Nexus is a connection to a state or taxing jurisdiction that is sufficient for a business to be subject to their tax laws. The U.S. Constitution does not define nexus, but gives guidance under two separate clauses. The Due Process clause states that more than a minimal connection is required. The Commerce clause allows Congress to regulate commerce, which includes preventing discrimination against interstate commerce. It requires “substantial nexus” for state taxation.

In April of this year, the U.S. Supreme Court heard the case of South Dakota v. Wayfair, Inc. This case addressed South Dakota’s sales tax nexus law which was enacted in May 2016. It was legislated to address the problem that most states are having of reduced sales tax collections.

How Did This Problem of Reduced Sales Tax Collections Come About?

Historically, the Supreme Court concluded based on their interpretation of the Constitution, that physical presence was needed in a state in order for that state to impose a sales tax collection responsibility on a business. Physical presence would generally mean an office, store, warehouse, other assets, employees or other representatives of the company performing services or soliciting in a state. If a business did not have physical presence, then they were not responsible to collect sales tax for that state.

Prior to the existence of the internet, states had an issue with out-of-state companies using catalogues to market and sell goods into their state. These companies were making significant sales in states and were not required to collect sales tax because they weren’t physically located in that state. When a company is not required to collect sales tax, the purchaser is required to pay a use tax to their state at the same rate as the sales tax; however, there is no reasonable mechanism to enforce the use tax, so it predominantly goes unpaid. Many purchasers are not even aware of the use tax requirement. In addition, by purchasing from the catalogue company, these customers are foregoing the physical stores in their area where they would have paid the sales tax. Alas, this is why the states are experiencing shortfalls in their sales tax collection.

In 1987, the state of North Dakota tried to combat these catalogue companies, and what they felt was unjust and outdated nexus decisions, by passing a new law declaring that regular or systematic solicitation of a consumer market in their state would be considered a nexus creating activity requiring sales tax collection. “Regular or systematic” was defined as three or more advertisements in a year.

The Quill Case

This law led to the well-known Quill case (Quill Corp. v. North Dakota), which was decided by the Supreme Court in 1992. Quill was a large office supply company that made mail order sales by distributing catalogues. The Supreme Court found that Quill had sufficient nexus under the Due Process clause, but not under the Commerce clause. They decided that physical presence is required to create nexus. They felt that requiring Quill to collect sales tax in a state where they were not present would be interfering in interstate commerce. The court liked the “bright line test” of physical presence established in a prior case, National Bellas Hess v. Department of Revenue of Illinois. It was clean and easy to determine. Furthermore, the court felt that Congress has the authority, and is better suited to create laws to regulate these matters.

In the internet age, the sales tax shortfall has increased exponentially. It has been estimated that the states have been losing approximately $20 billion in sales tax revenue per year.

Wayfair

The Wayfair case actually involved three internet sales companies contesting South Dakota’s 2016 law. The companies are: Wayfair and Overstock, both selling home goods and furnishings, and Newegg, which sells electronics. Each of these companies has over $1 billion in annual sales. The new South Dakota law is an economic nexus law rather than physical nexus. It states that a company has nexus in South Dakota if they have over $100,000 in sales or 200 transactions delivered into South Dakota. All three companies easily exceeded this threshold.

The South Dakota courts found in favor of Wayfair because the precedent in the Quill case makes the South Dakota law unconstitutional. South Dakota then applied to the U.S. Supreme Court and the case was accepted.

The Supreme Court Decision

The Supreme Court shook up the nexus world with their findings in the Wayfair case. They did not actually decide on the merits of the South Dakota law. What they did was to revisit their decision in the aforementioned Quill case, and they overturned their prior decision. They now decided that physical presence IS NOT required to create nexus. While in 1992 they were trying to protect Quill and others from the undue burden of multi-state taxation when there was no physical presence, they now realize that they were overly generous to Quill, and actually unfair to the brick-and-mortar businesses within North Dakota. Furthermore, the court went as far as to say that in today’s internet society that protection actually creates a tax shelter for the large internet retailers. They were exempt from tax collection, while a small company with one employee in the state is required to collect sales tax. The court in 1992 had no way of knowing that 26 years later, an internet company would be the largest retailer in the world.

Now that Quill was overturned, the conclusion reached by the South Dakota court—that their law is unconstitutional because there was no physical presence—was no longer valid. The case was remanded back to South Dakota.  Apparently as a hint to Wayfair as well as to all states, the court opined that they liked the South Dakota law because their threshold of $100,000 or 200 sales transactions protected small businesses, it did not require retroactive payment, and South Dakota was a member of the Streamlined Sales Tax Project, which is a group of states whose goal is to simplify and modernize sales and use tax collection and administration.

Wayfair, Overstock, and Newegg have since settled with South Dakota and agreed to begin collecting sales tax for South Dakota on January 1, 2019.

Now that physical presence is not required for sales tax nexus, each state must decide if they want to change their laws to be consistent with South Dakota. Each state is on its own. There is no national nexus law. Many states already have economic nexus laws, others do not.

Wayfair and Corporation/Income Tax nexus?

With this issue resolved for sales tax purposes, where do we stand with regard to Corporation or Income Tax nexus?

Many states have already imposed economic nexus standards for corporation or income tax. New York State, for example, has a $1 million nexus threshold with no physical presence since 2015. Other states have varying thresholds. This primarily affects companies with sales of services, digital goods, and intangibles. Sales of tangible personal property (with no physical presence, or with merely the presence of a salesman) have been protected by Public Law 86-272 since 1959 against a tax on net income. The law does not say “no nexus.” It says, “no tax on net income.” If a company meets the nexus threshold with sales of tangible personal property, states can charge a privilege tax or minimum tax. New York does not charge these supplementary taxes however when P.L. 86-272 applies.

Some states’ partnership and sole proprietor (Income Tax) laws follow their corporation laws regarding economic nexus. Other states including New York do not. Physical presence is required for a partnership or sole proprietor to have nexus in New York State.

Please note, as stated above, P.L. 86-272 protects against tax on net income. Some states such as Ohio and Washington tax gross income, not net income. P.L. 86-272 does not protect against tax on gross income, nor does it protect against tax on service income, digital sales, or intangibles. It is a very specific law. It also must be noted that New York’s corporation tax law as well as most other states’ laws use market-based sourcing rules. This is particularly important with regard to service income. Prior to 2015, New York required service income to be allocated to the location that the service was performed. Now, income from services is allocated to where the benefit of the service is received; generally the customer location. This can create nexus without entering a state.

While the court in Wayfair specifically addressed a sales tax law, most tax professionals that specialize in state taxes feel that the implication is that Wayfair does support economic nexus for corporation tax/income tax as well. In fact, historically the Supreme Court has been more lenient with regard to corporation tax nexus than sales tax. In the Quill decision where the court found that physical presence was required for sales tax nexus, they also said:

…concerning other types of taxes we have not adopted a similar bright line, physical presence requirement…

Not long after the decision in Quill, a corporation tax case, the Geoffrey case, was heard in the South Carolina Supreme Court (Geoffrey, Inc. v. SC Tax Com'n). A subsidiary of Toys R Us, Geoffrey owned the trade name “Toys R Us” and leased it to the parent company who had presence in South Carolina. Geoffrey did not have a presence; however it was found that the leasing of the intangible trade name into South Carolina was sufficient to create nexus with that state. Geoffrey then applied to the U.S. Supreme Court and they were denied. With this history, it is unlikely, given the Wayfair decision, that the U.S. Supreme Court would hear a case on economic nexus for a corporation. The trend is clearly moving in the direction of economic nexus and not physical presence.

When the Supreme Court ruled in the Quill case, they did not want to effectively create new law by their decision, which is most likely why they maintained the physical presence standard in 1992. In their decision, they challenged Congress by making it clear that it was the responsibility of the Congress to create laws. If nexus laws needed to be changed or clarified, they are better qualified and have the ultimate authority to make those changes.

In the 26 years since Quill, nexus legislation had been proposed, but no laws were passed. Now, after the Supreme Court ruled in Wayfair, there have been some proposals in Congress to change the effect of the Supreme Court decision, including expanding P.L. 86-272 to protect against all corporate tax, not just tax on net income. The Wayfair decision was a monumental decision 26 years in the making. After 26 years of failing to pass a nexus law, a new proposal in Congress to effectively overturn the Supreme Court decision would not be very popular.

Brian Gordon, CPA, is president of State Tax Audit Representation, Inc., a tax audit and controversy representation firm. He represents clients on audits involving residency, sales tax, corporation tax, and various other state and local tax issues. Previously, Brian was with the NYS Department of Taxation and Finance for many years as the district audit manager in the New York Metropolitan District where he worked on many high net worth tax audits of all types. Following his government experience, he was state and local tax director, most recently at Gettry Marcus, CPA, PC. He is a former president of the NYSSCPA Queens/Brooklyn Chapter and a member of the NYSSCPA New York, Multistate & Local Taxation Committee. He writes and speaks on various state and local tax issues. He can be reached at 516-510-6041, or by email at bgordon@StateTaxAuditRep.com.