State income tax is undoubtedly complicated and ever-changing. In this shifting landscape of rules, it is important to understand how income tax return filing requirements are established. State income tax can often comprise a large portion of a taxpayer’s tax burden. It can also be a point of risk if proper analysis of the company’s physical and economic activities and footprint are not carefully considered. With increased reliance on remote employees, e-commerce, and the influx of states incorporating economic nexus standards for income tax, now is a good time to ask, “Are you filing everywhere you should be?”
A taxpayer need only file and pay income tax in a state if it establishes a “connection” to the state—nexus. While on the surface this seems straightforward, how this connection is defined continues to evolve. Historically, nexus was only established if a taxpayer had physical presence in a state, generally by way of company property or employees located in the state. Enacted in 1959, Public Law (PL) 86-272 provides protection to sellers of tangible personal property from nexus in a state as long as their physical activity within that state is restricted to the mere solicitation of orders. Specifically, orders that are “sent outside the State for approval or rejection and, if approved, are filled by shipment or delivery from a point outside the State which would be shipped from out-of-state.” The protected activities of PL 86-272 were further defined by the U.S. Supreme Court in the 1992 decision of Wis. Dep’t of Revenue v. William Wrigley, Jr., Co. - 505 U.S. 214, 112 S. Ct. 2447. Examples of protected activities include carrying samples and promotional materials only for display, furnishing and setting up display racks, and checking of customers' inventories. Unprotected activities include making repairs or providing maintenance or service to the property sold, collecting current or delinquent accounts, whether directly or by third parties, through assignment or otherwise, investigating credit worthiness, installation of property at the customer site, and picking up or replacing damaged or returned property.
Excluding the protection from PL 86-272, nexus is established with a presence in the state. Activities such as owning property, having employees providing a service with “boots on the ground” in the state, providing a warranty for sales in the state, and the act of approving a sale within a state all rise to the level of a physical presence. Economic presence and intangible presence can also be considerations. Economic presence is especially aggressive, and activities such as banking within a state could be considered a connection for this purpose. Two notable court cases have ruled that the presence of intangible property within a state is enough to establish “intangible nexus” as well. While Geoffrey, Inc. v. SC Tax Com'n, 437 S.E.2d 13 (S.C. 1993) found that royalties from licensing trademarks established nexus, Kmart Properties Inc., Dkt.No. 21,140, N.M. Ct. App. (November 28, 2001) went so far to equate intangibles within a state with a physical presence.
Many states have established a factor presence standard, which essentially requires taxpayers to file an income tax if they are above a certain dollar “threshold of property, payroll, or sales in the state.” Often referred to as “bright-line tests,” currently a common threshold for property, payroll, and sales within the state is $500,000. All of that being said these bright line tests do not cause income tax nexus if a taxpayer’s only activities in a state are “protected” under PL 86-272. Therefore, even if for example a taxpayer has $1,000,000 of sales to customers in a state with economic nexus standards in place but the taxpayer’s activities are protected under PL 86-272, an income tax return filing requirement would not be established.
As noted earlier, this emphasizes the importance of establishing what can be considered a “protected” activity under PL 86-272 versus an “unprotected” activity that triggers nexus and an income tax filing requirement. Most recently, this consideration has revolved around remote employees and e-commerce. The pandemic has caused many employees to work from home, and some of these employees may live in a state different from their employer. Does the employer now have to file in the home state of their remote employee? Telebright Corp. v. Director, New Jersey Division of Taxation, 424 N.J. Super. 384 (N.J. Super. Ct. App. Div. 2012) ruled yes. If the employee is performing an “unprotected” activity, then his activity establishes a presence in the state.
The Multistate Tax Commission (MTC) most recently issued guidance on how internet activities could be handled by states. While it is up to the individual states to accept this guidance, if enacted it could force some sellers of tangible personal property to file in new states. A few of the most common activities that would trigger a filing requirement listed in this guidance are: 1) “regularly provid[ing] post-sale assistance to in-state customers via either electronic chat or email,” 2) using “cookies [to] gather customer search information that will be used to adjust production schedules and inventory amounts, develop new products, or identify new items to offer for sale,” 3) “sell[ing] extended warranty plans via its website,” and 4) selling its products via a marketplace facilitator that “maintains inventory, including some of the business’s products, at fulfillment centers in various states.”
To complicate matters further, some states require income tax or franchise tax filings if a sales tax registration is made. Given the evolving nature and complexity of these rules, it may be prudent to re-evaluate where your business is filing. Penalties could be assessed if a state identifies in-state business activity without a corresponding income tax return filing in that state.
To help avoid such penalties and assist with meeting compliance requirements, tax advisors at FORVIS can perform “nexus studies” to help identify which states have these filing requirements under the current law. Reach out to your professional at FORVIS for more information or fill out our Contact Us form below.