What Creates Income Tax Nexus for a Business?

Income tax nexus is the connection a business must have with a state before that state can legally tax its income. If a business has customers, operations, or employees in more than one state, understanding nexus is a requirement for legal operation. The level of connection needed to trigger a tax obligation is defined by state-specific rules, making it a complex landscape for any company. Navigating these obligations is important for business owners to ensure they remain compliant and avoid unforeseen liabilities.

Establishing Physical Presence Nexus

The traditional standard for creating an income tax obligation was a direct physical footprint within a state’s borders, known as physical presence nexus. The most straightforward example is having employees working within a state. This includes not only staff in a corporate office but also remote employees who reside and work from home in a different state, a factor of growing importance.

Owning or leasing property is another creator of physical presence nexus. This applies to real property, such as an office or warehouse, as well as tangible personal property. A business that owns or rents equipment, vehicles, or even temporary displays for trade shows can establish a physical connection that triggers an income tax filing requirement. The duration of the property’s presence can be a factor, but even short-term rentals may be enough to create nexus.

Storing inventory within a state is an activity that establishes physical presence. This is particularly relevant for e-commerce businesses that use third-party logistics or fulfillment centers. When a company places its goods in a warehouse, it creates a tangible link to the state. This applies even if the warehouse is owned and operated by a separate entity.

The use of in-state representatives can also create physical presence nexus. This is not limited to direct employees and can extend to agents or independent contractors who act on the business’s behalf. If these individuals perform services or solicit sales to establish or maintain a market for the company, their activities can be attributed to the business for nexus purposes.

Understanding Economic Nexus

A more recent development is economic nexus, which does not require a business to have any physical footprint in a state. This standard emerged from the 2018 Supreme Court decision in South Dakota v. Wayfair, which initially applied to sales tax. The ruling overturned the requirement of physical presence, allowing states to tax businesses based on their economic connection. Many states have since extended this logic to income tax.

The core of economic nexus lies in sales thresholds that states establish. While these figures vary, many states have set thresholds for income tax nexus that often start at $100,000 in gross sales into the state. Unlike the sales tax standard, a transaction count alone is less commonly used to trigger income tax nexus. Once a company’s sales exceed a state’s monetary threshold, it is considered to have a substantial economic presence and must comply with that state’s income tax laws.

This standard has profound implications for businesses that operate remotely, particularly those in e-commerce and software. A company selling digital goods, offering a software-as-a-service (SaaS) platform, or shipping products nationwide can meet these economic thresholds in multiple states without an office or employee there. For these businesses, tracking sales on a state-by-state basis is a component of tax compliance.

Some states have also adopted market-based sourcing rules, which solidify economic nexus for service-based businesses. Under these rules, revenue from services is assigned to the state where the customer is located, rather than where the service is performed. This means a consulting firm in one state could have income tax nexus in another simply by providing services to clients located there, even if all the work is performed remotely.

Federal Limitations on State Taxation

Despite state nexus rules, a federal law provides a degree of protection for certain businesses. Public Law 86-272 prevents states from imposing a net income tax on a business if its only activity within that state is the solicitation of orders for sales of tangible personal property. For this protection to apply, the orders must be sent outside the state for approval, and if approved, the goods must be shipped from a point outside the state.

The law narrowly defines what constitutes “solicitation.” Protected activities include advertising, carrying samples for display, and visiting potential customers to encourage them to place orders. The protection is limited to the sale of tangible goods, meaning it does not apply to companies selling services, real estate, or intangible property like software.

The protections of P.L. 86-272 are forfeited if a business engages in activities that go beyond mere solicitation. Unprotected activities include:

• Making repairs
• Providing installation or maintenance services
• Collecting on accounts
• Providing technical assistance or training to customers
• Accepting returns of merchandise within the state

Maintaining an office or owning or leasing any property in the state will also disqualify a business from the law’s protections.

In the digital age, states have begun to reinterpret what it means to exceed the protections of P.L. 86-272. Some state tax authorities argue that certain internet-based activities constitute an in-state business presence that goes beyond simple solicitation. For example, providing customer support through an online chat function, placing certain types of cookies on customers’ computers to gather data, or offering non-sales-related video and streaming services could be viewed as unprotected activities. This evolving interpretation means businesses must carefully evaluate their web-based interactions.

Determining Your Filing Obligations

Once a business determines it has nexus in a state, it must register with the state’s department of revenue or equivalent tax agency. This process involves completing an application to obtain a state tax account number. This number will be used for all future filings and correspondence.

A business with nexus in multiple states cannot simply pay tax on its total income to each state. Instead, it must divide its total taxable income among the states where it has an obligation to file. This process is known as apportionment. States prescribe specific formulas to calculate the portion of a company’s income that is taxable in that jurisdiction.

Historically, many states used a three-factor apportionment formula that weighed a company’s in-state property, payroll, and sales. Many states have now adopted a single-sales factor formula, where apportionment is based entirely on the percentage of a company’s total sales that are made to customers in that state.

After apportioning its income, the business must file the required annual tax return in each state where it has nexus. This is typically a corporate income tax return or a franchise tax return, which may be based on income or another measure like net worth. Failure to do so can result in significant penalties, interest charges, and potential legal action from the state.