What is a Nexus Study - and Why Does a Business Need One?

Background

If you do business outside your home state, you may be liable for taxes in other states. Nexus is a connection that establishes a state or local tax obligation. These jurisdictions cannot tax a business unless that business has nexus with the state or locality (e.g., cities, counties, etc.).

Nexus is one of the most complex and important considerations for multistate and multinational businesses operating in the United States. A nexus study is helpful in determining tax obligations in states and localities as it is essentially an evaluation of whether a business has a taxable connection with a jurisdiction.

How is Nexus Established?

Nexus is an ever-evolving concept as business practices, technology, and tax rules change. Generally, nexus can be established in a variety of ways, which vary by jurisdiction and type of tax:

• Physical Nexus: Established when a business has a tangible presence in a state. Examples include having an office, warehouse, or employees physically located within the state.
• Economic Nexus: Focuses on revenue generation rather than physical presence. Once a business reaches a certain level of sales or transactions within a state, it triggers economic nexus. The specific thresholds vary from state to state.
• Affiliate Nexus: Arises when a business is related to another entity (usually through common ownership) that has nexus in a state. Even if the business itself lacks physical presence or economic activity in the state, it may still have nexus due to its affiliation with other entities that do.
• Click-Through Nexus: Established when an out-of-state business rewards in-state businesses or individuals for directly or indirectly referring customers through website links. As with economic nexus, click-through nexus rules typically include a threshold.
• Agents/Independent Contractors: Nexus can be created through agents or independent contractors performing certain activities for the taxpayer.

Income Tax Nexus Framework

• The U.S. Constitution prohibits a state from imposing a tax on a taxpayer's net income unless the taxpayer’s activities within the state create a sufficient connection, or nexus, with the taxing state.
• Federal Public Law 86-272 prohibits a state from imposing a tax based on net income when a business’s activities in the state are limited to soliciting sales of tangible personal property and ancillary activities.
• Economic nexus has become commonplace in recent years, and income tax nexus has been further complicated by the 2018 decision of the U.S. Supreme Court in South Dakota v. Wayfair, a sales and use tax case with income tax implications. (More on Wayfair below)

Sales Tax Nexus Determinants

• Prior to the Wayfair decision, a physical presence in a jurisdiction was required for sales and use tax nexus. Post-Wayfair, the economic nexus standard, which historically applied to income tax only, became the prevailing standard for sales and use tax nexus.
• Economic nexus looks at economic activity within a state to determine if a business has nexus (e.g., $100,000 of annual sales to customers in the state) even if the business lacks a physical presence within the jurisdiction’s borders.
• States with a sales tax have enacted provisions under which sales tax nexus is imposed on nonresident businesses that meet a specified economic threshold. This may cause businesses to have nexus in significantly more states than they had previously, especially for businesses making online sales, even if the business lacks a physical presence within the state’s borders.

It is also important to note that P.L. 86-272 doesn’t apply to non-income types of taxes, such as sales, net worth, and gross receipt taxes (e.g., the Washington Business and Occupation Tax, the Ohio Commercial Activity Tax, and the Oregon Corporate Activity Tax).

Nexus Complexities and Trends

• Most state tax departments have a nexus questionnaire that asks a variety of questions to determine whether a business has an income tax, franchise tax, sales tax, or other tax obligation. A business may receive one if the state has reason to believe it could have nexus.
• An increasing number of transactions occur remotely, with no face-to-face contact between the parties, raising complex questions about states' and localities’ ability to impose income tax on companies transacting business within their boundaries while having limited contacts there.
• In the 2018 case of South Dakota v. Wayfair, the U.S. Supreme Court ruled that an out-of-state seller can establish “substantial nexus” with a state for sales and use tax purposes through “economic contacts” and “extensive virtual presence.” Although a sales and use tax case, it resulted in the rapid adoption of economic nexus throughout the states, affecting both income and non-income type taxes.

Challenges Arising from Digital and Internet Activities

• The solicitation protections of P.L. 86-272, enacted in 1959, are receiving renewed attention after Wayfair, as current business contacts, services, and products are increasingly digital.
• In August 2021, the Multistate Tax Commission (MTC) approved revisions to its Statement of Information Concerning Practices of Multistate Tax Commission and Signatory States to address how P.L. 86-272 applies to modern business activities, with particular attention focused on the activities of “internet sellers” who conduct business activities with customers through the internet.
• Based on interpretations by the MTC concerning P.L. 86-272 protection associated with E-Commerce/Internet/Web-based Nexus, updated guidance is being implemented or under consideration by the states, determining whether selling tangible personal property through the internet is protected by P.L. 86-272 requires the same general analysis as sales of tangible personal property through other means.
• Based on the MTC’s interpretation, the states’ view seems to be that the options available to users of the website or mobile app could go beyond mere solicitation of sales and give rise to income tax nexus in the state where the customer is located while using the website or mobile app.
• For instance, in its regulations released in late 2023, New York State provides guidance for determining when P.L. 86-272 applies to corporations conducting business via the internet. They generally provide that a corporation may develop nexus by engaging in activities over the internet that would exceed the solicitation of orders of tangible personal property.

Why are Nexus Studies Important?

• Nexus studies help businesses understand their tax obligations in various jurisdictions.
• Many states and localities make changes to their nexus definitions on an ongoing basis. In recent years, different types of nexus have been created, going beyond the brick-and-mortar businesses, and affecting distance selling.
• Analyzing a business’s activities across multiple states and localities is needed to determine where a company may have filing requirements and potential tax obligations.
• A nexus study is a first step — options to cure any outstanding liabilities need to be carefully considered.

How Can a Business Remedy Nexus-Related Tax Exposures?

• A voluntary disclosure agreement (VDA) is a binding agreement between a state/locality and a taxpayer that has a tax obligation but hasn’t been compliant.
• A VDA is designed to encourage voluntary compliance with the state’s/locality’s tax rules by limiting the look-back period — the length of time a state/locality can reach back to hold a taxpayer liable for unpaid tax (and, often, penalties are reduced or eliminated).
• Most states/localities offer VDAs for tax, though the specifics of states’/localities’ programs vary.

Herbein is Ready to Help

Herbein’s state and local tax specialists are highly skilled and experienced in performing nexus studies to help taxpayers determine whether and where they have nexus. We analyze a business’s activities across multiple states and localities to determine where a company may have filing requirements and potential tax obligations.

To explore how a nexus study can help your business, please contact Lou Palladino at lapalladino@herbein.com. Our team of professionals is ready to discuss an efficient nexus study process and to address any exposures identified.

Article Contributed by Lou Palladino