Are you operating your business in multiple states? Performing certain activities, or reaching certain thresholds, can create a requirement to file tax returns and pay taxes in those states. Tax nexus laws are used to determine if a state filing requirement exists. While the tax nexus laws vary by state and type of tax being imposed, most states use a similar approach. By understanding this approach, you can identify states where your business activities may create a filing requirement and further analysis is required. Please click below for more information.
Nexus is the minimum level of connection between a state and the business activities in the state required for the state to tax your income. Once a business establishes nexus with a state, it will be required to file a state tax return and pay tax on the income generated in that state. There are several different business activities that states use to establish nexus including factor based standards and several targeted activities.
Factor Based Standards
Most states use factor based standards to establish nexus. Factor based standards parallel the method used for apportioning or allocating income between states. Please see our February 2017 web-blast for a more detailed look at the apportionment rules. The most common apportionment methods allocate income between the states based on the ratio of revenue, payroll, and property in the state compared to the overall total reported on the federal tax return. Under a factor based standard, if any of these factors reach a certain threshold in the state, either a percentage ratio or dollar amount in total, then nexus has been created in that state.
As an example, in California nexus is established when any of these thresholds are met:
- $54,771 of property or 25% of total property are in California
- $54,771 of compensation or 25% of total wages are paid in California
- $547,711 of sales or 25% of total sales are in California
State Targeted Activities
Even when factor based standards are not met, there are several activities that states will target to establish nexus. These activities don’t necessarily create nexus; however, they tend to be items that the states consider self-reporting of nexus and establish a presumption of a filing requirement. For example, if you register to conduct business with the Secretary of State, it will be reported to the state’s Department of Taxation. At that point, the Department of Taxation will expect a tax return and most likely send a notice if it is not received. If research into the state’s tax laws confirm nexus was not established in the state, it is your responsibility to substantiate it.
In addition to registering to conduct business, states also target domicile (location) of the business, payroll tax returns, and inventory location. If you have any of these within a state, further research, and documentation, should be completed in the event a notice is received.
The federal government has provided some protection for taxpayers limiting the states’ ability to establish nexus. If a business’ activities in a state are limited to several protected activities, then Public Law 86-272 prevents states from taxing the income. These activities include solicitation of orders, advertising, having a display room for 2 weeks or less, having an employee home office, among others. However, it is important to note that Public Law 86-272 only applies to income taxes, leaving you subject to gross receipts tax and net worth tax.
Is Nexus Bad?
While filing in additional states is a hassle and not very fun, from a tax perspective it may not be a disadvantage. For individuals and pass through entities, besides a nominal filing fee in some states, additional state filing requirements usually are a tax neutral event.
However, for corporations it may actually result in a net decrease in tax. As we discussed in our February 2017 web-blast, each state uses a separate apportionment formula. This means very rarely does the apportioned income add up to 100% of the total income. With proper tax planning, less than 100% of the business income can be subject to state taxation resulting in a lower state tax expense.
Determining if state nexus has been established can be a complicated undertaking. Please call your L&B professional at 858-558-9200 if you need help determining if a state filing requirement exists.