Over the past few years, we have seen enormous technological advancements that have shifted the way we do business; from remote employees to the expansion of e-commerce businesses, a lot has changed. These shifts coupled with the application of state and local tax laws have created an environment where unwary companies may be surprised to find themselves subject to tax in new jurisdictions due to evolutions in tax nexus rules. This article considers current state and local income tax nexus issues, with a specific focus on the impacts of remote work and the South Dakota v. Wayfair (6/21/2018) decision.

Unlike sales tax nexus prior to Wayfair, physical presence has not been a requirement under the U.S. Constitution to establish taxable nexus for purposes of imposing an income tax. Rather, the Supreme Court has seen fit to permit income taxation under the broader norms of the Due Process and Commerce Clauses. Many states responded by establishing income tax nexus standards that permit taxation under the U.S. Constitution. In recent years, though, two things have altered this application: the ruling in Wayfair and the adoption of bright-line factor presence nexus thresholds.

Nexus risks associated with remote work

Even though the COVID-19 national emergency has ceased, employees are continuing to operate remotely in numbers far exceeding pre-pandemic levels. The effect for companies is an increased risk that employees working remotely in other states can create income tax nexus for their employer in that state. Physical presence has not been a component of income tax nexus in the way it historically was for sales tax nexus, however, physical presence is one of the few clear indicators of income tax nexus.

Remote work has the potential to be a real concern for companies since different departments within an organization are frequently charged with hiring employees than those complying with tax laws. A company can establish nexus with a state due to the actions of the personnel department long before the tax department is aware nexus exists.

Consider the following scenario: A company establishes income tax nexus in a state under the state’s factor-presence standard. While the tax department is evaluating its reporting obligations and voluntary disclosure opportunities, the personnel department hires a remote employee in the state on which the payroll department withholds payroll tax and remits it to the state revenue department. The state revenue department recognizes the presence of the company’s employee in the state and determines the company has income tax nexus as a result and has not filed an income tax return. The department sends the company a notice demanding the filing of tax returns and a proposed estimated tax liability. The company, now having been contacted by the department, can be precluded by statute from entering into a voluntary disclosure agreement that would have abated the late filing and late payment penalties related to the period in question. As such, the company now owes penalties in addition to the tax and interest due on the late-filed return unless it can establish a valid cause under which to have the penalty abated.

From this scenario we can see the complications created by remote work and it underscores the necessity of companies to not only understand income tax nexus rules but to have adequate communication throughout the enterprise to help ensure business decisions do not create unknown, negative tax effects.

The lingering effects of Wayfair

In 2018, the U.S. Supreme Court issued its decision in Wayfair, which established that certain economic contacts with the state were sufficient to establish nexus when no physical presence exists. The impact of Wayfair on interstate retailers, especially small businesses that have physical presence in only a handful of states, has been burdensome. Since the adoption of economic standards by 46 states with sales tax, retailers have had to assess their business model, perform nexus studies to determine how best to approach their growing state tax obligations, and implement costly software programs to manage their increased sales tax collection and filing obligations. However, what is less frequently addressed is the impact Wayfair has on income taxation.

Prior to Wayfair it was much easier for a company to avoid detection by a state revenue department; however, now companies with no physical presence in a state are obligated to make sales tax reports to states. Where previously a company may have only considered the risk of detection, now a company must consider whether it has income tax nexus in addition to sales tax nexus in any given state. Moreover, under the patchwork quilt that is states’ income and sales tax nexus standards, there is no clear unifying nexus standard which applies to all states. A company without physical presence in two states, and comparable sales levels in each, could have both income and sales tax nexus in one state but only sales tax nexus in the other. Absent a thorough nexus analysis, that company could not be certain of income tax nexus implications and would risk unnecessary tax filings in one state or risk the penalties of non-filing in the other.

Evolution of factor-presence standards

Certain states have also adopted income tax nexus standards comparable to the economic-nexus standard per Wayfair. These factor-presence standards have the potential benefit of providing clarity to companies. The most frequently adopted factor-presence standard (also the standard promoted by the Multistate Tax Commission) provides that having or exceeding $50,000 of property, $50,000 of payroll, or $500,000 of sales in a state creates income tax nexus. The benefit to companies is twofold: 1) the thresholds provide certainty that nexus has or has not been established, and 2) the thresholds are sufficiently large enough that they are not perceived as punitive by out-of-state companies who may otherwise have de minimis contact with the state.

Factor-presence standards, however, are not without their problems. A prime example of this is California, which has adopted the above factor-presence standard subject to inflation adjustments. California’s nexus standard, however, is “actively engaging in any transaction for the purpose of financial or pecuniary gain or profit” and the statute provides the factor-presence standard as a condition satisfying the nexus rule. As such, California’s factor-presence standard is only a bright-line rule for determining if income tax nexus exists, not for determining that income tax nexus does not exist. The practical effect of this is that California’s factor-presence standard does not actually remedy the problem these types of standards should address: the ability to objectively determine whether a state does or does not have nexus to tax. Unfortunately, companies with California activity not meeting the factor-presence threshold must therefore still engage in the subjective analysis needed to determine nexus that a factor-presence threshold should render unnecessary.

Impact of P.L. 86-272

Riding the coattails of Wayfair, in August 2021, the Multistate Tax Commission (MTC) adopted revisions to its statement on P.L. 86-272. These revisions seek to expand the definition of unprotected activities in relation to how companies operate using the internet. Remote activities that previously have not been viewed to exceed activity ancillary to the solicitation of sales are now being targeted by the MTC and a select number of states that have proposed adopting the new MTC statement. Specifically, remote activities such as placing certain internet cookies on a customer’s computer, responding to inquiries from a customer through a “chat” option, or advertising online for non-sales related employment positions would go beyond solicitation and create taxable nexus for a business. Two major states, California and New York, have already taken steps to try to adopt these provisions. While litigation on this subject is pending in California, a broader adoption of the new MTC revisions will have a significant impact on how companies conduct their business in an ever-increasing digital environment, especially those in the retail industry which primarily benefits from P.L. 86-272 protection.

Nexus risks associated with remote work

Lastly, even after the COVID-19 national emergency has ceased, employees are continuing to operate remotely in numbers far exceeding pre-pandemic levels. The effect for companies is an increased risk that employees working remotely in other states can create income tax nexus for their employer in that state. As was stated before, physical presence has not been a component of income tax nexus in the way it historically was for sales tax nexus, however, physical presence is one of the few clear indicators of income tax nexus.

Remote work has the potential to be a real concern for companies since different departments within an organization are frequently charged with hiring employees than those complying with tax laws. A company can establish nexus with a state due to the actions of the personnel department long before the tax department is aware nexus exists.

Consider the following scenario: A company establishes income tax nexus in a state under the state’s factor-presence standard. While the tax department is evaluating its reporting obligations and voluntary disclosure opportunities, the personnel department hires a remote employee in the state on which the payroll department withholds payroll tax and remits it to the state revenue department. The state revenue department recognizes the presence of the company’s employee in the state and determines the company has income tax nexus as a result and has not filed an income tax return. The department sends the company a notice demanding the filing of tax returns and a proposed estimated tax liability. The company, now having been contacted by the department, can be precluded by statute from entering into a voluntary disclosure agreement that would have abated the late filing and late payment penalties related to the period in question. As such, the company now owes penalties in addition to the tax and interest due on the late filed return unless it can establish a valid cause under which to have the penalty abated.

From this scenario we can see the complications created by remote work and it underscores the necessity of companies to not only understand income tax nexus rules but to have adequate communication throughout the enterprise to help ensure business decisions do not create unknown, negative tax effects.

Conclusion

The world of state income tax has become much more complicated following the ruling in Wayfair and the beginning of the pandemic. Now more than ever, it is necessary for companies to have a thorough understanding of state nexus rules and to know how their business activities affect the establishment of nexus under those rules. Companies are encouraged to seek advice from their tax advisors on making income tax nexus determinations.

Contact

Corey L. Rosenthal, JD, Principal, Practice Leader, State and Local Tax Services

646.625.5729

Arvinder Kaur, CPA, Senior Manager, State and Local Tax Services

646.448.5466

Jamie Kelly, Manager, State and Local Tax Services

312.788.6058