Guide to State Income Tax Nexus

For businesses that operate on a national or even regional scale, the concept of state income tax nexus is important to understand. The existence of nexus generally means a business has enough business activity in a state to potentially create a liability for income taxes.

Unfortunately, among the 50 States, there are varying definitions of the levels of activity that must be present to generate state income tax nexus. While some standards do exist, no two states have exactly the same nexus rules. This creates significant complexities for finance leaders tasked with determining the level of income tax exposure their business has in any given state. 

There are many misconceptions when it comes to state income tax nexus. The risks of incorrectly interpreting state income tax nexus can be severe, making it vital for leaders to embrace a proactive approach to evaluating their state income tax nexus. 

What is State Income Tax Nexus?

From a tax perspective, the word ‘nexus’ is essentially synonymous with the word ‘connection’. If a business has state income tax nexus, they have a level of business connection with the state that requires them to file tax returns and pay state income taxes that are due. 

The complexities arise when it comes to defining what level of activity creates an obligation to pay state income taxes. While there have been efforts, led by the Multistate Tax Commission (MTC), to create more uniform standards that apply across states, no two states share the same thresholds for state income tax nexus. Not every state is a member of the MTC, and all recommendations made by the MTC are just that, recommendations: they are not legally binding. 

This lack of conformity means that accurately defining your business’s state income tax nexus is a complex undertaking that requires the support of a sophisticated accounting firm. The process should be completed on a multi-state basis and requires an in-depth knowledge of the tax laws of every state where a business has the potential to meet nexus thresholds. 

If it’s determined that a business does have state income tax nexus, it’s important to note that it may not be required to pay state income taxes on 100% of its income: instead, businesses pay only based on the activities (also defined differently by each state) in the states where they have nexus. 

Public Law 86-272

State nexus laws continue to evolve to account for changing business environments, but one guiding principle holds true: Public Law 86-272. This law, enacted by the federal government in 1959, provides protections for certain interstate activities. 

A common misconception is that sales to customers in a state automatically creates income tax nexus. In reality, Public Law 86-272 protects sellers of tangible personal property when they sell outside their home state. Many activities that facilitate sales of tangible personal property to out-of-state customers are protected and do not cause state income tax nexus. It should be noted that this law does not protect service providers and other businesses that do not meet this narrow exception. Further, selling out of state can cause sales tax nexus: particularly since the Supreme Court’s 2018 decision in South Dakota vs. Wayfair. 

State Income Tax Nexus vs. Sales Tax Nexus: Key Distinctions

It’s important to understand the difference between state income tax nexus and sales tax nexus. Sales tax nexus refers to a retailer’s obligation to collect state sales taxes on purchases made outside of their home state. 

Sales tax nexus has become an increasingly important consideration since the 2018 Wayfair Supreme Court decision, with many companies, from online retailers to manufacturers, now required to collect sales tax from customers and remit payments to the customer’s state of residence even if they do not have a physical presence in the state.

It’s critical to note that if a business has sales tax nexus in a state, it does not necessarily mean they also have a state income tax nexus. The thresholds that determine sales tax nexus and state income tax nexus are entirely different. That poses the question: how can businesses understand where they have state income tax nexus?

How Can Businesses Determine their State Income Tax Nexus?

It’s easy to think that having customers in a state gives a business state income tax nexus, but the math is rarely that simple. Determining state income tax nexus must be done on a state-by-state basis. Each state has its own rules around the types of activities that constitute income tax nexus, and it’s vital for businesses to work closely with their internal operations team as well as their accounting firm to gather and assess all the facts.

In general, if a business has any sort of physical presence in a state, it’s indicative that state income tax nexus should be investigated in more detail. Exactly what this presence looks like can vary: it could be the presence of remote employees, a manufacturing facility, or even something as seemingly innocuous as having inventory stored in an Amazon warehouse. 

While physical presence is an important factor in many states, it’s far from the only consideration. Some states might consider a business to have state income tax nexus even if nobody from the business has ever stepped foot in the state. As business models change and commerce increasingly moves online, many states are revising their laws to ensure they continue to capture their share of state income taxes. 

The Importance of a Proactive Approach to State Income Tax Nexus

State income tax nexus is an extremely important topic; one that businesses should tackle proactively. In general, there is no statute of limitations when a business fails to file and pay state income taxes. If a business is audited by a state where they have erroneously failed to file state income taxes, they could owe years of back taxes, interest, and penalties. 

A proactive approach helps avoid damaging events such as this. The first time a business evaluates its state income tax nexus typically involves a significant investment to complete the analysis. However, in the years that follow, the process is generally more streamlined: businesses only have to determine whether their activities in the state have changed materially or whether any state has passed any relevant new legislation.

If a business has failed to file in states in previous years but now wishes to become compliant, it may enter into a Voluntary Disclosure Agreement with the appropriate states. These agreements allow businesses to come forward to file and pay some outstanding tax obligations in exchange for reduced penalties and limitations on the number of years the income tax can be assessed.

Partner with Smith + Howard: Experienced State Income Tax Nexus Advisors

Determining whether a business has state income tax nexus is a complex undertaking that requires guidance from experienced tax advisors. At Smith + Howard, our tax practice constantly re-evaluates the nature of our clients’ businesses and their activities in different states across the country. 

State income tax nexus is rarely a cut and dry issue, but it’s our goal to give clients a comprehensive understanding of their tax exposure. Every engagement is driven by a collaborative approach, and we aim to rigorously assess all available information to provide accurate yet practical tax recommendations. 

If you’re interested in learning more about working with Smith + Howard to determine your business’s state income tax nexus, contact an advisor today.