumer. Drug user versus drug dealer.

There are voluntary disclosure initiatives to allow online sellers to come clean with their dirty sales tax deeds. Several states will waive the penalties and limit the lookback to only three years. You must weigh the chance of the hammer versus the certainty of a light tap. Peisner Johnson and co-hosted by TaxJar held a wonderful webinar in 2016 on the Multi-State Tax Commission amnesty program. You can see the slide deck from Michael Fleming here-

wcginc.com/5863

The issue of trailing nexus must be considered as well. For those familiar with Amazon and FBA services, you understand that your inventory is continuously being shifted to different states. Just because your inventory no longer exists in a state does not mean your nexus is instantly cutoff. This concept was broached in the beginning of this chapter, and is reiterated here to stress the importance of keeping up with the Kardashians and the location of your stuff, and who you owe an obligation to. Good luck.

By Jason Watson, CPA
Posted Monday, October 18, 2021

Allocation of the sales and subsequent income is at the top of this heap of nexus mess. States don’t want to unnecessarily complicate things, but they do want money.

Throwback is a common concept but not every state uses it. Again, we’ll pick on California. Under the old rules, when a California business ships TPP to another state, and that business does not have nexus in that state, the sales are “thrown back” to California since it is considered a California sale.

Interestingly enough, there are cases where a sale would not have a tax home at all. Let’s say you sold a service to a customer outside of California. Using the market-based approach and under California’s new rules of bright line nexus (turn back a few pages to review), sales exceeding $500,000 in another state are not thrown back to California. So, if you had sales in another state that did not trigger a filing in that state, these sales could arguably be allocated outside of California but disappear into a black hole. Sounds crazy, but true.

Allocation issues such as these can create tax arbitrage and there are other examples of the same dollar being taxed twice by different states. It truly is a mess. States recognize this growing problem and are working together to eliminate the loopholes. In about three perhaps four hundred years we’ll be good to go.

By Jason Watson, CPA
Posted Monday, October 18, 2021

Prior to Al Gore inventing all the internets, most states used the costs of performance as the method to determine nexus. If your butt was in Colorado and you provided a service to people in California, the costs of performing the service would be in Colorado and therefore you would not have nexus to California. You would only be subjected to Colorado income taxes.

Given the latest Bloomberg survey, there is a growing minority of states that are using the market-based approach. This can be loosely defined as the assignment of revenue based on the location of either

• the service provider’s customers, or

• where the customers received benefit from the service provided.

Consider a web server. As of 2016, 38 states plus the District of Columbia and New York City would consider a web server physically located in their taxing jurisdiction as enough of a presence to find income tax nexus. And most would find sales tax nexus as well. Wow. 38 is a high number, and it is old.

There is an executive summary for 2018 available from Bloomberg, and it is only 20 pages (nice!)-

wcginc.com/1746

By Jason Watson, CPA
Posted Monday, October 18, 2021

Public Law 86-272 protects TPP as we previously mentioned. But services are fair game for states to tax. Generally speaking states do not impose a sales tax on services but they can impose a franchise, business or privilege tax.

To make things more interesting, the definition of a service is expanding in light of ecommerce and cloud computing. For example, most states characterize cloud computing as a sale of intangibles or services, but Utah considers cloud computing as the sale, lease or license of TPP. Subtle difference, yet important.

Let’s say what you do is a service. What is the standard for determining nexus for your business? Read on please.

By Jason Watson, CPA
Posted Monday, October 18, 2021

As mentioned before, the U.S. Supreme Court ruled on June 21, 2018 in favor of a South Dakota statute enacted in 2016 that defined substantial nexus (remember that word from Complete Auto Transit v. Brady in 1977) as-

• Deliver more than $100,000 of goods and services in a year, or

• Have 200 or more separate transactions for the delivery of goods or services

Note the Or! Interestingly the suit was brought against Wayfair, Newegg and Overstock collectively. More interestingly, the court noted that other functions of ecommerce like cookies being left behind by browsers and customers downloading retailer apps may be introduced as proof of physical presence. Holy smokes!

Another tidbit was Kennedy, who wrote the majority opinion, admonished Wayfair by stating they could not have a customer base attracted to images of beautifully decorated homes if it weren’t for a stable local and state government. Kennedy was just piling on like the cop giving you a ticket, and a lecture. You can read the full opinion here-

wcginc.com/1788

Our little home state of Colorado is famous in the sales tax arena too (not just the Dakotas). In 2010, the state of Colorado passed a law that required out-of-state vendors to collect and provide information to its citizens regarding their total purchases, so that the residents could determine their tax liability for the state. Direct Marketing Association v. Brohl was a U.S. Supreme Court case that essentially upheld Colorado’s statute. DMA was a trade group and Barbara Brohl was the Executive Director for the Colorado Department of Revenue.

This stuff is changing all the time. Keep referring to our blog posts for updates-

wcginc.com/blog

Also, we encourage any interstate seller of goods and services to seek the advice of professionals who handle sales tax every day. Our referrals are TaxJar, Avalara and Peisner Johnson.

By Jason Watson, CPA
Posted Monday, October 18, 2021

There are two issues at play, and they are not necessarily connected. First is sales and use tax which frankly receives the most attention because of online retailers. Some theory first. When you purchase a computer at your local Best Buy, the seller is collecting sales tax in a fiduciary role. In other words, it is collecting your sales tax obligation for you on your behalf, and remitting it to the authorities. Nice of them, right?

If you buy this same computer from an Amazon retailer, the seller might or might not collect sales tax on your behalf. If the retailer does not collect sales tax, it is still your responsibility to pay this sales tax along with your state income tax return. No one does this of course. We have asked 25,000 times in the past decade, and we have never heard a Yes from a client. But understand that you are required to pay sales tax if not collected by the online seller.

States are getting tired of the under-reported sales tax obligations. Therefore several are going after businesses with strong internet presence. Here is a summary about New York’s “Amazon Law” from Cbiz.com (Corrente, 2011, yeah a bit outdated but provides context)-

In practice, such an online selling scheme may work as follows. A retailer selling neckties has a shop in Florida, and it wants to increase sales by selling over the internet. The retailer sets up a website, and decides that to generate traffic on its website, it will partner with other online websites. In this example, the retailer places an ad on the website of the New York Times. When a customer reaches the retailer’s website by clicking on the link at newyorktimes.com, the “click-thru” is logged. If the retailer makes a subsequent sale as a result of the click-thru, the New York Times is paid a commission. As a result of the Amazon law, New York assumes that the relationship has created nexus for the online retailer.

According to Avalara.com (one of the first experts in sales tax nexus), Amazon does not have fulfillment centers in New York. As of 2016, they further listed about 25 states with similar click-through nexus legislation or policies.

The other issue is income tax. Just because a retailer has an obligation to collect sales tax does not necessarily mean they have an instant income tax obligation. Some states have a fruit of the poisonous tree mentality where sales tax nexus creates an income tax nexus and vice versa. Don’t forget that states cannot impose an income tax per se, but they can impose a business tax or a franchise tax or a whatever tax that smells, walks and talks like an income tax but isn’t call an income tax.

Remember too that Public Law 86-272 protects TPP only from a strict income tax. However states are the using the same “non-income tax” tax as a work around for everything from tangible personal property to services.

By Jason Watson, CPA
Posted Monday, October 18, 2021

Time to go back to school. The Due Process Clause of the United States Constitution requires the seller to have some “minimum contacts” with the taxing state. The seller must reach out and purposefully avail itself of the benefits of that state. Historically, courts have held that a physical presence is required to meet the Due Process Clause, but that was dramatically changed in the Wayfair case.

Once this is satisfied, which is no easy task for a state, a four-part test of the Commerce Clause must be met.

Article 1, Section 8, Clause 3, of the Constitution empowers Congress to prohibit a state from unduly burdening interstate commerce and business activities. The law authors were very concerned with states colluding or combining forces near major trade hubs and routes, and thus created the Commerce Clause. A vision of gangs holding up covered wagons in California.

The United States Supreme Court in Complete Auto Transit v. Brady (1977) stated that a seller must meet the following four-part test to be forced to collect a tax:

• The seller must have substantial nexus (was physical presence with Quill and now it is substantial nexus with Wayfair) in state;

• The tax cannot discriminate against interstate commerce;

• The tax must be fairly apportioned; and

• The tax must be fairly related to services provided by state.

The common theme after nexus is fairness. The only time a tax is fair is when you pay the minimum amount, right?

Moving onto legislative standards. Public Law 86-272 was quoted earlier in this chapter and basically prevents a state from imposing income tax on businesses whose only activity in the state is the solicitation of orders, provided the orders are accepted and delivered from a point outside the state (interstate commerce). And this only refers to tangible personal property (TPP) and not services. At the time of this law, services were inherently personal and required a close, physical presence to perform (proximity). That has changed with telecommuting and the pure definition of a service (more on that in a bit).

So we have three standards yet states vary across the board based on the definition and triggering of nexus.

By Jason Watson, CPA
Posted Monday, October 18, 2021

Nexus is a Latin word meaning to bind, join or tie. Simply stated, tax nexus is the minimum amount of contact between a taxpayer and a state, which allows the state to tax a business on its activities. Every state defines nexus differently using terms such as physical presence or economic presence, and those concepts will be discussed in a bit.

There is also a concept called trailing nexus where an entity that once had nexus in a state ceases activities that created nexus in the first place. This is a point of contention between taxpayers and states, and is commonly created by Fulfillment By Amazon (FBA) and other online retailers since product (and therefore physical nexus) is continuously moving around.

The theory behind the trailing nexus concept can be better illustrated with an example. If your business sent a sales rep to Washington for several months to solicit orders, it is safe to say that after the sales rep leaves a residual effect would remain. This in turn would generate sales (business activity). As an aside, Washington is one of the few states that defines trailing nexus explicitly. Pot + Coffee = Progressive Law.

By Jason Watson, CPA
Posted Monday, October 18, 2021

The United States Supreme Court in a 5-4 decision in South Dakota v. Wayfair changed the sales tax nexus landscape dramatically. Until then, Amazon retailers and other online resellers were partially safe as a result of the 1992 Quill v. North Dakota decision where the Court required nexus through physical presence before states could demand sales tax collection. But with Wayfair, the Court changed this to “substantial nexus.” Here is the U.S. Supreme Court opinion-

wcginc.com/1788

We will explore the significance of this court decision throughout this chapter, and some concepts are moot but remain for legacy and illustrative purposes. Keep referring to our blog posts for updates-

wcginc.com/blog

By Jason Watson, CPA
Posted Monday, October 18, 2021

This section is not designed to address all your nexus concerns or be a solution. We are merely shining a light on all the angles to this massive problem. Our darn forefathers couldn’t imagine internets (yes plural), and other things like trains, planes and automobiles. State nexus is a massive issue both on the sales tax and income tax fronts, and states are becoming increasingly aggressive. Again, our chapter is full of generalities and summations to give you the landscape. Your particular situation will need specific attention from us and other professionals, including your own research.

By Jason Watson, CPA
Posted Monday, October 18, 2021

This in itself is not a reason to avoid the S corporation election, but there is not a better place for this material. State nexus stuff is getting very complicated so we decided to make this a separate chapter since it will continue to grow over time.

Every year all 50 states plus the District of Columbia and New York City participate in a survey conducted by Bloomberg. Here is the link for the latest results, but a warning is in order first. The 2017 report is 523 pages (yet the table of contents is rich with detail to find your particular area of interest).

wcginc.com/1744

There is also an executive summary for 2018 available from Bloomberg, and it is only 20 pages (nice!)-

wcginc.com/1746

There are several concepts here and a ton of material. Here is the mini table of contents-

• Disclaimer

• Wayfair Case Part 1

• Nexus Theory

• Constitutional and Legislative Standards (Commerce and Due Process Clause, and Public Law 86-272)

• Sales Tax, Income Tax

• Physical and Economic Presence, Nexus Attached

• Wayfair Case Part 2

• Services and Tangible Personal Property (TPP)

• Costs of Performance, Market-Based Approach

• Allocation and Throwback

• FBA, Drop Shipments, Trailing Nexus Revisited

We will explore each of these in turn, and then attempt to bring it all together with a recap. The operative word is attempt since this stuff is changing all the time and will continue to evolve through court decisions, state legislation and the impending congressional moves.

By Jason Watson, CPA

Posted July 11, 2017

This article is legacy and has been replaced with several mini articles on state sales tax, nexus and the Wayfair case. Please visit this following link to be re-directed.

https://wcginc.com/kb/chapter-5-introduction/

—

This in itself is not a reason to avoid the S corporation election, but there is not a better place for this material. State nexus stuff is getting very complicated so we decided to make this a separate chapter since it will continue to grow over time.

Every year all 50 states plus the District of Columbia and New York City participate in a survey conducted by Bloomberg. Here is the link for the latest results, but a warning is in order first. The 2015 report is 429 pages (yet the table of contents is rich with detail to find your particular area of interest).

www.wcgurl.com/1744

There are several concepts here and a ton of material. Here is the mini table of contents-

• Nexus Theory

 

• Constitutional and Legislative Standards, Commerce and Due Process Clause, Public Law 86-272

 

• Sales Tax, Income Tax

 

• Physical and Economic Presence, Nexus Attached

 

• Services and Tangible Personal Property (TPP)

 

• Costs of Performance, Market-Based Approach

 

• Allocation and Throwback

 

• FBA, Drop Shipments, Trailing Nexus Revisited

We will explore each of these in turn, and then attempt to bring it all together with a recap. The operative word is attempt since this stuff is changing all the time and will continue to evolve through court decisions, state legislation and the impending congressional moves.

And this section is not designed to address all your nexus concerns or be a solution. We are merely shining a light on all the angles to this massive problem. Our darn forefathers couldn’t imagine internets (yes plural), and other things like trains, planes and automobiles.

Nexus Theory
Nexus is a Latin word meaning to bind, join or tie. Simply stated, tax nexus is the minimum amount of contact between a taxpayer and a state, which allows the state to tax a business on its activities. Every state defines nexus differently using terms such as physical presence or economic presence, and those concepts will be discussed in a bit.

There is also a concept called trailing nexus where an entity that once had nexus in a state ceases activities that created nexus in the first place. This is a point of contention between taxpayers and states, and is commonly created by Fulfillment By Amazon (FBA) and other online retailers.

The theory behind the trailing nexus concept can be better illustrated with an example. If your company sent a sales rep to Washington for several months to solicit orders, it is safe to say that after the sales rep leaves a residual effect would remain. This in turn would generate sales (business activity). As an aside, Washington is one of the few states that defines trailing nexus explicitly. Pot + Coffee = Progressive Law.

Constitutional and Legislative Standards
Time to go back to school. The Due Process Clause of the United States Constitution requires the seller to have some “minimum contacts” with the taxing state. The seller must reach out and purposefully avail itself of the benefits of that state. Courts have held that a physical presence is required to meet the Due Process Clause, but that is eroding and being redefined every day.

Once this is satisfied, which is no easy task for a state, a four-part test of the Commerce Clause must be met.

Article 1, Section 8, Clause 3, of the Constitution empowers Congress to prohibit a state from unduly burdening interstate commerce and business activities. The law authors were very concerned with states colluding or combining forces near major trade hubs and routes, and thus created the Commerce Clause. A vision of gangs holding up covered wagons in California.

The United States Supreme Court in Complete Auto Transit v. Brady (1977) stated that a seller must meet the following four-part test to be forced to collect a tax:

• The seller must have substantial nexus (physical presence) in state;

 

• The tax cannot discriminate against interstate commerce;

 

• The tax must be fairly apportioned; and

 

• The tax must be fairly related to services provided by state.

The common theme after physical presence is fairness. The only time a tax is fair is when you pay the minimum amount.

Moving onto legislative standards. Public Law 86-272 was quoted earlier in this chapter and basically prevents state from imposing income tax on businesses whose only activity in the state is the solicitation of orders provided the orders are accepted and delivered from a point outside the state (interstate commerce). And this only refers to tangible personal property (TPP) and not services. At the time of this law, services were inherently personal and required a close, physical presence to perform (proximity). That has changed with telecommuting and the pure definition of a service (more on that in a bit).

So we have three standards yet states vary across the board based on the definition and triggering of nexus.

Sales and Use Tax, Income Tax
There are two issues at play, and they are not necessarily connected. First is sales and use tax which frankly receives the most attention because of online retailers. Some theory. When you purchase a computer at your local Best Buy, the seller is collecting sales tax in a fiduciary role. In other words, it is collecting your sales tax obligation for you on your behalf, and remitting it to the authorities. Nice of them, right?

If you buy this same computer from an Amazon retailer, the seller might or might not collect sales tax on your behalf. If the retailer does not collect sales tax, it is still your responsibility to pay this sales tax along with your state income tax return. No one does this of course. WCG (formerly Watson CPA Group) has asked 25,000 times in the past decade, and we have never heard a Yes from a client. But understand that you are required to pay sales tax if not collected by the online seller.

States are getting sick of the under-reported sales tax obligations. Therefore several are going after businesses with strong internet presence. Here is a summary about New York’s “Amazon Law” from Cbiz-

In practice, such an online selling scheme may work as follows. A retailer selling neckties has a shop in Florida, and it wants to increase sales by selling over the internet. The retailer sets up a website, and decides that to generate traffic on its website, it will partner with other online websites. In this example, the retailer places an ad on the website of the New York Times. When a customer reaches the retailer’s website by clicking on the link at newyorktimes.com, the “click-thru” is logged. If the retailer makes a subsequent sale as a result of the click-thru, the New York Times is paid a commission. As a result of the Amazon law, New York assumes that the relationship has created nexus for the online retailer.

The other issue is income tax. Just because a retailer has an obligation to collect sales tax does not necessarily mean they have an instant income tax obligation. Some states have a fruit of the poisonous tree mentality where sales tax nexus creates an income tax nexus and vice versa. And don’t forget that states cannot impose an income tax per se, but they can impose a business tax or a franchise tax or a whatever tax that smells, walks and talks like an income tax but isn’t call an income tax.

Remember too that Public Law 86-272 protects TPP only from a strict income tax. However states are the using the same “non-income tax” tax as a work around for everything from tangible personal property to services.

Physical and Economic Presence, Nexus Attached
In a 1992 U.S. Supreme Court case docketed as Quill Corporation v. North Dakota, the court established a physical presence test for sales tax nexus. The court did not address income tax, and since this decision states have varied quite a bit on attaching nexus to taxes other than sales and use tax.

Several appellate courts have limited the Quill case to sales and use tax nexus, and have deferred income tax nexus to economic presence rather than physical presence. According to Bloomberg’s survey at the beginning of this topic, only 7 states applied the physical presence test in determine an income tax nexus leaving 43 states to apply an economic presence test for income tax nexus. It is safe to say that the 7 will decrease over time.

Let’s consider California’s economic presence rules. A company is considered doing business in California if it meets any of the following conditions-

• They have property in California, with a value of $50,000 or 25% of total property, whichever is less.

 

• They have payroll in California, in the amount of $50,000 or 25% of total payroll, whichever is less.

 

• They have sales in California, in the amount of $500,000 25% of total sales, whichever is less.

California’s numbers above are a bit out dated since they are annually adjusted for inflation. In 2015, the sales trigger is roughly $525,000.

These hard numbers is called bright-line nexus. You simply meet a numeric threshold, and you magically have nexus in that state. Several states have a preponderance of the evidence set of rules using phrases such as “businesses earning significant income.” Really!? Sounds like fun trying to defend that.

And to make matters worse, your business might be protected by Public Law 86-272 if you are simply soliciting orders for tangible personal property in California. But if you are selling services in California, even with independent contractors, there is no protection and the income will be taxed if you meet one of the three criteria above.

More bad news. Your company might not have income associated with California but be deemed as doing business in California. Seriously! And, in this case you would be subjected to the $800 minimum franchise tax regardless. Yuck.

Here is the direct language from California’s Franchise Tax Board website-

An out-of-state taxpayer that has less than the threshold amounts of property, payroll, and sales in California may still be considered doing business in California if the taxpayer actively engages in any transaction for the purpose of financial or pecuniary gain or profit in California.

Partnership A, an out-of-state partnership, has employees who work out of their homes in California. The employees sell and provide warranty work to California customers. Partnership A’s property, payroll, and sales in California fall below the threshold amounts. Is Partnership A considered to be doing business in California?

Yes. Partnership A is considered doing business in California even if the property, payroll, and sales in California fall below the threshold amounts. Partnership A is considered doing business in California through its employees because those employees are actively engaging in transactions for profit on behalf of Partnership A.

Corporation B, an out-of-state corporation, has $100,000 in total property, $200,000 in total payroll, $1,000,000 in total sales, of which $400,000 was sales to California customers. Corporation B has no property or payroll in California. Is Corporation B doing business in California?

Yes. Although Corporation B’s California sales is less than the $500,000 threshold, Corporation B’s California sales is 40 percent of its total sales which exceeds 25 percent of the corporation’s total sales ($400,000 ÷ 1,000,000 = 40%.).

California is a fun state to research since they are usually on the forefront of legislative changes and updates, and there is so much economic activity. The following link is California’s FTB1050 where they outline in plain language a list of protected activities and unprotected activities as they relate to Public Law 86-272 (tangible personal property).

www.wcgurl.com/1751

There are 51 other examples aside from California (including Washington DC and New York City). Please do the homework!

Some more fodder for your consideration. In two U.S. Supreme Court cases, Scripto v. Carson (1960) and Tyler Pipe v. Washington Department of Revenue (1987), the court affirmed that a third party can create nexus. The court specifically stated what matters

“is whether the activities performed in the state on behalf of the taxpayer are significantly associated with the taxpayer’s ability to establish and maintain a market in this state for the sales.”

This third party connection is detrimental to Amazon and eBay retailers (and the like) and discussed in more detail later.

Services and Tangible Personal Property (TPP)
Public Law 86-272 protects TPP as we previously mentioned. But services are fair game for states to tax. Generally speaking states do not impose a sales tax on services but they can impose a franchise, business or privilege tax.

To make things more interesting, the definition of a service is expanding in light of ecommerce and cloud computing. For example, most states characterize cloud computing as a sale of intangibles or services, but Utah considers cloud computing as the sale, lease or license of TPP. Subtle difference, yet important.

Let’s say what you do is a service. What is the standard for determining nexus for your business? Read on please.

Costs of Performance, Market-Based Approach
Prior to Al Gore inventing all the internets, most states used the costs of performance as the method to determine nexus. If your butt was in Colorado and you provided a service to people in California, the costs of performing the service would be in Colorado and therefore you would not have nexus to California. You would only be subjected to Colorado income taxes.

Given the latest Bloomberg survey, there is a growing minority of states that are using the market-based approach. This can be loosely defined as the assignment of revenue based on the location of either

• the service provider’s customers, or

 

• where the customers received benefit from the service provided.

Consider a web server. 38 states plus the District of Columbia and New York City would consider a web server physically located in their taxing jurisdiction as enough of a presence to find income tax nexus. And most would find sales tax nexus as well. Wow. 38 is a high number.

Allocation and Throwback
Allocation of the sales and subsequent income is at the top of this heap of nexus mess. States don’t want to unnecessarily complicate things, but they do want money.

Throwback is a common concept but not every state uses it. Again, we’ll pick on California. Under the old rules, when a California company ships TPP to another state, and that company does not have nexus in that state, the sales are “thrown back” to California since it is considered a California sale.

Interestingly enough, there are cases where a sale would not have a tax home at all. Let’s say you sold a service to a customer outside of California. Using the market-based approach and under California’s new rules of bright line nexus (turn back a few pages to review), sales exceeding $500,000 in another state are not thrown back to California. So, if you had sales in another state that did not trigger a filing in that state, these sales could arguably be allocated outside of California but disappear into a black hole. Sounds crazy, but true.

Allocation issues such as these can create tax arbitrage. And there are other examples of the same dollar being taxed twice by different states. It truly is a mess. States recognize this growing problem and are working together to eliminate the loopholes. In about three perhaps four hundred years we’ll be good to go.

FBA, Drop Shipments, Trailing Nexus Revisited
Fulfillment By Amazon (FBA) and other fulfillment services add a new dimension to the nexus conversation. States are scrambling to figure it out so tax revenue can keep up with population growth and resource use.

Avalara is a consultation company who specializes in sales tax issues, and they wrote a wonderful article on FBA and what it means to you. We will attempt to paraphrase some of the concepts here, but if you want the full details use the following link-

www.wcgurl.com/5858

The first concept is nexus, which we’ve beaten to death. But here is a different spin for those selling products online. There are four common nexus creating activities-

• Your Location

 

• Inventory

 

• Warehouse Use, and

 

• Fulfillment Services

The common theme to these four activities is Where is your stuff? More importantly, is your stuff in a state that ships within the state, and if so, does that state have a sales tax obligation? In other words, if a competitor located in the same state that you are selling your tangible personal property (TPP) through an online channel is collecting sales tax, then you probably have a similar obligation. Location. Location. Location.

There is guilt by association as well. If the distributor, warehouse, fulfillment center, storage facility, or whatever else you want to call it has nexus within the state you are selling to, then you also have nexus by the fact they are storing and handling your stuff. The essence of the facility argument for a state is that the facility is helping you create a marketplace for your goods.

There are some fine lines with who holds title and when does title transfer. For most online retailers and sellers, title arguments probably won’t do much good unless there is a lot at stake and you have a war chest to spend on attorney fees.

The next concern is materiality. If you’ve determined that you have nexus and are required to collect sales tax, is the obligation material? If you sold $200 worth of stuff to a Colorado Springs consumer, is the $16 in tax worth the headaches? Remember, if you do not collect sales tax from a consumer, he or she is still obligated to pay sales tax on his or her individual state income tax return. Unless, of course, your nexus and materiality tips the scale, and you have the responsibility to collect sales tax on behalf of the consumer.

States can spend some time on going after the head of snake, such a medium-sized online retailers or states can spend a lot of time going after the consumer. Drug user versus drug dealer.

There are voluntary disclosure initiatives to allow online sellers to come clean with their dirty sales tax deeds. Several states will waive the penalties and limit the lookback to only three years. You must weigh the chance of the hammer versus the certainty of a light tap.

The issue of trailing nexus must be considered as well. For those familiar with Amazon and FBA services, you understand that your inventory is continuously being shifted to different states. Just because your inventory no longer exists in a state does not mean your nexus is instantly cutoff. This concept was broached in the beginning of this section, and is reiterated here to stress the importance of keeping up with the Kardashians and the location of your stuff, and who you owe an obligation to. Good luck.

Recap of State Tax Issues
We attempted to provide several angles and concepts to the state taxation issue. There are very few hard and fast solutions. There are tax attorneys and consulting firms who do nothing but argue and litigate state nexus issues.

If there is nexus, is there allocation? If there is allocation, who gets what? If there is a sales tax obligation is there an income tax (or franchise tax or business tax) obligation? Can you have one and not the other? Are your services considered tangible personal property by some states?

Be careful. States are taking on the giants like Best Buy, WalMart, Amazon, etc. And they now appear to be shifting their focus to those companies who do not have deep pockets to fight or pay fines. If what you are doing smells wrong or keeps you up at night, it probably is worth looking into.