August 9, 2023

The Post-Wayfair Landscape: How States are Reshaping Income and Sales Tax Laws

By Tri Hoang, Principal, Tax & Business Services

The Post-Wayfair Landscape: How States are Reshaping Income and Sales Tax Laws State & Local Tax

Almost five years ago, when the US Supreme Court issued its decision in South Dakota v. Wayfair, Inc., the state and local tax landscape significantly changed in many states. While the case specifically addressed whether South Dakota could impose a sales tax collection obligation on remote sellers that merely met economic thresholds based on sales activity into the state (e.g., delivery of $100,000 of goods or services or 200 or more separate transactions), the Court’s decision impacted many other areas of state and local taxation.

For state income or franchise tax purposes, a state’s ability to assert an income tax is generally limited by (1) state law or (2) US Constitutional limitations. While a state is free to dictate the terms under which it will impose a tax, it cannot if it violates US Constitutional limitations such as the Due Process Clause or Commerce Clause (more to come on this later). Many states levy an income/franchise tax when a taxpayer is “doing business” under state law. In most states, “doing business” is generally defined under one or more of the following approaches:

  1. any activity that exceeds a bright-line threshold (commonly referred to as “factor-based nexus”),
  2. any activity in which a taxpayer actively engages for purposes of financial gain or profit or any activity which results in state source income, or
  3. any activity that can be taxed to the fullest extent allowed by the US Constitution.

In the post-Wayfair world, many states (and political subdivisions) have begun to trend toward a factor-based nexus standard for corporate income/franchise and gross receipts tax purposes.

These states include:

  • Philadelphia (City): $100,000 in sales (effective January 1, 2019).
  • Texas: $500,000 (effective for the report year 2020 (calendar year 2019)).
  • Massachusetts: $500,000 sales (effective October 18, 2019).
  • Hawaii: $100,000 in sales or 200 or more transactions (effective January 1, 2020).
  • Oregon (Corporate Activity Tax (CAT)): $1,000,000 in sales (effective January 1, 2020).
  • Pennsylvania: $500,000 in sales (effective January 1, 2020).
  • Washington: $100,000 (effective January 1, 2020 – threshold reduced from the previous threshold of $285,000).
  • Maine: $500,000 sales or either $250,000 payroll/property or 25% of total payroll/property/sales (effective January 1, 2022).
  • New York (City): $1,000,000 in sales (effective January 1, 2022).
  • New Jersey: $100,000 in sales or 200 or more transactions (effective tax years ending on or after July 31, 2023).

These jurisdictions join Alabama, California, Colorado, Connecticut, Michigan, New York, Ohio, Tennessee, and the City of San Francisco, which adopted factor-based nexus standards pre-Wayfair. Factor-based nexus standards are becoming increasingly popular because they can be objectively applied, are easy to understand, and are structured similarly to Wayfair sales/use tax economic nexus standards, which have survived constitutional scrutiny. Accordingly, it can be expected that additional states will continue to adopt factor-based nexus standards in the future.

In many states, a taxpayer is “doing business” when the business engages in any activity for gain or profit. Some states assert nexus to the extent that a taxpayer merely derives income from state sources. From our perspective, states that adopt these standards haven’t changed their view in the post-Wayfair world. However, some states have become more aggressive in asserting nexus, as evidenced by updates and revisions to income tax nexus questionnaires.

In response to Wayfair, some states have taken a different approach. For example, on May 1, 2019, Governor Holcomb of Indiana signed SB563 into law, which redefined “adjusted gross income derived from sources within Indiana” as “income derived from Indiana shall be taxable to the fullest extent permitted by the Constitution, regardless of whether the taxpayer has a physical presence in Indiana.” While Indiana’s revised law was clearly intended to expand the state’s ability to assert nexus for income tax purposes because the statute continues to lack a bright-line nexus standard, it remains subjective and prone to potential litigation. Nevertheless, Indiana is not alone in its approach. Other states have previously adopted similar standards, including Massachusetts and New Jersey. Interestingly, Massachusetts and New Jersey have since implemented factor-based nexus standards to complement (not replace) Constitutional nexus standards. While the clause “to the fullest extent permitted” by the US Constitution seems to imply that it is always taxable unless an exception applies, the language can make enforcement difficult to apply objectively.

With respect to the limitations of a state’s ability to impose a tax under a US Constitutional standard, the US Constitution contains two key provisions that courts have used to evaluate whether a taxpayer has sufficient nexus with a state – the Due Process Clause and the Commerce Clause. Under the Due Process Clause, there must be a minimum connection between a state and the person, property, or operation the state seeks to tax-a primary concern of Due Process in the notion of fairness.

The Commerce Clause requires a substantial nexus between the taxed entity and the taxing state, and the tax cannot unduly burden interstate commerce. In Quill v. North Dakota, 504 US 298 (1992), the Supreme Court held that physical presence was required to establish substantial nexus under the Commerce Clause for purposes of a sales or use tax. For many years, the issue of whether a similar standard could be extended to state income/franchise taxes was one of contention between taxpayers and taxing authorities. However, the Court indirectly addressed this issue in Wayfair by reversing the physical presence standard set in Quill. Accordingly, for income/franchise tax purposes, most tax practitioners will agree that physical presence is not a requisite to establish nexus.

In a post-Wayfair world, most businesses with an economic presence in a state, even when lacking a physical presence, will find that they may have income, franchise, or gross receipts tax filing obligations. These taxpayers, if they comply with Wayfair sales &use tax collection and filing obligations, will often be on a state’s radar for income/franchise and gross receipts taxes by virtue of filing sales &use tax returns. However, few protections from nexus may still be available. For taxpayers that sell only tangible personal property, if orders are sent outside a destination state for approval and goods are shipped from a point outside the state into the destination state, Public Law 86-272 may provide protections from income taxes. Note that Public Law will not protect a taxpayer from franchise or gross receipts taxes, as these are non-income-based taxes. Another potential protection that may be available is the Due Process Clause. This clause ensures that a tax is applied fairly. To that end, courts have held that Due Process requires that a taxpayer purposefully avail itself of a state’s marketplace before the state can assert a tax. In other words, a taxpayer that passively earns income in a state where the taxpayer performs no marketing activity and no customer outreach may be protected under the Due Process Clause since that taxpayer lacks purposeful availment with respect to the income it earned in the state. For example, a software-as-a-service (SaaS) provider that focuses its business activities on a customer in State A may find that State B will attempt to assert nexus using the argument that some of its services benefit the customer in State B. State B may try to estimate that benefit and assert an income tax using a population approach. In this case, the SaaS provider may raise a Due Process Clause defense since it does not perform any activities in State B to purposefully avail itself of that state’s marketplace.

Taxpayers operating multistate businesses, especially those impacted by Wayfair for sales and use tax purposes, should monitor their potential income/franchise and gross receipts tax filing obligations. The trend of moving toward a factor-based nexus standard will likely continue in additional states. However, even in states that haven’t adopted factor-based nexus standards, businesses should be aware that Wayfair has emboldened states to become more aggressive in asserting nexus.

Taxpayers that states have contacted regarding potential filing requirements should evaluate whether Public Law 86-272 or a Due Process Clause defense can apply. Your Marcum tax professionals are here to help.