Evolving Tax Nexus in a Changing Business World
The growth of America’s service sector as well as the rise in remote work during the pandemic raises important tax questions for companies that are active in multiple states.
With no national standards, the issue was complex enough when companies had operations and contractors in other states. But now that many organizations have remote-working employees in different jurisdictions, it becomes even more difficult. And state-specific guidance has been hit or miss.
Nexus—The Basic Question
The term “nexus” is used to describe a situation in which a business’s presence or activities in a state make it subject to that state’s tax laws. In the past, the most common factor for determining nexus was a company’s physical presence in a state. States were generally prohibited from imposing tax requirements on a company that was based out of state, even if the company sold its products within the state.
As online sales grew, many states began asserting that physical presence is not the only way to establish nexus. In several court cases they argued successfully that nexus could also be established if a company has a significant economic presence in a state, regardless of whether it has physical facilities there.
Moreover, the shift to a service-based economy has generated even more fundamental changes. In many instances, the nexus standards that states apply to the sale of tangible, physical products are different from those they use to determine nexus for service-oriented businesses.
As a result, determining nexus has become more complicated. Not only do today’s rules vary from one state to another, they also may vary within a state, depending on the type of tax being collected. For instance, the nexus rules for requiring a company to collect sales taxes may differ from those used in determining if it has a state income tax liability.
Apportionment—Who Gets What
In addition to how they determine nexus, states are also changing how they determine what portion of a service-based business’s taxable income should be subject to their corporate income tax. Historically, states used what was known as the cost-of-performance method, in which taxable income was apportioned to the state where the company performed the majority of its income-producing activity.
As the basis of the economy shifted toward the sale of services, many states began developing new apportionment formulas that would enable them to tax out-of-state service providers for sales within their borders. These new approaches, known as market-based sourcing, allocate taxable income—and the company’s relevant tax obligations—to the state in which the benefit is received or the service is used, rather than the state in which the value was created.
Further complicating things, states use different methods to evaluate how taxable income is apportioned. Some states use a three-factor method, which considers a company’s sales, payroll, and physical assets, but most are now moving toward a single-sales-factor approach, which apportions taxable income solely on the basis of sales.
The Search for Consistency
The goal is a consistent, easy-to-apply approach that works across state lines. That is the mission of the Multistate Tax Commission, and it has made progress, but the situation is far from ideal. We’re still a long way from a true nationwide standard.
That leaves businesses stuck in what can be a frustrating and time-consuming process of trying to match a specific approach and strategy to each state. With the service sector growing and the remote-work landscape forever changed by the pandemic, businesses will soon have to choose between navigating the tax and withholding situations themselves, or retaining expert accountants with multistate expertise to avoid government scrutiny and minimize their tax burden.
Get in touch with the experts at Dembo Jones for insight on tax nexus implications on your business and the proper steps to take.