What Creates Tax Exposure for You or Your Business?

Tax exposure is the total potential tax liability a person or business could owe to government authorities. It includes identifying all possible obligations, such as income, sales, and payroll taxes, especially in places where you are not currently filing returns. Understanding your exposure requires reviewing your complete financial picture, including where you earn money, sell products, employ staff, and own assets. Failing to address these potential liabilities can lead to audits, back taxes, penalties, and interest charges that impact your financial stability.

Core Concepts That Create Tax Exposure

A government’s authority to tax you or your business hinges on establishing a connection, or “nexus,” to its jurisdiction. The most traditional form is physical presence nexus. If your business has a tangible footprint, such as an office, warehouse, inventory, or an employee working within a state’s borders, it has established a physical presence and must comply with that state’s tax laws.

A more recent standard is economic nexus, which is based on the volume of your economic activity in a jurisdiction. This concept was solidified by the 2018 Supreme Court case South Dakota v. Wayfair, which allowed states to require out-of-state sellers to collect and remit sales tax if they meet certain economic thresholds.

The Wayfair case involved a threshold of $100,000 in sales or 200 separate transactions, and many states have adopted similar standards. This is an evolving area of law, and a growing number of states have eliminated their transaction thresholds, relying solely on a sales revenue figure to establish economic nexus. Because rules differ by state, you must verify the requirements for each jurisdiction where you do business.

For individuals, the primary concept creating tax exposure is residency, which determines which state has the primary right to tax your worldwide income. It is often determined by your domicile—the place you consider your permanent home. However, you can be considered a tax resident of a state even if your domicile is elsewhere.

This occurs if you spend a significant amount of time in a state, more than 183 days, and maintain a permanent place of abode there. Because the rules for residency can differ, it is possible for an individual to be treated as a tax resident of more than one state simultaneously. This can lead to complex filing requirements and the potential for double taxation if not managed correctly with tax credits.

Common Areas of Tax Exposure for Businesses

One of the most widespread areas of tax exposure for businesses is sales and use tax. Once a business establishes nexus with a state, it is required to register for a sales tax permit and begin collecting sales tax from customers in that jurisdiction. The collected funds must then be remitted to the state, and failure to do so can result in the business being held liable for the uncollected tax, plus penalties and interest.

Business activities can also create an income tax filing obligation in multiple states. States use a method called apportionment and allocation to determine how much of a company’s total income is subject to their tax. Apportionment formulas consider the proportion of a company’s property, payroll, and sales within a state’s borders to assign a taxable share of the net income.

The rise of remote work has expanded payroll tax exposure for many businesses. When a company hires an employee who works from home in a different state, it establishes nexus in that employee’s state of residence. This triggers obligations for the employer to comply with the new state’s payroll tax laws, including withholding state income tax and paying state unemployment insurance taxes.

Key Tax Exposure Scenarios for Individuals

For individuals, tax exposure can arise from multi-state employment situations. If you live in one state but work for a company in another, you will likely have to file tax returns in both states, which is particularly relevant for remote workers. Some states have “convenience of the employer” rules, which state that if you work from home for your own convenience, your income may still be taxed by the state where your employer’s office is located.

Investment activities can also create tax filing requirements in other states. A common example is owning rental property in a state where you do not reside. The rental income generated from that property is sourced to that state, creating an obligation to file a non-resident state income tax return and pay tax on the net rental earnings there.

Individuals with significant assets should be aware of state-level estate and inheritance taxes. The federal government has a high estate tax exemption, but a number of states impose their own estate tax with much lower exemption amounts. If you own property, such as a vacation home, in one of these states, its value could be subject to that state’s estate tax upon your death.

Quantifying and Documenting Tax Exposure

Once a potential tax exposure is identified, you must measure the liability. This process involves a historical review of your financial activities to determine the tax that should have been paid. For sales tax, this means applying the correct tax rates to sales data for each state, while for income tax, it requires calculating the income apportioned to a specific state for each year.

Proper record-keeping is needed to support these calculations and to defend your figures during an audit or resolution program. The documents required depend on the type of tax exposure. Important records include:

• For sales tax, keep detailed sales reports, invoices, and any sales tax exemption certificates.
• For income tax, maintain financial statements, records of property and payroll per state, and detailed sales ledgers.
• For individual multi-state work, use a travel log or calendar to document days worked in each state.
• For payroll tax, have precise records of employee locations, wages paid, and taxes withheld.

Resolving Previously Unidentified Tax Exposure

When a taxpayer discovers a past-due tax liability, the most common way to resolve it is through a Voluntary Disclosure Program (VDP). These programs are offered by most state tax agencies to encourage taxpayers to come forward and pay their back taxes. The primary benefit of a VDP is that the state will agree to waive penalties and may limit the number of past years you need to file for, known as the “look-back period.”

The process begins by submitting an application, which can often be done anonymously at first to allow for negotiation. The taxpayer presents their calculation of the tax owed for the look-back period, which is often three to four years, along with supporting documentation. Once the state agency accepts the calculation, both parties sign a formal Voluntary Disclosure Agreement (VDA) that finalizes the total tax and interest due. After the VDA is executed, the taxpayer files the required back-year returns and remits full payment to become compliant.