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Article by Roger Russell | Found on Accounting Today

Nexus — the minimum amount of contact between a taxpayer and a state that allows the state to tax the business on its activities — is under attack by the states as they seek to broaden its reach in order to increase their taxing revenue.

States are challenging the traditional physical-presence standard as a basis for collecting tax from companies doing business in the state. While they previously collected taxes from companies having a physical presence in their state, they are now adopting a broader economic-nexus standard requiring businesses to pay taxes when they have earned revenue within a state above a certain sales dollar threshold.

At the heart of the issue are general nexus concepts, as different taxes have different nexus rules, and the different states have their own nexus rules.


“As a result of states attempting to expand their tax rolls to out-of-state vendors, state legislatures have created a patchwork of economic nexus standards that are a compliance nightmare for companies of all sizes and industries,” explained Patrick Duffany, a partner at Top 100 Firm CohnReznick who also leads the firm’s state and local tax practice. “States want more revenue and they want taxpayers in their states to pay less tax. To the extent that states can export the tax, meaning the more revenue they can realize from out-of-state taxpayers, it makes it more attractive for businesses to locate into that particular jurisdiction.”

“The consequences of such vastly different standards is that there are significant risks to companies, especially those in service and IT industries and those that are growing quickly,” Duffany noted. “Executives and advisors are forced to approach their tax filings on a state-by-state basis, an approach that takes considerable time and effort.”

In 1992, the Supreme Court established a physical presence test for sales tax nexus in the Quill case, but left unanswered the question as to its application for income tax nexus. Public Law 86-272 limits states’ power to impose income tax by prohibiting taxing businesses whose only activity in the state is the solicitation of orders, so long as the orders are accepted at and delivered from a point outside the state. Confusion has come subsequent to the Quill decision, primarily on the sales tax side, according to Rocky Cummings, partner and national director of state and local taxes at Top 10 Firm BDO. The “click-through” or Amazon laws seek to ascribe nexus through the agency theory. “Click-through nexus says, ‘OK, seller, if an agent in another state is directing traffic to your Web site, we’ll get nexus that way.’”

“There has been confusion as to whether Quill extends to income tax,” Cummings said. “Many think so. After all, the Commerce Clause should apply equally to sales and income. However, the Supreme Court declined to review two cases in 2005 which treated income tax differently, so a lot take the position that you don’t need physical presence for income tax nexus. As a result, states started enacting factor presence rules, requiring that if a company has a certain amount of sales, it is deemed to have nexus.”

“P.L. 86-272 only deals with companies sending solicitors into a state to solicit sales,” he said. “If the sale is consummated outside the state and shipped back into the state, P.L. 86-272 preempts corporate income taxation by the state. It only applies to income tax —it does not apply to business activity or net worth taxes.”


There’s not that much difference between pure economic nexus and factor-based nexus, according to Joe Pizzimenti, tax director at Top 100 Firm Margolin, Winer & Evens LLP. “If a company does not have P.L. 86-272 protection in order to determine the requisite presence, instead of looking for physical presence or other form of agency presence, you look to an objective test. If you have, say, $1 million of sales in the state, or some other number they determine legislatively, you are deemed to have economic nexus in the state.”

In a factor-based test, payroll, property and sales in the state are considered. “Factor-based nexus looks at all three of these,” said Pizzimenti. “Economic and factor nexus are two forms of objective nexus standards, generally for net income-based corporate taxes. They haven’t generally been adopted for sales and use tax nexus, though a couple of states either have or are proposing this.”

The reason for the dichotomy is that until recently most states determined corporate income tax nexus based on net income, according to Pizzimenti. “However, some states have adopted a gross margins or gross receipts test. For those types of taxes, P.L. does not apply to offer protection from a state asserting nexus.”

When a company derives its revenue from the sale of services, there is an issue of how to source the revenue for nexus purposes, Pizzimenti observed. A number of states have now adopted market-based sourcing, which sources the revenue to the state where the service is received. “When you combine market-based sourcing and economic or factor-based nexus, there is the potential that nexus exists where it is unexpected.”

Regarding sales tax nexus, Pizzimenti has a word of caution: “In almost every jurisdiction, sales tax is a fiduciary tax. Once it is determined that an entity has enough presence to require registration as a sales tax vendor, all of its responsible persons become personally liable for taxes that should have been collected on transactions.”


Because of the revenue that is at stake, many states are finding ways to challenge the Quill physical presence test. These include passing “click-through” and affiliate nexus provisions, and use tax notification requirements. Ohio has asserted a “cookie” nexus concept that would create taxable presence every time a retailer’s Web site is accessed by a customer in the state. And Colorado has filed a cross-petition asking the Supreme Court to determine if the case of Direct Marketing Association v. Brohl (upholding Colorado’s requirement that retailers notify any Colorado customers of the state’s tax requirement and to report tax-related information to the state’s Department of Revenue) is compelling enough to overturn Quill.

“This case represents the continued struggle by states and businesses with the definition of nexus as defined by Quill,” said Clark Calhoun, a partner in law firm Alston & Bird’s State & Local Tax Group. “Although the original ruling sets a precedent for other states that might consider adding a similar reporting requirement, the current case fails to refocus on the issue of physical presence.”

“We expect that other states will attempt to impose obligations similar to Colorado’s on out-of-state retailers, as well as other Web-based companies, that do not collect state sales and use taxes,” said Andy Yates, an attorney in Alston & Bird’s SALT Group. “The Tenth Circuit’s decision in Direct Marketing to uphold Colorado’s reporting requirements undermines the cross-petition and affirms that Quill does not impair states from implementing these reporting regimes.”

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