State Income Tax Nexus: How to Know If You’re Compliant

It’s hard to solve a problem that you don’t know you have. It’s true in life, and it’s true when it comes to state income tax nexus. 

The complexities of multistate taxation make it difficult to know where a business is supposed to file and pay state income tax. Because the consequences of noncompliance can be severe, it’s worth staying on top of potential nexus issues. 

This article is the second in a series exploring what business leaders need to know about correcting and proactively managing state income tax nexus matters. Read the first article here: Guide to State Income Tax Nexus.  

How Do I Know If I Have a State Income Tax Nexus Problem? 

The clearest sign of a state income tax nexus problem is receiving an audit notice or a notice of assessment from a state tax authority that says you owe tax on income earned in the state. But you may still have nexus issues even if a state hasn’t come knocking. 

In general, states require businesses with income tax nexus to pay income tax based on their profits attributed to the state. Naturally, state income tax nexus problems can arise when a business doesn’t report or pay what it owes. 

Example: You lead an Atlanta-based consulting business. In its early days, the business only had employees based in Georgia. As the business grew, employee geographies spread to include Tennessee and North Carolina. Before you know it, you’ve had out-of-state employees for five years, but you’ve only been filing a state income tax return in Georgia. The business may have nexus in these two other states, which means you’re at risk of having to pay more state income tax in addition to failure-to-file penalties and interest on taxes owed. That’s a potential state income tax nexus problem. 

What constitutes state income tax nexus varies a little—or a lot—by state, but it generally hinges on the business’s activity level in the state, which can include having employees in a state, storing inventory in a state, or selling a substantial amount of goods and services in a state. 

Trying to interpret these laws yourself is time-consuming and may leave you, a business leader, with more questions than answers. The best way to know whether you have a state income tax nexus problem is to work with multistate tax experts to conduct a nexus study. 

What Is a Nexus Study? 

A nexus study—also called a nexus analysis—involves tracing your business’s activities to states with the right to tax your income. Conducting a nexus study is the first step in identifying and resolving state income tax nexus matters. 

The scope of a nexus study depends greatly on your goals. Your trusted tax advisor will get an understanding of your potential nexus problems by asking about your entity’s industry, its profitability, and your business’s specific activities within each state.  

From there, your tax advisor will investigate and compile a report showing where you have state income tax nexus, how much you might owe in taxes, and your options to remedy any issues. How you decide to address nexus issues depends in part on your risk tolerance, which is how comfortable you are with the possibility of being audited and assessed for taxes owed to a state. 

Nexus studies can address state income tax nexus, sales tax nexus, or both. 

What Triggers State Income Tax Nexus? 

If a nexus study is the best way to tell whether a business has nexus in a particular state, how do you know when it’s time for a nexus study? Think about whether your business has a meaningful connection in a state or states where it doesn’t currently file a state income tax return or pay income tax. 

No two states’ tax laws are the same, but many base income tax nexus on the concepts of physical and economic presence. 

Physical Presence in a State 

State income tax nexus is often established when a company, including its assets or employees, has some form of physical connection to a state. Physical presence for state income tax nexus purposes typically comes from: 

• A storefront, office, warehouse, or other property in the state (rented or owned) 
• An employee working from the state 
• Inventory stored in the state 

Nexus based on physical presence can be created in some surprising ways, too. For example, your company may have nexus in the state where Amazon warehouses your inventory to sell on its online platform. 

Keep in mind that federal law bars states from collecting income tax from businesses that merely sell physical goods to in-state customers. Specifically, Public Law 86-272 makes it so that businesses won’t establish nexus through many activities related to selling tangible personal property to out-of-state customers. These protections aren’t available for service providers, and the law doesn’t bar states from requiring businesses to collect sales tax, however. 

Economic Presence in a State 

Before the rise of e-commerce—and even some time after—physical presence was the primary way for a business to establish income tax nexus in a state. However, things changed in part due to South Dakota v. Wayfair, a landmark U.S. Supreme Court case that paved the way for states to collect sales tax on online purchases.  

Wayfair focuses on sales tax nexus, but the decision emboldened states to alter their income tax nexus rules to say that nexus can be established without even stepping foot in a state — through economic presence. With the growing popularity of online shopping, it’s easy to understand why states want to tax companies that transact within their borders even if they don’t set up a physical shop.  

Each state can define economic presence differently. Some states, such as California and Texas, apply economic presence using the factor presence nexus standard, which generally says that an out-of-state business has nexus in a state if it has more than a specified amount of property, payroll, or sales in a state.  

For example, California law says that a business has income tax nexus if it does business in the state and either: 

• In-state sales exceed $500,000 (adjusted for inflation), 
• In-state real property and tangible personal property values exceed $50,000 (adjusted for inflation), 
• In-state payroll costs exceed $50,000 (adjusted for inflation), or 
• In-state sales, property, or payroll costs exceed 25% of the company’s total sales, property, or payroll. 

What are the Consequences of State Income Tax Nexus Noncompliance? 

The consequences for failing to pay income tax owed to a state include financial penalties and interest due on taxes owed.  

It’s easy for business leaders to underestimate the consequences of state income tax noncompliance. Having a nexus study can reveal just how quickly penalties and interest can add up: There’s no statute of limitations on assessing tax due on a company that hasn’t filed a tax return in the state. That means a state can go back to your business’s first tax year to investigate whether any income is attributable to the state. 

Beyond the financial repercussions, resolving state income tax nexus compliance issues requires significant research and analysis and can be a major headache that takes you away from doing the work to help your business grow and thrive.  

You often have more options to correct compliance issues if you solve them before the state catches up with you. However, even if you’re assessed penalties and interest from a state income tax nexus issue, there are solutions out there to have them eliminated. That’s why it’s essential to work with an accounting firm that’s experienced in resolving nexus matters. 

Smith + Howard: Your Multistate Business Tax Experts 

As a business leader, your vast responsibilities make it impractical to know the precise tax implications of every cross-state transaction you consider. With state tax law in seemingly constant flux, it’s crucial to have a trusted tax advisor in your corner that regularly assesses your state income tax nexus risk as you make big business decisions. 

Smith + Howard helps scores of businesses get and stay compliant with state tax authorities. You can rely on our experienced professionals to ask the right questions about your business and keep you informed on state income tax nexus matters as they affect your decision-making.  

Gain confidence in your business’s level of state income tax compliance by contacting an advisor.  Once you discover that may have a state income tax nexus issue, the next step is to figure out the best way to resolve it — which is what we’ll discuss in the next part of the series. Stay tuned.