Clearing up contingencies when accounting for tax nexus
Since the U.S. Supreme Court’s 2018 South Dakota v. Wayfair ruling, which led to the enactment of numerous state tax laws that affect remote sellers, you might wonder whether your company owes new taxes in states where you have no physical presence. Here, we answer a few of the most common questions we’ve heard while helping companies determine their economic nexus and state tax liability under Wayfair.
How does Wayfair affect my financial reporting?
Under the 1992 Quill decision, the Supreme Court required businesses to have a physical presence (for “substantial nexus”) in a state for sales/use tax purposes. However, because Quill didn’t clearly explain whether this physical presence nexus requirement applied to income, franchise or gross receipts taxes, several states’ highest courts have asserted nexus for those taxes over companies “earning income from sources” there. Your company may have encountered these rules as “factor presence” standards that govern minimum gross sales thresholds for nexus.
Wayfair validated the use of an economic nexus standard for all state and local taxes. All but two states with a sales tax have since passed economic nexus laws, and both states and cities have passed factor presence laws for other taxes. Other states have eliminated minimum-sales thresholds. (For income tax purposes, Public Law 86-272 protects many remote sellers.)
How should I apply Wayfair to state income taxes?
The accounting standards governing uncertain tax positions mandates the following procedure:
- Inventory all tax positions. For example, did you decide not to file a state income tax return in one location?
- Determine whether each tax position meets the recognition threshold. Use this guide:
- Highly certain positions require no accrual.
- Less-than-highly certain positions that are more than 50% likely to be sustained on technical merits — also known as more likely than not (MLTN) — require only a partial accrual.
- Less-than-highly certain positions that are less than 50% likely to be sustained on technical merits require a full accrual.
- You can’t consider detection risk when evaluating the recognition threshold.
- Measure the amount of each MLTN tax position that you will accrue. (Use the largest amount that you’re likely to realize when settling with the taxing authority.)
Your company will generally lack MLTN support for not filing in states with clear, widely enforced economic nexus laws.
Example #1
Chicago-based TechCo provides nationwide software consulting services. Since 2016, TechCo has annually sold $1 million of consulting services to CustCo, which is headquartered in Tennessee and has locations in two other states.
Even though Tennessee has enforced a factor presence nexus standard since 2016, TechCo has never filed a franchise, excise (net income), or business tax return there.
TechCo has clearly had nexus in Tennessee since 2016, but only if more than $500,000 of its annual sales are sourced there under the state’s market sourcing laws. TechCo believes it has MLTN technical support for sourcing one third of its CustCo sales to each of CustCo’s three locations, where only $333,333 of its CustCo sales would be sourced to Tennessee. Because TechCo’s Tennessee excise tax position met the recognition threshold, TechCo may accrue something less than 100% of the maximum expense.
TechCo measures its accrual using the portion of the related amount MLTN to be realized upon settlement with the Tennessee Department of Revenue. Based upon its experience with the Department and similar taxpayers, TechCo accrues a liability for 70% of the maximum possible expense.
How does Wayfair apply to other state tax liabilities?
Are you certain that you must collect sales or use taxes in one or more jurisdictions, but haven’t yet done so? You’ll need to record the uncollected tax, plus penalty and interest, in your financial statements as a liability, even if you’re not sure if the taxing authority knows of the obligation.
However, if you’re uncertain whether you’re required to collect these taxes, your accountant will treat them under regulations for loss contingencies. Because Wayfair upheld economic nexus laws, if you exceed a state’s nexus threshold, you will have nexus there, and you must record the uncollected tax, penalty and interest as liabilities for clearly taxable sales.
You must accrue an estimated liability for uncertain sales tax positions if both of the following conditions apply:
- It is probable (“likely”) that your company incurred the liability as of the financial statement date; and
- You can reasonably estimate your total liability. (Is this loss actually a range? Make your best estimate of the accrual within that range.)
To evaluate these conditions, identify the factors that influence them and assign each a weight. Along with the most common factors — such as whether products are taxable or exemption certificates are available — consider the odds of a sales tax audit and assessment, and of an unfavorable outcome.
By contrast, if your company’s contingent loss is at least reasonably possible (“more than remote but less than likely”), you’ll need to issue a disclosure instead of an accrual. You must explain the nature of the contingency and provide either an estimate of the possible loss or a statement that the loss cannot be estimated.
Example #2
Here’s an example of how you might decide which treatment applies:
WidgetCo is an Oregon-based retailer of goods used by manufacturers. It ships nationwide via common carrier. During 2018, WidgetCo sold $500,001 in goods to California manufacturers. Even though on April 1, 2019, WidgetCo clearly established sales tax nexus in California and was required to register, it didn’t, because it believed that sales of goods used in manufacturing were always exempt. From April 1 to December 31, 2019 WidgetCo made $1 million in gross sales to California manufacturers, but collected no exemption certificates.
WidgetCo didn’t realize that under California’s partial exemption, the sale of goods used in manufacturing is taxed at 3.9375%. Even if it could retroactively collect exemption certificates for all $1 million, WidgetCo could owe $39,375 in sales tax.
WidgetCo definitely has nexus in California, and its goods are taxable without an exemption certificate (making this a liability). However, because it’s uncertain whether WidgetCo can collect all related exemption certificates or whether California will audit and assess tax, it would consider this a loss contingency and apply the two-part test above.
If the factors make liability probable, WidgetCo must accrue a liability for a reasonably estimable amount. If it can’t figure out how many exemption certificates it can obtain, then it can’t reasonably estimate its liability and should make a disclosure.
Conclusion
In summary, when calculating an accrual for a contingent liability like this, you need to use all the tools in your toolbox.
While history is one factor to consider, you also must be aware of current trends in the industry and what is happening with other companies. You also need stay up to date on what various states are doing to pursue collection. All these factors should be considered when calculating your accrual.
Sometimes, you will need to estimate several scenarios (best case, worst case, most likely, etc.) and determine a “range” of potential results. Think about the kicker kicking the ball through the uprights in football. It doesn’t have to go right down the middle to count, it just has to be between the uprights. And just like anything else in accounting, it is important to document how you came to your conclusion in case that conclusion was to come into question.
You can find more information on this topic under Finance Accounting Standards Board (FASB) ASC 740-10 (Uncertain Tax Positions) and 450-20 (Loss Contingencies). But with states aggressively pursuing tax revenues, you shouldn’t have to navigate the contingent liabilities affecting tax compliance and financial reporting on your own. For help calculating how the Wayfair ruling and related laws might affect your business, contact Wipfli today.
Related reading:
Economic nexus reporting requirements reference table
Webinar: SCOTUS overturns Quill: What you should be doing today
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