June 3, 2010

Sales and Use Tax Nexus

By Camille Mule, Manager -

Sales and Use Tax Nexus

As a State and Local Tax (“SALT”) Manager I field client’s multi-state sales and use tax questions on a regular basis. By far, the single most asked question concerns nexus. As a business owner you should be concerned about nexus as it relates to sales and use tax.

What is sales and use tax nexus?
Nexus can be defined as a seller’s minimum level of physical presence within a state that permits a taxing authority to require a seller to register, collect and remit sales and use taxes. Whether a state can require an out-of-state seller to comply with its sales and use tax law is determined by a combination of federal and state laws.

The United States Constitution limits what states can do in determining whether a business has nexus in their state. The Due Process Clause establishes a minimum connection requirement, while the Commerce Clause provides a substantial nexus requirement. If a sufficient connection, or nexus, exists pursuant to federal requirements, then a state must show that a business is “doing business in the state” in order to require collection and remittance of sales and/or use tax.

Nexus cases have been in the courts dating back to the 1940’s and are still being heard today. The most well known case is a U.S. Supreme Court case, Quill Corp. v. North Dakota [504 U.S. 298 (1992)]. In Quill, which remains the standard for sales and use tax nexus today, the issue of when a state can impose a sales and use tax collection responsibility on an out-of-state retailer was decided. Quill was a mail order vendor of office supplies with customers located in North Dakota. The company had no locations or employees located in the state and all deliveries were via common carrier. However, Quill did provide computer disks to some customers in North Dakota for the purpose of checking inventory and ordering supplies.

On these facts, the Supreme Court ruled that Quill’s presence in the state of North Dakota did not meet the substantial nexus requirement of the Commerce Clause. In addition, the Court ruled the company’s practice of mailing computer disks into the state was a de minimis contact. De minimis activities are those that only establish the “slightest presence” in a taxing jurisdiction. This “slightest presence” is not sufficient to satisfy the standards of substantial nexus. Therefore, in order for a state to require a business to register for sales tax purposes, the company must have more than a de minimis physical presence in the state. To this day, many believe that the problem with the Quill ruling was that the Supreme Court did not go far enough in defining what constitutes substantial nexus. To determine what constitutes substantial nexus one must now look further to state and local rules and cases, which only adds more confusion to an already difficult area of state and local taxation.

In recent years, courts have held that a business – even if it has no physical location in a state – may, under certain circumstances, be liable for collecting sales tax on all goods shipped into that state. An example of this concept is New York State’s expanded definition of what constitutes a vendor for sales and use tax purposes as found in N.Y. Sales Tax Law 1101 (b)(8)(vi) (enacted in June of 2008). This law, often referred to as the “Amazon Tax”, establishes a rebuttable presumption that certain out-of-state Internet retailers with no physical presence in New York may be deemed vendors for New York State sales and use tax purposes if certain conditions apply. These requirements are satisfied if there is an agreement with a New York resident to refer customers to the online retailer by virtue of a link on the resident’s Web site, for a commission, and the arrangement generates over $10,000 in annual sales. In such instances, the online retailer is presumed to be soliciting business in the state through in-state representatives. They must then register for New York sales and use tax and collect sales tax where due. Although in direct contradiction to the ruling issued in Quill, companies such as Amazon are complying to avoid serious penalties. Several lawsuits have been filed – Amazon.com, buy.com and overstock.com to name a few, but so far New York State has prevailed. Based upon New York’s success, other states now require out-of-sate Internet retailers to comply with their sales and use tax laws.

What are sales and use tax nexus creating activities?
In general, nexus can be created in various ways:
  • In-state employees
  • Sporadic employee visits
  • Attending trade shows and seminars
  • In-state deliveries made by one’s own truck
  • Physical presence of property even temporality
  • Affiliate nexus; volunteers, agents, independent contractors
  • Internet nexus i.e., NY’s new “Amazon Tax”
  • Incidental ownership of property
  • Voluntary registration or incorporation

One must be aware of all nexus creating activities in each state where they conduct business, as the rules vary from state to state.

What is meant by “Doing business in the State”?
Before a state can require an out-of-state business to collect and remit sales tax on sales within the state, it must be able to show that a connection or nexus exists with the state. As mentioned, both federal and state law set forth the guidelines for the establishment of nexus.

If a connection or nexus exists pursuant to the federal requirements, then a state must show that a business is “doing business in the state” in order for the state to require collection and remittance of the sales and/or use tax.

Although each state has its own definition of what constitutes doing business, some general rules apply. Most state laws include in their definition of “doing business in the state” persons who regularly or systematically solicit business either by employees, independent contractors, agents or other representatives or by distribution of catalogs or other advertising matter. It is important to know the rules in each state where your company conducts business.

How does nexus for sales and use tax purposes differ from nexus for income tax purposes?
When a state seeks to impose an income tax on a multistate business, it faces the same constitutional constraints as exist for sales tax purposes. However, a business does have a bit more protection under Public Law 86-272, which applies when a non-resident company’s sole activity within a state is the presence of individuals soliciting sales. The statute provides that if the activities are limited to solicitation only, with no authority to accept or reject orders, then income tax nexus does not exist. It is important to note that this law only applies to the sale of tangible personal property and not to services.

Sales tax is a ready source of revenue for every state government. It is estimated that over 50% of states rely on sales tax for more than 25% of their total revenue. Today with online sales exploding, and states in dire need of new revenue sources, they are all looking to capture sales tax revenue lost by not taxing online sales. It is estimated that nearly $2 billion in sales tax is lost annually due to online sales. Requiring Internet retailers to collect sales tax is an easy way to reduce state budget shortfalls in this depressed economy. Most states require their residents to report use tax due on online purchases where sales tax was not paid at time of the purchase. But, it is clear that the honor system is not working.

To further address the problem of sales tax loopholes and outright avoidance, states are joining together to share information and resources. They are aggressively forming nexus teams to help identify nexus audit candidates, while conducting more audits than ever before. As states evolve to keep up with the world of online commerce, businesses need to evolve too. Whether you sell taxable items online across state lines, or purchase items online from out-of-state retailers, you must know the sales and use tax consequences of your activities in each state you do business in.