States have acted quickly in response to the U.S. Supreme Court’s decision in South Dakota v. Wayfair, Inc. Many have already enacted sales and use tax nexus rules that will enable them to require more out-of-state retailers to collect sales tax. Such a quick response is understandable, as states do not want to miss out on the wave of sales tax revenue up for grabs during the holiday season. However, don’t be surprised if after eradicating the “physical presence” standards in their sales tax laws, states begin to focus on expanding their reach in imposing their income tax on businesses.
In Wayfair, the U.S. Supreme Court overturned its 26-year-old “physical presence” sales tax nexus standard that was affirmed in Quill Corp. v. North Dakota. When taking that into account that Quill reaffirmed a prior decision, the Court in Wayfair actually changed an over 50-year-old sales tax nexus standard. However, in spite of the existence of Quill, a growing number of states in the last two decades have taken the position that the Quill physical presence test was limited to sales and use tax even though the court never actually made it abundantly clear in the decision.
Thus, multistate businesses currently face a landscape with a number of states with laws that specifically provide for the imposition of their income tax on businesses that have no physical presence in the state. These types of nexus rules are typically referred to as “economic nexus,” the same type of nexus rule that Wayfair held as constitutional for sales and use tax purposes. The most explicit and common type of “economic nexus” standard in the income tax arena is a “factor presence” (or “bright-line”) nexus standard. States that have enacted such rules include Alabama, California, Colorado, and Tennessee. A “factor presence” nexus rule typically provides that an out-of-state business has an income tax filing obligation in a state if the business exceeds a certain threshold of revenue received from customers located in the state. The most common threshold is $500,000. From a taxpayer’s perspective, although these aggressive nexus standards may result in additional state income tax filings, such rules are at least clear in terms of when they are triggered.
Many other states have vague income tax imposition rules requiring businesses to file an income tax return when they are “doing business” or “deriving income from in-state sources.” Taxpayers have long taken the position that, in the absence of a state law that clearly reflects an “economic standard,” these states have a “physical presence” nexus standard. Before the Wayfair decision was issued, taxpayers that took this position could point to the lack of clarity in the state law and also fall back on the Quill “physical presence” to support their non-filing position.
Wayfair has changed the landscape. Taxpayers, when faced with a vague income tax provision, can no longer fall back on Quill as a backstop. Further, states will likely ramp up efforts to enact “economic nexus” rules in light of the Supreme Court’s approval of such a rule in the sales tax realm. Indeed, the Wayfair decision does not appear to limit its scope to sales and use tax. Instead, the Court concluded that the “physical presence” rule established in Quill was “flawed on its own terms,” “arbitrary,” and “formalistic,” and that the Commerce Clause “simply asks whether the tax applies to an activity with a substantial nexus with the taxing state” established by a taxpayer that purposely availing itself to a state. Of course, in the era of e-commerce, mobile technology, and readily available online services, determining what constitutes a substantial nexus and when a taxpayer purposely avails themselves to a state remain rather subjective determinations. It’s likely that these determinations will be made through increasingly aggressive state income tax nexus statutes, regulations, and audit positions. Taxpayers with large customer bases in states where they have no presence should at the very least confirm the current nexus rule in these states, and monitor developments in the next couple of years.
If you have questions regarding your businesses state income tax filing obligations, please contact Michael L. Colavito, Jr., or one of our tax advisors at 301.231.6200.