Concept of State Nexus

Let's explain the concept of "nexus," which is crucial for understanding state taxation, using specific examples. Remember that for a company to be required to file taxes in a state, it must have a nexus or business relationship with that state. In this discussion, we'll focus on income tax nexus. Later on, we'll also address sales tax nexus.

Continuing our discussion of state taxation matters, let’s use an illustration to demonstrate the concept of nexus. Remember, the company has to have nexus or some connection with the state ‘before it is required to file tax return with the state. In this discussion we will focus our discussion on income tax nexus. Sales tax nexus will be taken up later.

Consider the following example:

A Japanese company, (“J Corp”) that manufactures wireless phone charger in Japan wants to sell their products in US. They have decided to base their company in California (“CA”) and formed a Corporation(“CA Corp”). Immediately they decided to rent an office space and lease warehouse space in CA. Additionally, they decided to send one executive from Japan to its US company as a general manager. Also, they hired five local employees as administrators, accountants, and sales persons. At this point, we can infer that just by the act of inCorporating in CA signifies that company intends to conduct business in CA. Further activities such as renting office space, leasing warehouse and hiring employees to work in their office point that company is conducting business. As such, renting or leasing activities alone within the state means that company has a physical location in the state and create nexus. Other factors such as hiring employees or storing inventory in warehouse would also create nexus. A multitude of factors need not be present but any single factor can create nexus. This means that the company must file tax return annually to California to report taxable income and satisfy its tax liability. It is equally important to report a loss so that the company will be able to offset the loss against future income.

During the first three years, CA Corp focused on building business in CA, but soon thereafter other customers in other states such as New York (‘NY”) contacted them via online or telephone and began to order their products. The orders were shipped thru third party transport companies such as FedEx.

Question: Under this situation, does the CA Corp have nexus with other states ? Answer: No, because the company does not have any physical items or location in the other state. The answer would be different if the CA Corp sent products to NY vender to sell their products on their behalf as consignment sales or leased warehouse space to store inventory. In these cases, the CA Corp is deemed to have nexus with NY since they had inventory or leased space in NY. Now CA Corp must file CA & NY tax returns. Soon after CA Corp realizes that demand for their products in the east coast is significant, they decided to send sales person to solicitate sales to potential customers.

Question: How would this activity affect CA Corp nexus status.

Answer: It will depend on the sale person’s activity. In 1959 due to the proposal and recommendation of many business groups, congress promulgated public law 86-272 (“pl 86-272”) to exclude salesperson’s limited activity from nexus. (Federal government did not want state’s nexus regulation to hamper or impair US commerce,) According to the law, if the salesperson’s activity is limited, such activity would not constitute nexus as follows:

“Public law 86-272 prohibits a state from imposing “net income tax” if the Corporation’s only in-state activity is:

  1. Solicitation of orders by company representatives
  2. For sale of tangible personal property
  3. Which orders are sent outside the state for approval or rejection
  4. If approved, are filed by shipment or delivery from the point outside of the state.

There are several items of caution when applying this law. They are as follows:

  1. PL 86-272 applies only to tax measured by income. Therefore, this does not apply to some states that do not utilize the net income method such as Ohio’s CAT tax, Washington state business and Occupation tax or franchise tax of CA (CA utilizes both the franchise tax and income tax method). Also, this law does not affect state’s sales tax transactions.
  2. PL 86-272 only protects sales of tangible personal property. Therefore, this law protects CA Corp since they sell tangible personal property but if they provided services instead of personal property to their customers, solicitation of sales may create nexus.
  3. The law must be followed to the letter relating to approval or rejection of orders outside of state and orders are filled by shipment or delivery from point outside of the state.
So, we have learned from the preceding example, even if CA Corp sends its salesman to solicit sales and function within the limitations of PL 86-272. That will not create nexus and the company does not need to file a tax return. Companies who send salesman to other states must be aware and careful of PL 86-272. It is good practice to lay rules in their company’s practice policy to be in compliance of PL 86-272 if they don not want to create needless nexus.
On the other hand, in order to expand its sales and marketing, the company may no longer be in compliance of PL 86-272 and intentionally engage in activities such as opening a satellite office, hiring employees for repair or collection activities of AR accounts, etc. Then in such a situation, the Corporation will deem to have nexus and is required to file tax return in the state.
Affiliate and Agency Nexus

Besides traditional physical presence, companies can create nexus through use of affiliates or agency as a proxy to engage in marketing and sales activities on behalf of the company for a fee.

Economic Nexus
Recently the traditional concept of physical presence to create nexus has been upended by concept of economic nexus. This concept comes from the idea that if a company is obtaining significant economic benefit in the state as reflected by significant gross sales amount, then the state has the right to tax them regardless of physical presence requirement. There are several sates that inCorporate this concept such as Alabama, California, Colorado, Connecticut, Michigan, New York, Tennessee and Virginia.
Let’s take a look at California’s case, under the background of economic nexus, CA set the following 2022 factor presence threshold to test the company’s nexus status:
Sales: 690K
Payroll: 69K
Property: 69K
Companies exceeding any one of the thresholds will be deemed as having nexus in CA. For example, let’s say the New York company had $700K sale in CA during the year and the company did not have any property or payroll. In this case, the company will deem to have nexus in the state.
Question: Does the company have to file tax return in CA? Answer: No for income taxes but yes for franchise tax. It must be confusing to have both answers. Let me explain. It is “no” for income taxes because PL 86-272 applies, although we are not talking about salesperson’s activity, the sole act of selling still falls under the purview of PL 86-272 and protects the company’s income tax from nexus. But as you remember PL 86-272 only applies to income tax and does not apply to non-income tax matters such as CA’s franchise tax.
Therefore, since CA Corp tax system consist of franchise tax and income tax, income tax will be ignored but cannot escape franchise tax. So, the company must file CA tax return and pay the franchise tax of $800.
Nexus study
Be wary of nexus issues, beside the basic points I have picked up as introductory discussion, there are still many factors that affect nexus as follows:
  1. What is the business of the company, do they sell tangible property, provide services or
  2. collects fee from licensing or selling intangible property?
  3. Is the company a part of affiliate group that does business in the state?
  4. The form and frequency of advertisement in the state.
  5. Is the company a partner in a partnership that does business in the state?
  6. Any real estate investments in the state?
  7. Who performs warranty work?
  8. Does company provide training sessions at client’s location?
  9. Who installs the equipment that was sold?