As another year draws to an end, people may question whether their businesses must file tax returns in another state. The question is answered by asking whether a business has acquired “nexus” in a state. The determination of nexus affects a business’s financial reporting as well as tax compliance.
Nexus is the degree of activity an out-of-state business must have before a state can enforce a right to file and collect taxes. Nexus can be established when a business has a connection with a state through employees, independent contractors, property, or sales. The potential for recognizing a tax liability exists when a business has nexus in a state and does not file returns with that state.
The nexus standards can vary between states and can be different for income and sales taxes, both impacting obligations that may need to be recorded and disclosed in a business’s financial statements.
Income Tax Nexus
Historically, income tax nexus was created by having some type of physical connection. A company needed to have an office or property in the state or needed to have employees living in or traveling to the state. Many states now take the position that physical presence is not needed and that income tax nexus occurs when a company is “doing business” in a state or creating a “market” in a state. Several states, including California and New York, have created “economic” nexus rules whereby a business has nexus simply by conducting a certain amount of sales in a state without any physical presence.
For companies that sell only tangible personal property, there is a federal law that says a state cannot subject them to income tax if the only activity they perform in the state is the solicitation of sales. This federal law “trumps” any economic nexus provision a state may have, but companies should be aware that states aggressively look for any activities a company may perform in the state that go beyond solicitation.
Nexus can be problematic for financial accounting and reporting purposes as well. Under U.S. Generally Accepted Accounting Principles (GAAP), tax positions must first meet a more-likely-than-not test before they can be initially recognized. The term more likely than not means a likelihood of more than 50 percent that the position will be sustained upon examination by a taxing authority. Tax position is defined as a position that is reflected in measuring current or deferred income taxes. Examples of tax positions include the decision of whether to expense or capitalize an expenditure, the time period for recognizing revenue, and the deductibility of certain accruals. The decision not to file a tax return in a jurisdiction is also a tax position. Consequently, the decision an income tax-paying entity makes regarding filing a tax return in a particular state must meet the more-likely-than-not threshold. And remember, that threshold is assuming the transaction will be examined by the taxing authorities. The likelihood of a tax audit is not a consideration; it is assumed there will be one. Therefore, if a C corporation decides not to file a tax return in a state where it could potentially have nexus for income taxes, the corporation may still need to record a liability for taxes that may be due if the corporation is examined by the state taxing authority. For financial reporting purposes, the corporation is not able to recognize the tax benefit of not filing in that state.
Sales Tax Nexus
The law is clear that a company must have physical nexus in a state before that state can assert sales tax nexus. This physical presence is usually established by a salesperson or an independent sales representative visiting customers or potential customers in a state. Nexus may also be established through trade shows or business relationships. A single customer visit can easily create sales tax nexus. Companies should take note that the above-mentioned federal law that protects the solicitation of sales activities from creating income tax nexus does not apply to sales tax.
Because of e-commerce, the sales tax nexus rules are becoming more complicated as states try to capture lost revenue. States are looking for creative ways to create the physical presence connection required for sales tax nexus purposes.
A number of states have passed rules asserting sales tax nexus through the use of another company’s website to generate sales, known as “click through” nexus. Initially used to target large Internet retailers such as Amazon, these rules attach nexus to companies that pay other companies for each sale. For example, suppose a retailer sells hubcap covers and contracts with an online motor magazine to place an advertisement. For each sale generated through the motor magazine’s website, the hubcap manufacturer agrees to pay $1. In the states with “click through” nexus, this activity will create sales tax nexus. Most states have a minimum level of sales before nexus is triggered, but that level can be as low as $10,000. Once nexus is established, the hubcap manufacturer must collect sales tax on every sale in this state, regardless of whether it was generated from the motor magazine’s website or not.
More recently, some states have taken the position that Internet retailers have a physical presence in the state because their website installs information gathering software on customers’ computers. This “cookie nexus” attack is expected to be aggressively challenged in the courts by online retailers.
Do you sell through Amazon? You may have sales tax nexus in every state where you have product in an Amazon warehouse. Most Amazon vendor agreements contain clauses that the vendor is the owner of the inventory when it sits in the Amazon warehouse. This will create sales tax nexus (and likely income tax nexus) for the vendor in that state.
The issue of nexus for sales tax may affect any type of entity. Not charging, collecting, and remitting sales tax could create a contingent liability for financial accounting and reporting purposes. GAAP defines a loss contingency as an existing condition, situation, or set of circumstances involving uncertainty as to a possible loss to an entity that will ultimately be resolved when one or more future events occur or fail to occur. However, under the contingency rules, a loss is accrued only if (1) it is probable that a loss has been incurred and (2) the amount of loss can be reasonably estimated. Probable is defined as the future event being likely to occur. If the amount of loss, or a range of the loss, cannot be estimated, or if the likelihood that a loss has been incurred is only reasonably possible (more than slight, but less than likely), then the loss does not need to be accrued, but disclosure is required. Under the loss contingency rules, there is not a presumption that the entity will be subject to examination by the taxing authority. So there is a lower level of recognizing a potential liability. However, an entity must make the assessments considering all the facts and circumstances.
How Bad Can It Be?
The consequence of not understanding the nexus rules and not reviewing a company’s position annually can be very costly. Let’s assume a company established income and sales tax nexus several years ago but never filed income tax or sales tax returns. Because no tax returns were filed, the statute of limitations does not run. The state can require the company to file tax returns going back to the first year when nexus was established. In addition to tax, the company will be assessed interest and penalties, which in many cases are more than the tax assessed. Consequently, the financial statement effect never reverses and may increase year after year.
Based on the potential tax and financial reporting purposes, the topic of nexus should be evaluated by all entities on a routine basis. We encourage our clients to ask us any questions on nexus and keep us posted on changes in the geographic location of their operations and how business is conducted.