Be wary of unconventional and changing state nexus rules

Most business owners who have crossed state lines are familiar with the old tried and true methods to determine if they have nexus in a state. These rules have been gradually changing over the past seven years and there has been increased momentum toward changing them, thereby subjecting more and more businesses to income taxes in other states. Until fairly recently most states have deferred to a famous case referred to as the "Quill" case and have accepted that as the rule of thumb in order to determine if a business is subject to income tax in their state. Essentially this case held that there had to be a minimal physical presence in a state for a business to be subjected to that state's income tax. The rules for most states were relatively consistent in outlining that if you have an employee in their state or any type of property (buildings or land but also including equipment and machinery), then the business has what is referred to as nexus and must file an income tax return in that state. This is often referred to as the physical presence test. Astute businesses went to great lengths to prevent creating this nexus by keeping employees and assets out of certain states and using remote/electronic methods of servicing their customers. In the past seven years, states have grown increasingly aggressive and have found ways around the "Quill" case to pull unsuspecting businesses into a nexus-type position without them having any physical presence or nexus. These new tactics by the states not only make compliance for small to medium businesses more complex, but they also make doing business more costly, both from an income tax standpoint and the cost of the compliance from their service providers. There are two common ways in which states have changed their nexus rules that may impact businesses even if they do not have employees or assets in a state. One such way is the new sourcing rules that states are applying to services. Generally speaking in the past, most businesses would source their service revenue to the state that the service was invoiced to, also referred to as a "cost-of-performance" method. New sourcing rules that have been adopted by California and New York, (among other states) specify that service revenue should be sourced to the state where benefit of those services was received, referred to as "market-based sourcing." This may seem like a small nuance, but let's look at how this may impact a business owner in a fairly common situation. Let us say that a business is an IT service provider. Assume that the provider is located in Texas and that they are providing remote IT services for a business that is headquartered in Florida but has satellite locations in New York and California. Under the old rules, if the service provider invoiced the parent company in Florida for services provided to the New York or California locations there would not be any concern about nexus in those states. However, under the new rules enacted by California and New York those services would be sourced to their respective states because that is where the benefit of the service is received. Thereby, even though nothing changes with how our business is operating or invoicing their customers we are suddenly subject to New York and California income taxes. The second way that sates are seeking to catch unsuspecting businesses is through what is referred to as economic nexus. This is a concept founded in the belief that, while businesses may be able to generate some minimal amount of sales without a physical presence, there is a point where the sales themselves derive a presence in the state by a mere virtue of the dollar amount. For example, New York and California have implemented laws that say if the revenue sourced to their state is greater than a specified amount the business is deemed to have economic nexus and would be required to file income tax returns even though the business does not have any physical presence. To further develop the example of the IT service provider above let's say that they also sell hardware and that they have shipped servers, laptops, etc. to the satellite locations. New rules say that if sales to California are greater than $500,000 or to New York are greater than $1,000,000 in any year, there is a filing requirement for income tax returns. Contrary to previous rules where this revenue would not create a filing requirement unless there was some other physical presence in their state. The example shows how two seemingly small changes that states are making may impact unsuspecting businesses. It is evident that more and more states have become increasingly aggressive in this area and are seeking to find ways to trap unwary businesses into filing tax returns, which may not have been required to under the old rules. Business owners should be aware when they begin to do business in other states and consult their tax adviser. Furthermore, they should seek to thoroughly understand what the rules are for each state they are transacting or wish to transact business in to ensure they are not stuck with a surprise tax when their tax returns are filed. ----- James Saylor is a senior manager with Mengel, Metzger, Barr & Co. LLP. He can be reached at (585) 423-1860 or via email at jsaylor@mmb-co.com. Published: Fri, Jun 23, 2017