At a Glance
Main Takeaway
Understanding the basics of income tax nexus standards is crucial for projecting your company’s tax obligations. Income tax nexus refers to the connection between your business activities and a particular jurisdiction, determining whether you must pay taxes in that state.
Business income tax nexus standards vary from state to state, with each jurisdiction having differing criteria for determining nexus. Knowing the income tax nexus laws in the jurisdictions where you do business will help you navigate complex tax compliance issues.
Next Step
Partnering with a professional accountant can help you avoid penalties and ensure your company meets its tax obligations.
What is State Income Tax Nexus?
State income tax nexus is the connection or presence of an enterprise with a particular state that gives the state authority to impose income tax on the business.
Nexus is typically established when a business has sufficient contacts or activities within a state, such as physical presence, sales revenue, employees, or tangible property ownership, that meet the state’s threshold for taxation.
When it is determined that a business has nexus within a state, it must file a state income tax return and pay income tax on the taxable income earned within that state. The specific rules and thresholds for establishing nexus vary by state, and businesses need to understand each state’s rules to ensure compliance with tax obligations.
Failure to comply with state income tax nexus requirements can result in penalties, interest, and legal consequences. Unnecessary barriers to entry can be caused in each state where nexus remains neglected and returns are not filed. Although many types of taxes must be paid from state to state, sales/use and business income tax are the two largest liabilities created in states when nexus is established.
Sales Tax Nexus in California
Sales tax nexus refers to the connection between a company and a state that requires the business to collect and remit sales taxes on sale transactions in that state. The retailer typically collects sales tax from the consumer when the transaction occurs.
Businesses must then remit the sales tax payments to the state where they have nexus. Within each state, a Department of Revenue, or equivalent, will require monthly, quarterly, or yearly reports to be filed in a timely manner and paid when reported.
To establish a sales tax nexus in California, businesses must meet the state’s sales threshold. In 2019, California set the sales tax nexus threshold at $500,000 in sales in the previous or current calendar year. If retail sales exceed $500,000, nexus is established, and reporting becomes required.
State Income Tax Nexus in California
State income tax nexus determines whether a business must pay income taxes in a state based on its activities within that state. State income tax nexus has different requirements than sales tax nexus based on each state’s guidelines.
California follows an economic nexus approach to determining state income tax nexus. This determination applies to businesses with a high level of business activity within a state, even if they do not have a physical presence there.
According to the California Franchise Tax Board’s (FTB) most recent numbers for 2021, businesses with income from California-based sales that exceed $637,252 or have more than 25% of total sales in California establish state income tax nexus.
For out-of-state-retailers with an established state income tax nexus, this means registering with the California Department of Tax and Fee Administration (CDTFA) and paying sales and income taxes.
How to Determine Your State Income Tax Nexus
Determining state income tax nexus requires careful assessment of your business activities. Start by evaluating whether you have a physical presence in the state, such as offices, employees, or tangible property. Next, consider your economic activities, such as sales, revenue, contracts, or transaction thresholds, that may result in nexus.
Review any specific criteria established by the state’s tax laws, such as the solicitation of sales or the extent of business conducted within the state. Because each state law differs and can change year-to-year, consulting with a state and local tax (SALT) professional can ensure you understand your nexus tax liabilities.
Why a Proactive Approach to State Income Tax Nexus is Essential
A proactive approach to state income tax nexus is essential to avoid penalties, interest, and compliance issues. Thoroughly evaluating your business activities and identifying nexus obligations ensures timely tax registration and accurate reporting. Try to get shipping and sales data to distinguish where sales are made and evaluate each state’s threshold for nexus.
Some states offer Voluntary Disclosure Agreements (VDAs) that provide benefits to businesses voluntarily coming forward to address past tax liabilities. A VDA could reduce penalties and interest while moving towards compliance if you were unaware of your previous tax nexus responsibilities. Engaging a professional with VDA experience is essential to understand the compliance issue and your business’s unique situations in scaling and identifying nexus.
Taking a proactive approach to addressing state income tax nexus can save your business from potential financial and reputational consequences, allowing you to meet your tax obligations.
What is Physical Presence as Defined in Quill vs. North Dakota?
In the landmark case of Quill Corp. v. North Dakota (1992), the United States Supreme Court established the physical presence standard for determining sales tax nexus. The case involved a mail-order company, Quill Corporation, and the state of North Dakota, which wanted the Quill Corporation to collect and pay sales tax in the state.
The Court ruled that for a state to require a business to collect and remit sales taxes, the business must have a physical presence within the state. According to the Court’s decision, physical presence refers to a tangible, substantial, and meaningful connection between the business and the state, typically involving physical facilities, employees, or tangible property.
The Quill decision set a precedent that physical presence is the benchmark for determining sales tax nexus. This standard provided clarity and rules for businesses to understand their sales tax obligations.
As e-commerce grew in the new millennium, the decision was criticized heavily, as it allowed businesses to make interstate sales without a physical presence and subsequently avoid paying taxes in those states. This led to another landmark case in 2018, South Dakota vs. Wayfair, which changed how states could define economic nexus to collect sales taxes from out-of-state corporations.
South Dakota vs. Wayfair, Inc. and Changes to Economic Nexus
In 2018, the Supreme Court revisited the Quill decision in South Dakota v. Wayfair, Inc., examining whether states should be allowed to establish economic nexus standards for sales tax collection based on sales thresholds or alternative economic activity within the state.
“Economic nexus” is a concept that expands the traditional physical presence standard for determining tax nexus. It considers a business’s economic activity or sales volume within a particular jurisdiction as the basis for establishing tax obligations. Under economic nexus, a business may be required to collect and remit sales tax or pay income tax in a state, even without a physical presence.
In South Dakota v. Wayfair, Inc., the Court overruled the physical presence requirement established in the Quill case. It held that states could enforce economic nexus standards for sales tax collection in addition to the physical presence standard.
Many states introduced or updated their economic nexus laws following the Wayfair decision. These laws vary by state but typically involve a sales revenue threshold or a specific number of transactions within the state. For example, a state may require businesses with annual sales exceeding $100,000 or 200 transactions to collect and remit sales tax. It can also determine nexus based on the proportionate share of activity for your entire business.
The Wayfair case changed the landscape of sales tax compliance, enabling states to enforce economic nexus rules to capture sales from many e-commerce and remote sellers. It marked a shift towards a more technology-driven approach in determining tax obligations based on a business’s economic presence rather than solely on its physical presence.
To ensure compliance with the evolving tax laws, businesses that conduct out-of-state transactions must closely monitor their sales activities and assess their economic nexus in the states where they operate. Seeking guidance from a SALT tax professional can help your company navigate these changes and new requirements.
What is Factor Presence Nexus?
The concept of factor presence nexus resulted from the need for a uniform standard for determining business activity taxes, such as income tax or gross-receipts tax. While physical presence was established as the requirement for sales and use taxes based on Quill, followed by Wayfair, no standard existed for business activity taxes.
To address this, the Multistate Tax Commission (MTC) proposed a uniform law, allowing states to adopt clear thresholds to establish substantial nexus. Factor presence nexus considers factors like property, payroll, and sales to determine nexus.
For instance, if a business in California exceeds thresholds such as $63,726 in property, $63,726 in payroll, $637,252 in sales, or 25% of total property, payroll, or sales during the tax period, it establishes substantial nexus. These thresholds are adjusted annually by the FTB to account for inflation.
Despite these thresholds, ambiguity remains in establishing factor presence nexus. For example, while the MTC thresholds were adopted and indexed for inflation in California, the state advises companies that even if the thresholds are not met, businesses still need to determine if they are actively engaging in any transaction for financial or pecuniary gain or profit, suggesting that the thresholds are an alternative test for establishing nexus.
Alternative Ways Your Business May Meet Nexus Criteria
Nexus can be established in ways other than physical presence or economic thresholds. For example, using a third-party logistics (3PL) provider to store inventory in a state can create nexus, also known as “drop shipping.”
Additionally, some states have adopted affiliate nexus laws where a business is deemed to have nexus if it has affiliates or related entities with a physical presence in the state (Texas, for example). If your company has affiliates or uses 3PL, you must understand whether you have an income tax nexus in that state to ensure your tax obligations are met.
Ensure SALT Compliance for Your Business
Understanding and navigating income tax nexus standards is crucial for companies doing business in California to meet their tax obligations and avoid potential penalties.
Windes recognizes the importance of addressing these challenges as business tax regulations evolve. Whether it is determining nexus thresholds, evaluating economic factors, or maximizing deductions such as the SALT deduction, our team is equipped to guide and support your business.
Our professionals are ready to provide tailored solutions to manage income tax nexus compliance and implement potential SALT strategies to ensure the success of your business. Contact us to speak with our SALT Team and get started on your tax planning strategy today.