Introduction and Overview to Nexus
The terminology “nexus” has numerous definitions and applications but where technology is concerned, this is a standard debugging interface for a number of embedded systems. In the most general of terms, nexus is defined as a connection. However, the terminology also applies to tax laws in which a business maintains a physical presence in that particular state. It is subject to the taxes of the state that the company is operating in and applies to the taxes on sales made by that company in that state.
The different states in the US are able to tax business entities because of the way in which a nexus defines and describes the amount of business activity, as well as the degree of it that must be present before business taxes apply. If a business/taxpayer in a particular state has nexus, the business/taxpayer is obligated to charging, collecting, and remitting taxes in that particular state. So what determines nexus? Nexus is determined for income and sales tax purposes although the determination is different for each type of tax.
Where income taxes are concerned, nexus is normally created if the business entity is deriving income from any one of the following sources:
- employs personnel in that state for reasons other than mere solicitation activities
- has capital or owns property within the state
- leasing and/or ownership of property within that state
- other state sources
Where sales taxes are the issue, there is a looser determination. Sales tax nexus applies to a business in a state where:
- the business has a physical location in that particular state
- the business owns property whether intangible or tangible in that state
- the employees of the business have a physical residence in that state
- the employees of the business solicit business in that state
The issues regarding a business having a nexus in their home state and therefore subject to that state’s taxing authority are extremely complex. Additionally, each state views the nexus concept differently. In the past, a state nexus established for tax purposes required that the business had a physical presence within that state
The case of Quill v. the State of North Dakota
This was a US Supreme Court case (504 U.S. 298 – 1992) that concerned state use taxes. The Quill Corporation, a retailer of office supplies, had no physical presence in the state of North Dakota, specifically a land-based location and a sales force. However, they did make a licensed software application available to North Dakota business customers so that those entities could check their inventories and order office supplies directly form the Quill Corporation. The state tried imposing a use tax on the corporation, but the Supreme Court overturned it.
Additionally, the North Dakota Tax Commissioner demanded that Quill collect and pay use taxes on any sales that were shipped into the state. Initially, North Dakota’s Supreme Court upheld this particular statute. The US Supreme Court’s opinion countermanded the state court’s decision. Arguing under due process of law, the North Dakota court ruled that the Quill Corporation had established a “physical presence” within state boundaries because the software applications were being shipped into the state.
As a result, the US Supreme Court ruled that in order for a state to impose a tax on a business entity that was conducting interstate commerce within the state of North Dakota, the business needed to have what was referred to as a “substantial” nexus within the state. The US court ruled that this test had to be distinguished from the test of due process where “minimum contacts” were concerned.
The court also noted that any state’s taxation is not governed by due process and is governed only by what is known as the “dormant commerce clause.” This was further clarification that businesses can have minimum contacts even though they did not have a substantial nexus. Citing previous “substantial nexus” court cases, the Supreme Court determined that contact by common carriers, mail, and telephone calls does not constitute a substantial nexus, therefore overruling the decision of the state Supreme Court.
So how did this case actually impact business owners throughout the US? Had the Supreme Court ruled in the state of North Dakota’s favor, it would have completely altered the way in which tax collection responsibilities were imposed. Not only this, but it would have impacted businesses by increasing their compliance burdens. Since the US Supreme Court ruled in Quill’s favor no significant changes were made in the way in which business collected use taxes.
Reduce your overhead and improve your profitability
Industry and tax experts alike will usually tell you that sales and use taxes (along with property taxes) are a tremendous source of revenue for the individual states that impose them. Conversely, the compliance issues have become a steadily growing burden for business entities. If you are curious about this issue where your business is concerned, you should ask yourself the following questions:
- Am I confident that I am in total compliance?
- Do I know if I am overpaying or underpaying these taxes?
- Are my staff members overextended and/or do they have the expertise and experience necessary?
- Should I hire full-time personnel in order to process my cyclical tax issues?
- Have I recently been scheduled for an audit or do I lack the necessary resources for managing things properly?
- Is there a way that I can improve my bottom line by reducing both headcounts and overhead while at the same time finding revenue to put in the company’s profits?
- Could I use some help with the processes I am currently using or should I just consider outsourcing these different processes?
The issue here is having the ability to manage your sales and use tax processes properly while at the same time ensuring that you are in total compliance with the state’s laws so that you are reducing your overhead expenses and increasing your sales and profitability at the same time.
Managing sales and use taxes
There are roughly 8,000 local and state tax rates as well as thousands of annual changes made by the different states which create a huge challenge for businesses during normal times where small to mid-sized companies are concerned. As many states are being challenged by increasing deficits, they are continually searching for ways in which to increase their revenues to offset this. As a result, they focus on increasing their sales and use tax base by raising existing rates.
The impact that results promises to make the compliance to sales and use tax laws that much more complex. Many states have implemented the taxing of internet sales on those companies that have affiliates in that state’s jurisdiction. Most of them are creating new items and services that are now subject to sales and use tax while at the same time reversing the exemptions to these laws. As these changes tend to be cyclical in nature, many of them will be reversed once business begins to improve.
The states are becoming increasingly more aggressive as a result and what has happened recently is that many have hired auditors for not only reviewing previous tax returns, but to look for smaller and mid-sized companies that are operating within the states without being registered to operate there. Many of these companies are searching for hosted services to handle these issues because they cannot afford the additional expense of hiring their own auditors or tax professionals, or they are completely outsourcing this.
Sorting through the confusion
Suffice it to say, there is a lot of confusion for businesses to sort through when they do not have a physical location in a particular state and trying to determine whether or not to charge sales and use taxes. The issue is determining how to simply its nexus for these tax purposes and whether or not they should establish a physical presence within that state. If they do establish that physical presence, then the nexus is clearly established and they have to collect state sales taxes.
However, this isn’t always the reality or a plan that relates to internet-era businesses. Businesses without this physical presence but have clients or customers there will be challenged with knowing whether or not they are required to collect these taxes. Needless to say, this has led to a lot of confusion and uncertainty as well as determining the types of improvements they need to make in order to solve their dilemma.
For any state to impose sales and use tax (hereafter referred to as SUT), the vendor must have a nexus established with that particular state. Remember that a nexus is the actual connection that is established between the state and its vendors. Additionally, it should be noted that subjecting these vendors to the state’s Sales and Use Tax laws is not going to harm interstate commerce in any way or be unfair to those vendors. This stems from the commerce clauses of the US Constitution and the due process of law.
Since Quill v. North Dakota (see above), the challenge has been how to determine the amount of a physical presence is necessary as well as what type of presence is necessary to having a substantial nexus in the state. The US Supreme Court basically ruled that the software applications being shipped to customers of the Quill Corp. and residing in North Dakota did not constitute what they defined as substantial nexus.
Determination of physical presence
First and foremost, the determination of a physical presence differs from one state to the next, hence the confusion that oftentimes results for online businesses that have land-based operations in some states but only an internet presence in others. In addition to this, the defining line between slight and substantial physical presence varies from state to state as well and can be vague with some states.
It is not uncommon to see court cases arise between the states and the US Supreme Court (e.g. Quill v. North Dakota) because of dissenting opinions between these two court entities. What is interesting is the fact that even though a business may have a physical presence in two separate states, they may have to charge and collect sales and use tax in one but not the other. A prime example of this occurred several years ago when a land-based bookseller launched a company website in order to expand their business and increase their sales.
At that particular point in time, there were separate legal entities formed that applied to online businesses in order to reduce the amount of physical presence and therefore reducing their obligations where charging and collecting SUT was concerned. These online entities shared the same name with the physical ones which also handled customer returns for both types of businesses. Ironically, a Louisiana ruling in the case of St. Tammany Parish Tax Collector v. BarnesandNoble.com concluded that the online entity had no substantial nexus.
Conversely, two years prior to the Louisiana decision, the state of California ruled just the opposite in the case of Borders online, LLC v. BOE, 29 Cal Rptr. 3d 176. The Louisiana case was based on the fact that the St. Tammany Parish Tax Collector reasoned that both the online and physical presence had:
- cross-promotional advertising
- preferential product return treatment was the same for both entities
- similar gift card and membership programs
Currently, the determination of physical presence from one state to the next will always differ and typically results in court cases similar to the ones mentioned above as well as Quill v. North Dakota.
Why is this confusion such a problem?
The problems created by this confusion typically result in misinterpretations by a company when they feel that there is no determination of a physical presence even though there is. As a result, if the company is in the wrong where this is concerned, they will be subjected to taxes, penalties, and interest. Conversely, should that error be made on the side of caution and the company charges and collects sales and use tax when it wasn’t necessary, then it is incurring unnecessary compliance costs.
Customers are oftentimes unaware of the fact that if they are not charged sales taxes that the company has higher prices than the competitors who do not collect sales and use tax. In addition to this, companies have to spend a significant amount of time reviewing both their business operations and their relationships with their clientele. They also have to review the laws of every state where they have customers in order to determine if they have established substantial sales and use tax nexus.
Since there is the possibility that they may not achieve any certainty in this matter, this leads to further consequences there will be additional confusion resulting from special state laws where the physical presence criteria is ignored or overlooked. This includes activities such as trade show participation. However, once again, the laws will differ between the states, which are not always clear, and usually leads to evolving interpretations of Sales and Use Tax laws.
Solving the Nexus and sales tax problem
So what are some of the possible solutions to this dilemma? First of all, SUT laws and nexus requirements need to be clarified so that they can be defined and understood as easily as is humanly possible. Another possible solution involves the creation of state checklists that allow these businesses to accurately determine if they have a state nexus under the Quill v. North Dakota standards and that particular state’s Sales and Use Tax laws.
Furthermore, if the results of the checklist indicate that a physical presence does exist, then the state tax agency should be required to assist those businesses in the collection of those taxes. As an example, let’s say that a company only has an internet presence and not a physical one. The state should also allow that business to place a link on their website so that if one of their customers pays using their credit card that they are charged for the purchased goods and are also charged for the applicable Sales and Use Tax (SUT).
This does two things. First of all, this eliminates the vendor having to file and secondly, it reduces the cost of compliance and credit card fees. On the other hand, should no physical presence be indicated by that vendor checklist the state should create a safety mechanism in order to ensure that those customers do pay use taxes. Another spin-off on this is that the state could require that vendors who do not have a physical presence are required to place a note on their website indicating that they do not collect Sales and Use Tax in that state and therefore, it is the responsibility of the customer to report the use tax on their purchases.
Should vendors comply with these requests listed above, then they should be relieved of any future liabilities that may result due to a tax audit arising because of a non-fraudulent error that they may have made when completing the aforementioned checklist. There are currently several states that have adopted uniform Sales and Use Tax laws. The hope is that the Quill v. North Dakota decision will eventually be reversed for these states in order to allow the collection of Sales and Use Tax from vendors who do not have a physical presence in that state.
However, not all of the states have adopted this uniform law as prescribed in the Streamlined Sales Tax Project which was originally organized 10 years ago with the goal of modernizing and simplifying the collection of Sales and Use Tax as well as the administering of this in the US. This developed as a response to congressional efforts to permanently prohibit the states from collecting sales taxes relative to online commerce transactions.
It is unfortunate that not all of the states have adopted the concept and there is the possibility that some never will. As an alternative, the US Congress could exercise its legal authority under the US Constitution’s commerce clause in order to provide consistent and uniform guidance for Sales and Use Tax (SUT) nexus. This could solve the issue of not all of the states adopting the concept of uniform laws prescribed by the Streamlined Sales Tax Project.
Taxpayers in the US today must have a substantial nexus with any state before the state tax authority can require the taxpayer to be in compliance with their specific laws. The taxpayer who has a nexus with any state may incur obligations to that state’s tax authority where collection, compliance, and remitting SUT is concerned. Let’s face it, as a small to mid-sized business owner, you are already being confronted with tax issues and the nexus issue is just adding fuel to that fire.
The primary reason that this has become the major issue that it has is because of the instability and uncertainty that currently exists with the US economy. Additionally, many US states today are literally broke and have a deficit where their budgets are concerned. The US Government has numerous venues for raising revenues or putting it in more simpler terms, ways in which to increase cash. The states don’t have currency printing presses like the US Mint does so they have to rely on a single stimulus – namely you, the taxpayer.
The primary problem is that we are left with a situation wherein there are 50 different versions of sales tax nexus information and physical presence definitions. At least this seems to be the case, though it may not be entirely. For the most part, that physical presence we discussed at great length above is required in some form or another in the 50 states in order for a business to have nexus in them.
Physical presence is basically defined as employees, fulfillment services, or offices in within the states in order for that to exist. The downside is that states are continually implementing new rules and regulations all the time where this issue is concerned, which just clouds the issue that much more. Just remember, once the state reasons that you have nexus, you are ultimately responsible the charging, collecting, and remitting of Sales and Use tax to that state’s tax authority.
Another possible solution where the nexus and sales tax dilemma is concerned might be the use of our “Shop by Phone” venue that our company developed and patented through the US Patent Office several years ago. We created this venue so that clients could acquire products in point-of-sale fashion. Additionally, we become the merchant at the point-of-sale and are therefore responsible for the nexus and the collection of sales taxes.