What Is Income Tax Nexus for a Business?

Understanding state income tax nexus is important for businesses that operate across state lines. A business may incur income tax obligations in states beyond its primary location, even if it does not have a traditional physical office or facility there. Navigating these varied state tax requirements helps businesses manage their tax responsibilities effectively.

Defining Income Tax Nexus

Income tax nexus refers to the sufficient connection a business must have with a state for that state to gain the authority to impose income tax on the business. This concept is rooted in the U.S. Constitution, specifically the Due Process and Commerce Clauses, which limit a state’s power to tax activities that occur outside its borders.

The establishment of nexus determines where a business is subject to income tax filing and payment requirements. Once nexus is established, the state has the legal right to require the business to file tax returns and potentially pay income tax on a portion of its earnings. This does not dictate the amount of tax owed, but rather the legitimacy of the state’s claim to tax the business.

Historically, nexus was primarily based on a physical presence within a state, such as owning property or having employees. However, the evolution of commerce, particularly with the rise of e-commerce and remote work, has broadened the interpretation of what constitutes nexus. States have increasingly adopted more expansive definitions, moving beyond strict physical presence to include economic activities. This shift aims to capture tax revenue from businesses conducting substantial activities within their borders, even without a traditional physical footprint.

Establishing Nexus: Key Factors

Various activities and connections can establish income tax nexus for a business, extending its tax obligations beyond its primary state of operation. These factors have evolved over time, reflecting changes in business practices and state tax policies.

Physical presence remains a common trigger for income tax nexus. This includes owning or leasing property within a state, such as an office, warehouse, or retail store. The consistent presence of employees in a state, whether they are sales personnel, remote workers, or service providers, can also create nexus. Even maintaining inventory in a third-party warehouse, like those used by online marketplaces, can establish a physical presence nexus.

Economic nexus has gained prominence, particularly after the U.S. Supreme Court’s decision in South Dakota v. Wayfair, Inc., which primarily addressed sales tax but influenced income tax nexus interpretations. Under economic nexus standards, a business can establish nexus based on a certain volume of sales or economic activity within a state, even without a physical presence. While specific thresholds vary by state, common examples include exceeding a certain dollar amount of sales, such as $100,000, or a minimum number of transactions within a calendar year.

Another increasingly adopted standard is factor presence nexus. This approach establishes nexus if a business exceeds specific thresholds related to its property, payroll, or sales within a state. For instance, some states adopt thresholds such as $50,000 in property, $50,000 in payroll, or $500,000 in sales, or if any of these factors constitute 25% of the business’s total property, payroll, or sales.

Federal Limitations on State Income Tax Nexus

Federal law places specific limitations on a state’s ability to impose income tax on certain businesses engaged in interstate commerce. Public Law 86-272, enacted in 1959, provides a “safe harbor” for businesses that limit their in-state activities to the solicitation of orders for tangible personal property. This law prevents a state from imposing a net income tax if the only business activities within that state involve soliciting orders for tangible personal property, provided these orders are sent outside the state for approval and are filled by shipment from an out-of-state location.

The protection offered by P.L. 86-272 is narrowly defined and applies only to income taxes on tangible personal property. It does not extend to other state taxes, such as sales and use taxes, gross receipts taxes, or franchise taxes not measured by net income. Furthermore, the law does not protect businesses that sell services, intangible property, or real property.

Certain activities are considered protected under P.L. 86-272 because they are viewed as ancillary to the solicitation of orders. These can include maintaining a sales office for employees whose sole activity is soliciting orders, or distributing free samples. Independent contractors may also engage in soliciting or making sales, and maintaining an office, without necessarily triggering nexus for the out-of-state company, provided they meet specific criteria as true independent contractors.

Many activities are not protected by P.L. 86-272 and can create income tax nexus. These include making repairs or providing maintenance services for sold property, collecting current or delinquent accounts, investigating creditworthiness, or installing goods after shipment. Conducting training courses for non-sales personnel, accepting orders within the state, or delivering products using company-owned vehicles also fall outside the protected activities. Even certain internet-based activities, such as providing post-sale assistance via electronic chat or accepting job applications for non-sales positions through a website, can cause a business to lose P.L. 86-272 protection.

Calculating State Income Tax with Nexus

Once a business establishes nexus in multiple states, the next step involves determining how much of its total income is taxable in each state. This process relies on the concepts of apportionment and allocation, which are methods used to fairly distribute a company’s income among the jurisdictions where it operates. Apportionment applies to a business’s “business income,” which is income derived from its regular trade or business operations.

Apportionment typically uses a formula to divide a company’s business income among the states where it has nexus. This formula is often expressed as a fraction, where the numerator represents the business’s activities in a specific state, and the denominator represents its activities everywhere. The resulting percentage is then applied to the company’s total apportionable income to determine the amount taxable in that state.

Historically, the most common apportionment method was the traditional three-factor formula, based on the Uniform Division of Income for Tax Purposes Act (UDITPA). This formula equally weights three factors: property, payroll, and sales. Some states modify this by giving greater weight to the sales factor, such as double-weighting sales, to encourage businesses to locate property and payroll within their borders while taxing more of the income generated from sales to in-state customers.

The trend among states has increasingly shifted towards using a single sales factor formula. Under this method, income is apportioned solely based on a company’s sales within the state. This approach simplifies calculations and often benefits businesses with significant property and payroll in a state but a larger sales base elsewhere. States vary in how they source sales, with some using a “cost of performance” rule (where income-producing activities occur) and others using a “market-based” sourcing rule (where customers are located).

Allocation is distinct from apportionment and applies to “non-business income,” which includes specific types of income such as certain rents, royalties, or interest. This income is typically assigned entirely to a specific state based on its source, rather than being divided among multiple states.