State Tax Nexus: Expect to Pay Income Tax in More States

State Tax Nexus: Expect to Pay Income Tax in More States

March 01, 2023

By now, prospective buyers are getting used to the fact that target companies have sales tax nexus pretty much everywhere. Unfortunately, once the brick-and-mortar walls of sales tax nexus came tumbling down, Joshua’s trumpet surrounding the walls of state income tax nexus began to blow.

Historically, sales tax nexus hinged on whether a company had physical presence within a state. Generally, physical presence nexus is defined as having any level of tangible personal property or payroll in a state. Practically speaking, this reflected the brick-and-mortar nature of our economy prior to the advent of the internet and the incredible success of online retailers such as Amazon and Wayfair.

However, in June 2018 the U.S. Supreme Court ruled in South Dakota v. Wayfair, Inc.1 (“Wayfair) that companies can establish sales tax nexus in states not only via physical presence but also by merely surpassing a level of revenue and/or transactions in a state. This signaled an end to the notion that a state can only impose sales tax on a company that has a physical presence within the state.

But tax law, like language, evolves over time. After the Wayfair decision, state and local jurisdictions were now empowered to impose state income tax nexus on out-of-state companies based on similar “economic nexus” standards.

Even prior to Wayfair, a handful of states imposed economic nexus standards for income and gross receipts taxes, and the Multistate Tax Commission adopted a $500,000 sales threshold for triggering economic nexus. It is worth noting that, prior to Wayfair, New York State established a bright-line threshold for establishing economic nexus at $1 million.

Unsurprisingly, after Wayfair, additional states and cities began jumping on the bandwagon to impose economic nexus standards for triggering state income and gross receipts tax nexus. This list now includes Hawaii, Maine, Massachusetts, Oregon, Pennsylvania and Philadelphia, and Texas. With the evolution of the U.S. economy moving from brick-and-mortar to the internet, state tax laws are adapting to ensure their states’ financial security by imposing tax on companies based on economic rather than physical presence.

In addition to the increased aggression in state tax nexus laws over the past decade, federal protection against triggering state income tax nexus solely based on the sale of tangible goods (P.L. 86-272) may be facing its demise in whole or in part. Accordingly, target companies will likely soon have state income tax nexus in more jurisdictions than they previously thought, which will have a direct impact on tax due diligence findings, ASC 740 tax reserves, and representation and warranties insurance.

With the continued demise of long-standing physical standards for state income tax nexus, both prospective M&A buyers and taxpayers should keep their eye on the ball of states further expanding the purview of income tax nexus and taxability, including tax on additional digital and cloud-based products or other services. Reflecting the fact that state and local government tax authorities are watching industry trends to refocus tax strategies, Apple just recently agreed to pay the Chicago tax on its streaming services (the so-called “Netflix Tax”) to settle long-standing litigation.

138 S. Ct. 2080 (2018).

Originally published in Practical Tax Strategies