New sales tax nexus standards are creating a larger compliance footprint for U.S. companies and, potentially, foreign entities selling into the United States. With the change from physical presence to economic nexus, states have become more aggressive in identifying and requiring entities to comply with sales tax collection and filing rules. Sales tax economic nexus is here to stay, and this article investigates what this means for companies and identifies potential legal arguments in this new area of tax jurisprudence.
In a post—South Dakota v. Wayfair, Inc., 138 S. Ct. 2080 (2018), sales tax world, how are states enforcing the new economic nexus rules and identifying companies that fall within them? Given the budget shortfalls due to COVID-19, states are identifying new ways to increase their revenue, and what better way than enforcing the Wayfair economic nexus rules as they relate to sales tax obligations? Accordingly, states have taken a broader perspective on enforcing economic nexus rules on various sellers (e.g., internet retailers) by creating new registration and collection tools for all registered sellers. Under this new nexus standard, it is important to note that if states find that the taxpayer purposefully did not comply with state law, then the departments of revenue (DORs) can not only require that the taxpayer pay back sales tax but also assert that it is liable for penalties as well as interest.
In the nearly three years since the Supreme Court in Wayfair upheld South Dakota's economic nexus law, overruling the Court's physical-presence precedents, states have faced challenges enforcing this new nexus standard on remote internet sellers, given that traditional audit approaches leverage information that is geared toward identifying sellers with some physical identity or connection within the state (see also "Sales Tax Compliance Post-Wayfair," JofA, Aug. 2019). For example, if employees work in the state, the entity is required to file payroll taxes, or if the entity owns real property, then DORs can obtain real property and tax records to help validate sales tax compliance or identify potential audit targets. Economic nexus, however, provides fewer avenues for states to prove that an entity should collect sales tax in comparison to traditional physical-presence standards, where data is more readily available.
ECONOMIC NEXUS THRESHOLDS
From a sales tax perspective, economic nexus, simply stated, requires sellers to collect sales tax in states where the seller's sales exceed the state's monetary or transactional threshold.
Most states have taken the legislative position that an organization has economic nexus if:
- It has annual retail sales of goods or services into the state that surpass a dollar threshold, e.g., $100,000; or
- It makes a specified number of sales transactions, e.g., 200 or more, into the state.
Several companies publish information online describing each state's rules, both at a summary and detailed level (see, e.g., "State-by-State Guide to Sales Tax Nexus Laws," by Sovos Compliance LLC, available at sovos.com) and tables of special features (see, e.g., "Do Exempt Sales Count Toward State Economic Nexus Thresholds?" by Gail Cole, Avalara, Aug. 19, 2020).
Twenty-eight states use both dollar-based and transaction-based threshold nexus standards. Another 15 states have enacted only a sales dollar threshold standard. In a controversial situation that has pitted the Kansas governor against the attorney general, Kansas currently imposes an economic nexus standard with no threshold whatsoever. Of the states or territories with state and/or local sales tax, all except Missouri have passed economic nexus legislation. Florida's new economic nexus legislation takes effect July 1, 2021. The Pennsylvania Department of Revenue enunciated its economic nexus rules in a sales and use tax bulletin (see Pennsylvania Sales and Use Tax Bulletin 2019-01).
As the states write their laws, they often look at both taxable and exempt sales in determining whether an entity has economic nexus. California specifically includes sale-for-resale transactions as part of its dollar threshold count. In contrast, Georgia, Illinois, Minnesota, Nebraska, and a host of other states exclude resale sales of tangible personal property from their economic nexus count. As of Jan. 1, 2021, Illinois requires remote retailers with economic nexus to collect its state and local "retailers' occupation tax" using the rate in effect at the location where tangible personal property is shipped or delivered or at which the purchaser takes possession of the property (destination sourcing). In-state retailers with an Illinois presence collect the tax using the rate in effect at the location of Illinois inventory from which a sale is fulfilled or the location where selling activities otherwise occur (origin sourcing).
Practically, what do these standards mean? In a state with a threshold of 200 transactions or $100,000 in sales, if a retailer sells 200 widgets at a dollar each, then it has to begin collecting and reporting sales tax, even though its total revenue for the state is only $200. In the alternative, if it has one large sale for $90,000, then the company has no obligation to collect sales tax and file returns. The taxpayer with $200 of sales into the state might find this incongruous. Further, what if the seller of $1 widgets almost always sells exempt items or sells otherwise taxable items to nontaxable customers? Is that seller required to file a tax return even though it reports only exempt sales, while another taxpayer that garnered a larger economic gain from the state has no requirement to collect? While this dichotomy seems unfair, inequitable, or burdensome, no taxpayers appear to have challenged any of the states' economic nexus rules.
If we borrow income tax principles enunciated in the Supreme Court case of Complete Auto Transit, Inc. v. Brady, 430 U.S. 274 (1977), one prong of the four-prong test set out in that case highlights that a state must not tax more than its fair share of the income of a taxpayer (i.e., that the tax is fairly apportioned). While Complete Auto Transit did not deal with sales tax, the prong itself speaks to a fairness and equity component in imposing tax compliance requirements on businesses. Arguably, there is an element of inequality in treating the two disparate sellers so differently. As discussed below, there is further inequality if we compare the states' sales tax nexus dollar thresholds to the income tax thresholds. Given this, there is room to challenge the states' sales tax economic nexus rules or, alternatively, petition Congress to provide equitable bright-line rules for economic nexus.
Most states' income tax rules use a factor-presence standard for nexus, which can include a combination of property, payroll, and sales, or may focus on sales only. Sales-factor thresholds generally range from $250,000 to $500,000 to upwards of $1 million. The Interstate Income Act of 1959, better known as P.L. 86-272, specifically prohibits a state from imposing a net income tax on a seller's business activity if it is limited to the solicitation of orders for sales of tangible personal property. Sales tax does not have a similar exception. So, while income tax does use a form of sales threshold for purposes of determining nexus, similar to the sales tax economic model, it does not consider the number of transactions. Further, the sales tax thresholds for economic nexus are generally much lower than the income tax sales-factor-presence thresholds, often by thousands of dollars.
The income tax economic-presence rules have existed far longer than their counterparts in sales tax, and, as such, taxpayers have actively litigated those income tax rules. The results of these cases further demonstrate the inequity that exists today in the sales tax world. In Tax Commissioner v. MBNA America Bank, N.A., 640 S.E.2d 226 (W. Va. 2006), the Supreme Court of Appeals of West Virginia permitted tax enforcement against MBNA, which had no tangible connection to the state. In part, the decision recognized that income taxes do not appear to impose the same degree of compliance burdens as sales tax. Further, the court noted: "Rather than a physical-presence standard, this Court believes that a significant economic presence test is a better indicator of whether substantial nexus exists for Commerce Clause purposes" (emphasis added). This was the court's response to the taxpayer's argument for use of the physical-presence standard for corporate income tax. The court highlights the requirement for a "significant" economic-presence test. Arguably, 200 transactions do not necessarily rise to the level of "significant" economic presence, especially when dealing with sellers of relatively low-dollar items.
In several income tax nexus cases involving the licensing of intangible assets, namely trademarks, the courts have found that the licensing of such intangibles between related entities is a revenue-generating activity that rises to the level of economic presence. In these cases, the licensing of the intangible was not the main business activity of the licensing entity. Should a similar standard apply for sales tax, if related and nonrelated entities charge for the use of intangible assets? Arguably, if such transactions meet the above economic nexus standards, those entities have an obligation to file and report sales tax. Not much has been litigated in this area, so taxpayers should be aware that just because states have imposed these standards does not necessarily mean that they would pass muster if litigated within state and federal courts. For states, it may make sense to leverage what has been litigated and resolved for income tax and use the same threshold in the sales tax area so that the measure is standardized and streamlined for taxpayers, thereby allowing for the use of income tax data to determine whether a taxpayer has a sales tax collection obligation.
The issuance of FASB Accounting Standards Update No. 2014-09, Revenue From Contracts With Customers (Topic 606), means that "all companies with tax compliance responsibilities (federal, state, and sales tax) should be considering potential issues relevant to tax planning and reporting" ("U.S. Tax and FASB's New Paradigm for Revenue Recognition," JofA, June 2017). To the extent a legally obligated company does not collect sales tax from its customer, then the tax owed becomes a liability on the taxpayer. As such, most companies have their books and records reviewed by independent third-party audit firms to evaluate and confirm state and federal tax liability, and having a standardized measure for nexus across state and local tax jurisdictions would make this easier for auditors.
Generally, audit firms place a higher priority on federal and state income tax liability rather than sales tax. In a post-Wayfair world this needs to change, and taxpayers should be aware a potential substantial liability relates to sales tax since states are now employing an economic nexus measure. It should be reviewed quarterly in a manner similar to income tax. Further, companies should set up a reserve for potential sales tax liabilities in states where they operate. Remote sellers should also consider contingencies required to be booked related to potential liabilities stemming from exceeding nexus thresholds.
STATES MAKE COMPLIANCE MORE MANAGEABLE
Some states are ostensibly working to make sales tax compliance and collection easier for taxpayers. Some examples include websites that allow users to manually calculate sales tax based on address, or an application programming interface (e.g., California's) that can be integrated into retailers' online order forms to determine the appropriate rate and taxing location in real time. A majority of states now have such a lookup tool in one form or another. Arkansas has a tool for searching by ZIP code or address. Washington state's lookup tool incorporates a state map, allows searching by geographical coordinates, and calculates the tax for any given taxable amount of sale. Colorado's site incorporates a clickable map and provides a breakdown of tax rate components.
Further, states such as Colorado and Alaska are working on unifying sales tax collection for local jurisdictions with administrations, rules, and reporting requirements independent from those of the state government. Arizona has already unified all local filing on the state return to reduce the complexity of compliance, although the Form TPT-2, Transaction Privilege, Use and Severance Tax Return, is far from simple to complete. Also, a handful of states, such as Alabama and Texas, have provided a unified state and local rate for internet sellers to provide greater ease of compliance. Other options offered by states to reduce penalties associated with noncompliance include voluntary disclosure programs. Be forewarned, though, that sellers are not automatically eligible for these programs. Sellers who believe they qualify for a voluntary disclosure program will need to seek permission to participate.
On the other hand, some states are taking an aggressive approach in seeking out taxpayers for compliance with the new nexus rules. For example, the author has seen in practice DORs sending out more nexus questionnaires to various companies to, for all intents and purposes, scare them into compliance. Companies should take great care in responding to these questionnaires because states can use this information to force reporting for sales tax and other areas of taxation. To find targets, state auditors have been known to visit an e-commerce site and place an order to see if the seller charges sales tax. If no tax is charged, a questionnaire is then mailed to the seller.
Auditors can also check on companies that advertise heavily in their state or have achieved some level of public notoriety. States will also continue to look for sellers that may have established facilities in their state to make sales or store inventory. A facility or in-state inventory constitutes old-school physical presence and can be the basis of an audit stretching back to well before economic nexus standards came into existence.
Much of this data can be garnered from entity-level income tax returns that the taxpayer files in the state, which provide a breakout of property, payroll, and sales. As discussed above, DORs can use information in property tax records to see if an entity has real property in the state to establish nexus. Another resource state DORs use is the purchase records of their in-state taxpayers that were obtained as part of consumer use tax audits. Do the records reveal sizable out-of-state vendors not currently charging tax? Aggregating this sort of data from many audits could generate a sizable list of targets.
Likewise, states can take advantage of information from Form 1099-MISC, Miscellaneous Information, as taxpayers are required to send these reports to their vendors if the total reportable payments exceed $600. States receive Form 1099-MISC data as part of the federal reporting, and it provides a wealth of seller data that they can use to identify sellers that should be collecting sales tax. States will also look to whether a company has sponsored or participated in conferences or trade shows within their borders to determine whether a company makes sales at a level that meets the states' economic nexus threshold.
REDUCING RISK AND RESPONDING TO AN AUDIT
Companies should be aware of and monitor their physical and economic presence nexus on a quarterly basis, using the tools and information discussed in this article. Also, companies should defend against and challenge state assertions concerning sales tax nexus rules, as well as petition Congress for clearer and more equitable nexus guidelines, especially during these times of financial upheaval caused by COVID-19. If organizations decide to register to collect sales tax in a state, they should take advantage of any benefits and tools that the state is providing. A company will be in a better position to manage its sales tax collection responsibilities for a state if it determines whether it has physical or economic nexus before it receives a notice, letter, or nexus questionnaire from the state DOR.
About the author
Antonio Di Benedetto, J.D., LL.M., is founder and president of ADB Advisors, a tax services and consulting firm in Boston.
To comment on this article or to suggest an idea for another article, contact Paul Bonner, a JofA senior editor, at Paul.Bonner@aicpa-cima.com or 919-402-4434.
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