State Nexus: The Big Issue for Business Owners in 2010

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Paul Austin
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1 Coaching Program State Nexus: The Big Issue for Business Owners in 2010 The tax word of 2010 is going to be nexus. States are broke. If they can find a way to draw you into their state, they can make your business liable for sales tax and you liable for their state s income tax. The first step for the state will be to prove that you have some kind of nexus, or connection, into that state. If there is no nexus, then there is no way to get hold of you and/or your business for tax purposes. The problem is that the states aren t following any kind of uniform guidance in determining what it takes to have nexus. So until either Congress or the US Supreme Court gives us some uniform, national guidance, all we can do is watch the states and see what they are doing. months. Here are some court cases that have been published in the last few Copyright 2009, Diane Kennedy and US TaxAid Series, LLC. All rights reserved. Page 1 of 9

2 INDIANA: The Indiana Tax Court ruled that income received from a out-of-state S Corporation from its membership interest did not constitute gross income. Therefore, the Indiana S Corporation income was not considered personal income tax for its nonresident shareholders. Nexus Analysis: The S Corporation was formed in Indiana, then performed work in another state. It s assumed that it was authorized to do business in that other state. The tax authorities argued that a shareholder who didn t live in Indiana should be forced to pay Indiana state income tax, simply because the Indiana S Corporation, which did NO WORK in Indiana, had originally been formed in Indiana. This win went to the taxpayers, but there is a heads-up here. If you have some lingering entities from other states, it s time to clean them up. For example, let s say you once lived in Indiana, have since moved to Florida. Your business works in Florida, but you continue to use that S Corporation. You might have dodged a bullet this time, but Indiana has already changed the law to widen its net. Look for other states to do the same. Lesson from Indiana: Clean up your company filings. OHIO: A company that is currently embroiled in a court battle with Ohio about whether they have Ohio nexus has been ordered to file as if they have Ohio nexus until the court case is determined. There s something wrong with that. It presupposes they are going to lose, I think. Lesson from Ohio: Stay out of nexus fights. Copyright 2010, US TaxAid Series, LLC and Smart Money, LLC. All rights reserved. Page 2 of 9

3 MICHIGAN: Michigan is considering a sales tax on services. This isn t specifically a nexus issue, but instead is a big warning. If Michigan can get a foothold on your service based company, you may end up with sales tax on something that s never been taxed before. Lesson from Michigan: Don t assume you know the sales tax laws in other states. Each state can put sales tax on anything they want. OREGON: Oregon s period of amnesty has expired now, but it brings up a good point. States are giving periods of amnesty for taxpayers that have nexus to come forward. You are forgiven for past sins, but have to start filing for nexus. Lesson from Oregon: If you have nexus in a state but have never filed before, have your accountant research amnesty periods within that state. Come clean when it won t cost you. TENNESSEE: Tennessee had tried to make a company call their interest income (typically considered an investment income item) business income. Why should we care? Business income gets pulled into business nexus apportionment. Investment income does not. Tennessee lost this case, but it s an important one to consider. Let s say you live in Nevada and have ownership in a Tennessee based company. You ll pay state income tax to Tennessee for the business income, but not for investment income. Tennessee tried to say that if the business earned interest, that would pull it into Tennessee. As I read Copyright 2010, US TaxAid Series, LLC and Smart Money, LLC. All rights reserved. Page 3 of 9

4 this case, I m reminded of some sloppy bookkeeping I ve seen in the past that just lumps all income together. In today s nexus-hungry state arena, that could cost you money. Lesson from Tennessee: Keep your records clean. MINNESOTA: Minnesota is going after part-time residents and nonresidents to try to prove residency. rules: In Minnesota, residency is generally defined based on one of two You have residency in the state, or You spend 183 days or more in one year in that state. Minnesota is looking for any link into the state. Once they find you, you ll get a questionnaire to complete. They re looking for something to hook you into Minnesota. Lesson from Minnesota: Be careful answering any questionnaires! ILLINOIS: Illinois has determined that two separate companies with common ownership had enough relation through centralized administration that they should be combined into one return. This is known as the unitary doctrine and it s a killer. Here s the official definition: Copyright 2010, US TaxAid Series, LLC and Smart Money, LLC. All rights reserved. Page 4 of 9

5 The term unitary business group means a group of persons related through common ownership whose business activities are integrated with, dependent upon and contribute to each other Unitary business activity can ordinarily be illustrated where the activities of the members are: (1) in the same general line (such as manufacturing, wholesaling, retailing of tangible personal property, insurance, transportation or finance); or (2) are steps in a vertically structured enterprise or process ; and, in either instance, the members are functionally integrated through the exercise of strong centralized management (where, for example, authority over such matters as purchasing, financing, tax compliance, product line, personnel, marketing and capital investment is not left to each member). There isn t a clear objective distinction. The determination is often subjective. And remember that the unitary doctrine is applicable equally to C Corporations, S Corporations, Limited Liability Companies and Partnerships. Lesson from Illinois: Watch how you manage companies in other states. Is your management style and the company work creating a unitary business group? FLORIDA: Florida has passed a new law regarding software sales or customization software work to Florida customers. This law is related to the sales apportionment calculation that you need to do for dividing up income between multiple states. Income that comes from customizing software should be sourced to the state in which the software customizing activities take place. In Copyright 2010, US TaxAid Series, LLC and Smart Money, LLC. All rights reserved. Page 5 of 9

6 other words, if you re doing the programming in Florida, then it s Florida income. Income that comes from other sales by the taxpayer are sourced to the location of the customer. In other words, if you make a sale to a client s office in Texas, it s Texas income. It s assumed that this means that there is some customization of the software. However, what if it is just a straight Internet sale. Is Florida opening to gate to apportioning income? And what if the other state has different definitions? Lesson from Florida: We re likely to get 50 different rules about nexus. You re probably best served by following your home state rules, but recognize if you broach nexus in another state there could suddenly be a lot of new wrinkles! MULTISTATE TAX COMMISSION: Ever so often we get to hear from the Multistate Tx Commission with a Nexus Bulletin. Up till now, they ve been making pronouncements and not a lot has happened with them. I predict that s all going to change as the states get more aggressive at asserting their own state s claim. One of the bulletins that s getting a lot of talk now is Multistate Tax Commission Nexus Bulletin (NB 95-1). This states that in-state warranty repair services through third-party repair service providers creates constitutional nexus for sales tax on all sales made to customers in that State. And income, franchise, gross receipts taxes or other comparable taxes will be due in the taxing State where the warranty services are performed. Copyright 2010, US TaxAid Series, LLC and Smart Money, LLC. All rights reserved. Page 6 of 9

7 Lessons from MultiTax Commission: Old bulletins are getting more significant. Remember if nexus pulls you into a state, you are, at the least, responsible for collecting sales tax for any sales that are subject to tax in that state. And that means that you also have to know what s subject to sales tax in the other states in which you have nexus. STATE TRENDS: We ve been concentrating on the lower standard of nexus for sales tax purposes, but that doesn t mean you re home free on calculating nexus for income allocation. Once you ve triggered that type of nexus, you ve got a lot more to worry about. Just one issue (and it s a big one) is what formula does the state use to apportion income? If you re in two different states that have different apportionment formulas, you can get stuck paying tax on more income than you actually have! The nexus question has gotten more difficult with a new trend in state nexus. This is called benefit derived treatment. More and more states are changing to the "benefit derived" treatment or "market-based sourcing" for sales by service providers. Meaning, sales related to services are sourced to where the benefit is being derived by the customer. As you may guess, determining where the 'benefit is being derived' is really subject to interpretation. A simple solution would be to source it to the state where the customer is located; however, what if the customer uses the benefit of the service in other states or more than one state? Copyright 2010, US TaxAid Series, LLC and Smart Money, LLC. All rights reserved. Page 7 of 9

8 This all adds confusion to already overly complicated section of tax law. So, here s where we are: Some states claim sales are in their state when the service is performed. This can produce an all or nothing result, or a proration of the sales. Some states have changed to "market-based sourcing" or "benefit derived" sourcing; sourcing sales to the state where the benefit of the service is being derived. Lessons From State Trends: I m personally concerned about this. With a virtual-service based company, I m going above and beyond to prove nexus where my chair sits. But with a benefit derived nexus issue, I could open up for nexus in a whole bunch of states. How about your business? New York and Pennsylvania: These states are recently announced amnesty programs in These types of programs have been successful at bringing non-compliers into voluntary compliance by forgiving past omissions. Lessons from New York and Pennsylvania: If you have a possible nexus issue in a state that you haven t reported in, look for the amnesty period and come clean then. Copyright 2010, US TaxAid Series, LLC and Smart Money, LLC. All rights reserved. Page 8 of 9

9 In general, we expect nexus to get more complicated in Until we see a national solution coming from Congress and/or the U.S. Supreme Court, the states will continue to make up rules anyway they want. And what they want is your money. Now. Copyright 2010, US TaxAid Series, LLC and Smart Money, LLC. All rights reserved. Page 9 of 9

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