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State Tax Issues and Nexus

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Last updated: 23 Nov, 2018
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By Jason Watson ()
Posted July 11, 2017

This article is legacy and has been replaced with several mini articles on state sales tax, nexus and the Wayfair case. Please visit this following link to be re-directed.



This in itself is not a reason to avoid the S corporation election, but there is not a better place for this material. State nexus stuff is getting very complicated so we decided to make this a separate chapter since it will continue to grow over time.

Every year all 50 states plus the District of Columbia and New York City participate in a survey conducted by Bloomberg. Here is the link for the latest results, but a warning is in order first. The 2015 report is 429 pages (yet the table of contents is rich with detail to find your particular area of interest).


There are several concepts here and a ton of material. Here is the mini table of contents-

  • Nexus Theory

  • Constitutional and Legislative Standards, Commerce and Due Process Clause, Public Law 86-272

  • Sales Tax, Income Tax

  • Physical and Economic Presence, Nexus Attached

  • Services and Tangible Personal Property (TPP)

  • Costs of Performance, Market-Based Approach

  • Allocation and Throwback

  • FBA, Drop Shipments, Trailing Nexus Revisited

We will explore each of these in turn, and then attempt to bring it all together with a recap. The operative word is attempt since this stuff is changing all the time and will continue to evolve through court decisions, state legislation and the impending congressional moves.

And this section is not designed to address all your nexus concerns or be a solution. We are merely shining a light on all the angles to this massive problem. Our darn forefathers couldn’t imagine internets (yes plural), and other things like trains, planes and automobiles.

Nexus Theory
Nexus is a Latin word meaning to bind, join or tie. Simply stated, tax nexus is the minimum amount of contact between a taxpayer and a state, which allows the state to tax a business on its activities. Every state defines nexus differently using terms such as physical presence or economic presence, and those concepts will be discussed in a bit.

There is also a concept called trailing nexus where an entity that once had nexus in a state ceases activities that created nexus in the first place. This is a point of contention between taxpayers and states, and is commonly created by Fulfillment By Amazon (FBA) and other online retailers.

The theory behind the trailing nexus concept can be better illustrated with an example. If your company sent a sales rep to Washington for several months to solicit orders, it is safe to say that after the sales rep leaves a residual effect would remain. This in turn would generate sales (business activity). As an aside, Washington is one of the few states that defines trailing nexus explicitly. Pot + Coffee = Progressive Law.

Constitutional and Legislative Standards
Time to go back to school. The Due Process Clause of the United States Constitution requires the seller to have some “minimum contacts” with the taxing state. The seller must reach out and purposefully avail itself of the benefits of that state. Courts have held that a physical presence is required to meet the Due Process Clause, but that is eroding and being redefined every day.

Once this is satisfied, which is no easy task for a state, a four-part test of the Commerce Clause must be met.

Article 1, Section 8, Clause 3, of the Constitution empowers Congress to prohibit a state from unduly burdening interstate commerce and business activities. The law authors were very concerned with states colluding or combining forces near major trade hubs and routes, and thus created the Commerce Clause. A vision of gangs holding up covered wagons in California.

The United States Supreme Court in Complete Auto Transit v. Brady (1977) stated that a seller must meet the following four-part test to be forced to collect a tax:

  • The seller must have substantial nexus (physical presence) in state;

  • The tax cannot discriminate against interstate commerce;

  • The tax must be fairly apportioned; and

  • The tax must be fairly related to services provided by state.

The common theme after physical presence is fairness. The only time a tax is fair is when you pay the minimum amount.

Moving onto legislative standards. Public Law 86-272 was quoted earlier in this chapter and basically prevents state from imposing income tax on businesses whose only activity in the state is the solicitation of orders provided the orders are accepted and delivered from a point outside the state (interstate commerce). And this only refers to tangible personal property (TPP) and not services. At the time of this law, services were inherently personal and required a close, physical presence to perform (proximity). That has changed with telecommuting and the pure definition of a service (more on that in a bit).

So we have three standards yet states vary across the board based on the definition and triggering of nexus.

Sales and Use Tax, Income Tax
There are two issues at play, and they are not necessarily connected. First is sales and use tax which frankly receives the most attention because of online retailers. Some theory. When you purchase a computer at your local Best Buy, the seller is collecting sales tax in a fiduciary role. In other words, it is collecting your sales tax obligation for you on your behalf, and remitting it to the authorities. Nice of them, right?

If you buy this same computer from an Amazon retailer, the seller might or might not collect sales tax on your behalf. If the retailer does not collect sales tax, it is still your responsibility to pay this sales tax along with your state income tax return. No one does this of course. The Watson CPA Group has asked 25,000 times in the past decade, and we have never heard a Yes from a client. But understand that you are required to pay sales tax if not collected by the online seller.

States are getting sick of the under-reported sales tax obligations. Therefore several are going after businesses with strong internet presence. Here is a summary about New York’s “Amazon Law” from Cbiz-

In practice, such an online selling scheme may work as follows. A retailer selling neckties has a shop in Florida, and it wants to increase sales by selling over the internet. The retailer sets up a website, and decides that to generate traffic on its website, it will partner with other online websites. In this example, the retailer places an ad on the website of the New York Times. When a customer reaches the retailer’s website by clicking on the link at newyorktimes.com, the “click-thru” is logged. If the retailer makes a subsequent sale as a result of the click-thru, the New York Times is paid a commission. As a result of the Amazon law, New York assumes that the relationship has created nexus for the online retailer.

The other issue is income tax. Just because a retailer has an obligation to collect sales tax does not necessarily mean they have an instant income tax obligation. Some states have a fruit of the poisonous tree mentality where sales tax nexus creates an income tax nexus and vice versa. And don’t forget that states cannot impose an income tax per se, but they can impose a business tax or a franchise tax or a whatever tax that smells, walks and talks like an income tax but isn’t call an income tax.

Remember too that Public Law 86-272 protects TPP only from a strict income tax. However states are the using the same “non-income tax” tax as a work around for everything from tangible personal property to services.

Physical and Economic Presence, Nexus Attached
In a 1992 U.S. Supreme Court case docketed as Quill Corporation v. North Dakota, the court established a physical presence test for sales tax nexus. The court did not address income tax, and since this decision states have varied quite a bit on attaching nexus to taxes other than sales and use tax.

Several appellate courts have limited the Quill case to sales and use tax nexus, and have deferred income tax nexus to economic presence rather than physical presence. According to Bloomberg’s survey at the beginning of this topic, only 7 states applied the physical presence test in determine an income tax nexus leaving 43 states to apply an economic presence test for income tax nexus. It is safe to say that the 7 will decrease over time.

Let’s consider California’s economic presence rules. A company is considered doing business in California if it meets any of the following conditions-

  • They have property in California, with a value of $50,000 or 25% of total property, whichever is less.

  • They have payroll in California, in the amount of $50,000 or 25% of total payroll, whichever is less.

  • They have sales in California, in the amount of $500,000 25% of total sales, whichever is less.

California’s numbers above are a bit out dated since they are annually adjusted for inflation. In 2015, the sales trigger is roughly $525,000.

These hard numbers is called bright-line nexus. You simply meet a numeric threshold, and you magically have nexus in that state. Several states have a preponderance of the evidence set of rules using phrases such as “businesses earning significant income.” Really!? Sounds like fun trying to defend that.

And to make matters worse, your business might be protected by Public Law 86-272 if you are simply soliciting orders for tangible personal property in California. But if you are selling services in California, even with independent contractors, there is no protection and the income will be taxed if you meet one of the three criteria above.

More bad news. Your company might not have income associated with California but be deemed as doing business in California. Seriously! And, in this case you would be subjected to the $800 minimum franchise tax regardless. Yuck.

Here is the direct language from California’s Franchise Tax Board website-

An out-of-state taxpayer that has less than the threshold amounts of property, payroll, and sales in California may still be considered doing business in California if the taxpayer actively engages in any transaction for the purpose of financial or pecuniary gain or profit in California.

Partnership A, an out-of-state partnership, has employees who work out of their homes in California. The employees sell and provide warranty work to California customers. Partnership A's property, payroll, and sales in California fall below the threshold amounts. Is Partnership A considered to be doing business in California?

Yes. Partnership A is considered doing business in California even if the property, payroll, and sales in California fall below the threshold amounts. Partnership A is considered doing business in California through its employees because those employees are actively engaging in transactions for profit on behalf of Partnership A.

Corporation B, an out-of-state corporation, has $100,000 in total property, $200,000 in total payroll, $1,000,000 in total sales, of which $400,000 was sales to California customers. Corporation B has no property or payroll in California. Is Corporation B doing business in California?

Yes. Although Corporation B's California sales is less than the $500,000 threshold, Corporation B's California sales is 40 percent of its total sales which exceeds 25 percent of the corporation's total sales ($400,000 ÷ 1,000,000 = 40%.).

California is a fun state to research since they are usually on the forefront of legislative changes and updates, and there is so much economic activity. The following link is California’s FTB1050 where they outline in plain language a list of protected activities and unprotected activities as they relate to Public Law 86-272 (tangible personal property).


There are 51 other examples aside from California (including Washington DC and New York City). Please do the homework!

Some more fodder for your consideration. In two U.S. Supreme Court cases, Scripto v. Carson (1960) and Tyler Pipe v. Washington Department of Revenue (1987), the court affirmed that a third party can create nexus. The court specifically stated what matters

“is whether the activities performed in the state on behalf of the taxpayer are significantly associated with the taxpayer’s ability to establish and maintain a market in this state for the sales.”

This third party connection is detrimental to Amazon and eBay retailers (and the like) and discussed in more detail later.

Services and Tangible Personal Property (TPP)
Public Law 86-272 protects TPP as we previously mentioned. But services are fair game for states to tax. Generally speaking states do not impose a sales tax on services but they can impose a franchise, business or privilege tax.

To make things more interesting, the definition of a service is expanding in light of ecommerce and cloud computing. For example, most states characterize cloud computing as a sale of intangibles or services, but Utah considers cloud computing as the sale, lease or license of TPP. Subtle difference, yet important.

Let’s say what you do is a service. What is the standard for determining nexus for your business? Read on please.

Costs of Performance, Market-Based Approach
Prior to Al Gore inventing all the internets, most states used the costs of performance as the method to determine nexus. If your butt was in Colorado and you provided a service to people in California, the costs of performing the service would be in Colorado and therefore you would not have nexus to California. You would only be subjected to Colorado income taxes.

Given the latest Bloomberg survey, there is a growing minority of states that are using the market-based approach. This can be loosely defined as the assignment of revenue based on the location of either

  • the service provider’s customers, or

  • where the customers received benefit from the service provided.

Consider a web server. 38 states plus the District of Columbia and New York City would consider a web server physically located in their taxing jurisdiction as enough of a presence to find income tax nexus. And most would find sales tax nexus as well. Wow. 38 is a high number.

Allocation and Throwback
Allocation of the sales and subsequent income is at the top of this heap of nexus mess. States don’t want to unnecessarily complicate things, but they do want money.

Throwback is a common concept but not every state uses it. Again, we’ll pick on California. Under the old rules, when a California company ships TPP to another state, and that company does not have nexus in that state, the sales are “thrown back” to California since it is considered a California sale.

Interestingly enough, there are cases where a sale would not have a tax home at all. Let’s say you sold a service to a customer outside of California. Using the market-based approach and under California’s new rules of bright line nexus (turn back a few pages to review), sales exceeding $500,000 in another state are not thrown back to California. So, if you had sales in another state that did not trigger a filing in that state, these sales could arguably be allocated outside of California but disappear into a black hole. Sounds crazy, but true.

Allocation issues such as these can create tax arbitrage. And there are other examples of the same dollar being taxed twice by different states. It truly is a mess. States recognize this growing problem and are working together to eliminate the loopholes. In about three perhaps four hundred years we’ll be good to go.

FBA, Drop Shipments, Trailing Nexus Revisited
Fulfillment By Amazon (FBA) and other fulfillment services add a new dimension to the nexus conversation. States are scrambling to figure it out so tax revenue can keep up with population growth and resource use.

Avalara is a consultation company who specializes in sales tax issues, and they wrote a wonderful article on FBA and what it means to you. We will attempt to paraphrase some of the concepts here, but if you want the full details use the following link-


The first concept is nexus, which we’ve beaten to death. But here is a different spin for those selling products online. There are four common nexus creating activities-

  • Your Location

  • Inventory

  • Warehouse Use, and

  • Fulfillment Services

The common theme to these four activities is Where is your stuff? More importantly, is your stuff in a state that ships within the state, and if so, does that state have a sales tax obligation? In other words, if a competitor located in the same state that you are selling your tangible personal property (TPP) through an online channel is collecting sales tax, then you probably have a similar obligation. Location. Location. Location.

There is guilt by association as well. If the distributor, warehouse, fulfillment center, storage facility, or whatever else you want to call it has nexus within the state you are selling to, then you also have nexus by the fact they are storing and handling your stuff. The essence of the facility argument for a state is that the facility is helping you create a marketplace for your goods.

There are some fine lines with who holds title and when does title transfer. For most online retailers and sellers, title arguments probably won’t do much good unless there is a lot at stake and you have a war chest to spend on attorney fees.

The next concern is materiality. If you’ve determined that you have nexus and are required to collect sales tax, is the obligation material? If you sold $200 worth of stuff to a Colorado Springs consumer, is the $16 in tax worth the headaches? Remember, if you do not collect sales tax from a consumer, he or she is still obligated to pay sales tax on his or her individual state income tax return. Unless, of course, your nexus and materiality tips the scale, and you have the responsibility to collect sales tax on behalf of the consumer.

States can spend some time on going after the head of snake, such a medium-sized online retailers or states can spend a lot of time going after the consumer. Drug user versus drug dealer.

There are voluntary disclosure initiatives to allow online sellers to come clean with their dirty sales tax deeds. Several states will waive the penalties and limit the lookback to only three years. You must weigh the chance of the hammer versus the certainty of a light tap.

The issue of trailing nexus must be considered as well. For those familiar with Amazon and FBA services, you understand that your inventory is continuously being shifted to different states. Just because your inventory no longer exists in a state does not mean your nexus is instantly cutoff. This concept was broached in the beginning of this section, and is reiterated here to stress the importance of keeping up with the Kardashians and the location of your stuff, and who you owe an obligation to. Good luck.

Recap of State Tax Issues
We attempted to provide several angles and concepts to the state taxation issue. There are very few hard and fast solutions. There are tax attorneys and consulting firms who do nothing but argue and litigate state nexus issues.

If there is nexus, is there allocation? If there is allocation, who gets what? If there is a sales tax obligation is there an income tax (or franchise tax or business tax) obligation? Can you have one and not the other? Are your services considered tangible personal property by some states?

Be careful. States are taking on the giants like Best Buy, WalMart, Amazon, etc. And they now appear to be shifting their focus to those companies who do not have deep pockets to fight or pay fines. If what you are doing smells wrong or keeps you up at night, it probably is worth looking into.

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