One of the biggest misunderstandings for entrepreneurs is the idea of nexus as it applies to:
- Sales taxes and
- Income taxes
This can be troublesome since nexus is crucial for understanding when and where businesses are required to collect and remit sales and income taxes.
In this post we will touch on what nexus is and how it’s generally determined for sales and income tax purposes. As a caveat, each state is unique in determining nexus, as such, you should review the laws of each respective state you operate or have sales in.
Nexus in General
Nexus refers to the connection or relationship between a taxing authority, such as a state, and a business entity. This connection provides states (and localities) the legal ability to request business information to assess the applicability of income and sales taxes.
Nexus can be established through physical presence, like owning property or having employees in a state, or through economic activity, such as meeting a certain threshold of sales within the state.
Determining Sales Tax Nexus
Sales tax nexus is created in a foreign state when a seller creates some type of physical connection with the state, which can be either direct, indirect, or remote.
- Direct connection: Involves sending employees into the state, having property in the state, or performing services in the state.
- Indirect connection: Involves the use of agents or independent contracts to do things employees would typically do. This is because using independent contractor(s) to solicit sales is viewed as similar to using employees to solicit sales.
- Remote / online connection: Involves making remote / online sales into a state. Nexus is generally based on the # of transactions and / or $ value of transactions.
Now, just because your business has nexus in a state does not mean that your company is subject to sales taxes. Instead having nexus means the state can legally request information from you concerning your obligations. Your actual obligation to register for sales tax depends on what products/services you sell, the amount of transactions, and / or the $ value of transactions.
Determining Income Tax Nexus
Prior to 1959, nexus rules for income taxes were similar to sales taxes. Any type of physical activity or connection with a state could allow the state to require the taxpayer to file an income tax return and to pay income tax based on some allocation of income to the state. This approach created a large burden for taxpayers, as a result Congress passed legislation establishing when a state could impose its “income tax” on nonresident companies and their owners.
This law is referred to as Public Law 86-272, which outlines what activities may or may not create income tax nexus. Activities that are permitted without creating income tax nexus include:
- Solicit sales of tangible personal property (directly or indirectly)
- Provide services that are ancillary to the sales of property
- Have samples for display in the state and have other property used for sale in the state (cars, computers, etc.)
- Orders are accepted and fulfilled outside of the state
Activities that exceed the above activities will generally create income tax nexus in the state. For example, the following activities would generally create income tax nexus in a state:
- Selling services and not personal property;
- Providing services in the state;
- Accepting orders in the state;
- Delivery of property into the state on company vehicles;
- Accepting deposits in the state;
- Repossessing property in the state; or
- Having inventory in the state.
Conclusion
When dealing with multi-state businesses, and investments, be sure to consult a tax advisor as every state applies their own tax strategies with respect to imposing income and sales taxes. Failing to understand these rules can create significant liabilities that can attach to the owner personally.
Disclaimer: The information provided herein is intended solely for informational purposes and no person(s) or other third-party may rely upon it as financial, tax, or legal advice or use it for any other purposes. As a result, Royal Financial, and any affiliates, assume no responsibility whatsoever to readers, or any other persons for that matter, as a result of the information contained herein.