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In light of ever-present budget shortfalls in most states' coffers, a go-to revenue-generating technique affecting all business owners is a “nexus” audit. The U.S. Supreme Court decision last summer in South Dakota v. Wayfair, 138 S.Ct. 2080 (2018), overturning the long-standing precedent in Quill Corp. v. North Dakota, 504 U.S. 298 (1992), has lengthened the states' reach to audit an out-of-state business without regard to whether the business ever physically crossed the state's borders.

In the “post-Wayfair” nexus landscape, many small and mid-size businesses are learning for the first time about their income and sales tax obligations from business activities (nexus) inquiries sent by taxing authorities invigorated by the changes in the law. The business can be blindsided by the substantial assessments over a period of six to eight years, including interest and penalties and potential personal liabilities for the owners.

This article analyzes what it means for a business to have physical and/or economic nexus through, respectively, its activities and receipts generated in another state. In addition, we discuss the importance of a prophylactic nexus study and tax savings that can be achieved with a proper allocation analysis.

Pre-'Wayfair' Definition of Physical Nexus

Since the 1992 Supreme Court ruling in Quill, an out-of-state (also known as “foreign”) business with significant physical presence in another state is deemed to have nexus with that state. The Quill case specifically addressed a state's ability to impose sales tax, but stands broadly for the “physical presence” nexus test in the income tax arena as well.

A business with physical contacts in a state is considered to avail itself of that state's benefits and privileges (this assumption is automatic for domestic businesses). In turn, the state is considered to have jurisdiction to impose taxes on the nonresident business.

Physical contacts, beyond outright ownership or leasing of property, may include, among other things, in-state deliveries (other than by common carrier) and banking activities in the state. For sales tax purposes, such contacts also include solicitation of sales, whether by employees, independent contractors or other agents.

State income tax is generally imposed on an out-of-state business on income sourced within the state. Federal protection is provided under 15 USC §381 (commonly known as “P.L. 86-272”), for businesses whose only activity in the state is solicitation. However, it does not protect a business from the obligation to collect sales and use tax. It also does not protect against non-income franchise tax. For this reason, states have enacted statutes that calculate tax based on gross receipts, apportioned capital, net worth and other non-income measures, such as the Washington Business and Occupancy Tax, Michigan Business Tax, Texas Margin Tax, and Ohio Commercial Activities Tax.

Over the past decade, states have pushed the boundary to assert nexus based on tenuous contacts in the state, such as licensing a trademark (Lanco v. Div. of Taxation, 188 N.J. 380 (S.Ct. 2006)), or storing website “cookies” on local computers (Mass. Regs. Code 830 CMR §64H.1.7(2). In addition, under “Amazon laws,” states created a rebuttable presumption of nexus when a business entered into referral agreements with residents. New York's highest court upheld such a statute against constitutional challenge in Overstock.com v. N.Y.S. Dept. of Tax'n & Fin., 20 N.Y.3d 586 (Ct. of App. 2013), aff'g Amazon.com v. Dept. of Tax'n and Fin., 913 NYS2d 129 (App. Div. 2010).

States have also asserted claims of physical nexus when a business enrolls in the Fulfillment By Amazon (FBA) program. This is a logistics service offered by Amazon to e-commerce businesses. The FBA directs a business to send inventory to a warehouse in a particular state, and subsequently, unbeknownst to the seller, may redistribute it to a warehouse in another state. That second state will often claim that inventory stored there creates nexus. The quantity of inventory or length of time the inventory spends in the warehouse seemingly does not make a difference.

Since states continued to insist that nexus was created through tenuous physical contacts and tortured interpretations of case law under Quill, it was only a matter of time before the Supreme Court would be asked to bless “economic nexus” rules, which do not require any physical presence at all.

Economic Nexus Under 'Wayfair'

In at least the second half of the past quarter-century since Quill was decided, pressure has been mounting to overturn this precedent because of perceived unfairness to brick-and-mortar businesses. States also began to feel the pinch from not being able to collect tax from the elusive and sometimes anonymous online marketplace. This culminated in several state campaigns to “Kill Quill.”

To provoke a constitutional challenge, South Dakota passed a sales tax law creating nexus if an out-of-state business generated over a certain dollar threshold of revenue ($100,000) from the state, or conducted a certain number of transactions (200) in the state. This new “economic nexus” law did not require physical presence in the state. South Dakota then proceeded to sue the largest out-of-state vendors, including Wayfair and Overstock. Losing in the state courts that considered themselves duty-bound to follow Quill, South Dakota appealed to the U.S. Supreme Court and won.

Post-'Wayfair' Legislation

New York passed a sales tax economic nexus statute decades before South Dakota did, but waited patiently for almost 30 years for constitutional approval to begin to enforce it. N.Y. Tax Law §1101(b)(8)(iv), and regulations under NYCRR 20 §526.10, require a vendor to remit sales tax if it conducts more than $300,000 of sales and more than 100 sales of tangible personal property in the state. Now, post-Wayfair, New York issued guidance in Notice N-19-1, in January 2019, that it will start enforcing this existing statute immediately.

New Jersey was the first state to pass an economic nexus statute after Wayfair was decided. The New Jersey thresholds exactly mimic the requirements of the South Dakota statute. In addition, in the case of remote sales, New Jersey has imposed a direct obligation for the marketplace “facilitator” to collect sales tax, as long as such middleman has access to the necessary information from the seller. We anticipate that New Jersey and other states will further develop audit programs that seek to aggressively enforce the new economic nexus laws.

Importantly, other middlemen, such as out-of-state wholesalers and distributors that do not sell goods to end users, generally do not need to register to collect sales tax, regardless of nexus to a state, because their sales are considered to be sales-for-resale. However, in light of the new laws implicating marketplace facilitators, under the more aggressive post-Wayfair audit programs, if such wholesalers and distributors cannot present valid resale exemption certificates to the taxing authorities, they may be held jointly liable for sales tax with the retail sellers.

Finally, note that the post-Wayfair legislation is intended to supplement and not replace the physical nexus test, which continues to apply to a business falling below the economic nexus thresholds. For such states, and for states that have not passed economic nexus legislation, inventory stored, employees located, orders taken, and affiliate contracts made in the state, along with many other physical contacts, continue to be relevant factors for determining nexus.

Income Allocation

An important aspect of the nexus analysis is to determine allocation of receipts in multiple states and whether income and/or sales tax returns need to be filed in those states.

In the area of income or receipts-based tax reporting, states including New Jersey and New York utilize a single-factor sales receipts formula to allocate income of domestic and foreign businesses. This is a simplified method from previous statutes that also weighed property and payroll in a three-factor allocation formula. The calculation currently is a ratio of receipts derived from the state as numerator over the denominator of all receipts derived from all other jurisdictions. New Jersey used to “throw out” from the denominator receipts not subject to income tax in any jurisdiction, thus capturing this otherwise untaxed income, but in 2010 abolished this requirement to encourage businesses to come to New Jersey. N.J.S.A. §54:10A-6(B); N.J.A.C. §18:7-8.7(d).

A nexus analysis can ensure that income generated from states where the company may have no nexus is excluded from the total income allocated among states where the company does have nexus. This could be because the business does not have physical contacts with the state, falls below economic nexus thresholds and/or the state has not passed economic nexus legislation. If properly allocated, income (or other type of tax base) from states where the business does not have nexus can potentially completely escape tax in any state at the entity-level.

Conclusion

In light of potential pitfalls facing a multi-state business with regular ties to several states (direct or indirect, and now, under Wayfair, purely economic), as well as potential tax savings from proper income allocation, it is every Controller's or Chief Financial Officer's fiscal obligation to have a confidential (and, if conducted by attorneys, attorney-client privileged) state-by-state nexus study conducted of its business' multi-state operations. If the business has exposure, it can apply for a voluntary disclosure program, or develop another compliance strategy to limit the look-back period, obtain a waiver of penalties and prevent personal liability to the owners that may not be dischargeable in bankruptcy.

Finally, income/receipts allocation for closely-held pass-through entities, such as S corporations and LLCs treated as partnerships, has tax implications for individual partners or shareholders. While outside the scope of this article, the individual tax consequences can be mitigated and even eliminated with proper residency planning.

Geoffrey N. Weinstein is special counsel, and Juliya L. Ismailov is an associate, in the Tax, Trusts & Estates Department of Cole Schotz in Hackensack.