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Income Tax Nexus 101 – Can That State Really Impose A Tax on My Company’s Income? Really?

Every company that operates in multiple states has the potential to have nexus issues in each state in which it is not filing an income tax return. 

What Is This Nexus of Which You Speak? 
Nexus is a connection between a taxpayer (such as a corporation, an S corporation or a partnership) and a taxing jurisdiction (e.g., a state such as Kentucky) that is constitutionally and statutorily sufficient enough for the taxing jurisdiction to impose on the taxpayer a tax (e.g., income tax) or an obligation to collect a tax (e.g., sales tax). The focus of this article is on income tax nexus. 

Basics of Computing State Income Taxes on a Multi-State Company 
To appreciate the role of nexus in the context of state income taxes, it is helpful to review the basics of taxing the income of companies that operate in multiple states. To this point, most states impose income tax on a company’s income in either one of two ways, which mostly depends on the type of company it is. A state can either impose the tax: [i] on the company directly (which is the most common way of taxing a C corporation) or [ii] on the income passed through to the owners of the company (which is the most common way of taxing a pass-through entity such as a S corporation, partnership, limited liability company taxed as a partnership, etc.). In the latter instance there is an additional issue of whether the state has nexus with the pass-through entity’s owners by virtue of their ownership interests. See, e.g., Revenue Cabinet v. Asworth, Corp. (Ky. App. 2009) (unpublished). 

When a company operates in and has nexus in only one state, that state will generally seek to apply its tax to all of the company’s income. When a company operates in and has nexus with multiple states, each state will seek to tax some portion of the company’s income, which is determined using an apportionment formula. In this regard, a company’s income can be thought of as a pie and the apportionment formula as the method for determining each state’s slice. 

Most states’ apportionment formulas are somewhat similar and somewhat different at the same time. This is because many states have adopted the Uniform Division of Income for Tax Purposes Act of 1957 (“UDITPA”) or patterned their income tax laws after UDITPA and then modified it. 

The formula UDITPA uses to apportion business income is an average of three ratios: property in the state divided by property everywhere, payroll in the state divided by payroll everywhere, and sales in the state divided by sales everywhere. As noted, many states have modified the formula. The most recent trend is to more heavily weight the sales factor (e.g., to double weight it as Kentucky has done); several states have taken this to the extreme by eliminating the property and payroll factors altogether and adopting a single sales factor. 

The apportionment factor is multiplied by a company’s income to determine what portion of that income is subject to tax by the taxing state, which must have the requisite nexus to impose that tax. 

Statutory Nexus Versus Constitutional Nexus 
First and foremost, a state’s income tax statutes must apply to impose tax on a company. For example, Kentucky has adopted a “doing business” nexus standard for purposes of imposing its income tax on business entities [see, e.g., KRS 141.040 & KRS 141.206]. What is meant by doing business is statutorily defined. See KRS 141.010(25). So, whether or not a company is doing business in Kentucky and thus has nexus with Kentucky is determined by reference to the statutory definition of the term, doing business. Reference can also be made to the Administrative Regulation concerning nexus, 103 KAR 16:240. 

For Kentucky income tax purposes, doing business includes: being organized under Kentucky law, having a commercial domicile in Kentucky, owning or leasing property in Kentucky, having individuals performing services in Kentucky, maintaining a pass-through entity doing business in Kentucky, deriving income attributable to sources within Kentucky, or directing activities at Kentucky customers for the purpose of selling them goods or services. See KRS 141.010(25). 

The United States Constitution sets limits on how far a state’s nexus statutes can reach. The Due Process Clause requires a minimum connection, and the Commerce Clause requires a substantial nexus. The United States Supreme Court last addressed the issue of nexus, in a sales and use tax case, Quill Corporation v. North Dakota, in 1992. Quill requires a nexus in the form of the taxpayer having at least a physical presence, i.e., property or payroll, in the taxing state. 

Federal Statutory Nexus Limitation - P.L. 86-272 
Congress can and has exercised its powers under the Commerce Clause to limit states’ authority to impose income taxes. Public Law 86-272, 15 U.S.C. §§ 381 to 384, prohibits a state from imposing an income tax provided that the only business activities within that state are limited to the solicitation of orders from customers and prospective customers for sales of tangible personal property that are sent out of state for approval or rejection and if approved, are filled by shipment from a point outside the state. 

Observe that P.L. 86-272 applies only to sales of tangible personal property (i.e., stuff) and not to services. Also note that the orders must be approved and filled from out of state. 

The Kentucky Department of Revenue’s position regarding the application of P.L. 86-272 is set forth in 103 KAR 16:240. That Regulation mentions the leading U.S. Supreme Court case regarding P.L. 86-272, Wisconsin Department of Revenue v. William Wrigley, Jr., Co. (1992). It is often useful to review Wrigley when looking at a P.L. 86-272 issue. 

Current Trends – Economic Nexus and Factor Threshold Nexus 
One relatively recent trend is for states to take the position that for income tax purposes, a physical presence in the state (à la Quill) is not necessary for nexus; rather, nexus can be based on directing activities at customers in the state. This is often referred to as economic nexus. For example, in Capital One Bank v. Commissioner of Revenue (Mass. 2009), the Supreme Judicial Court of Massachusetts held that an out-of-state bank issuing credit cards to Massachusetts residents had nexus with that state. 

Another developing trend is for states to enact so-called factor threshold nexus statutes. Under such a scheme, a company would have nexus if it had property, payroll or sales that exceeded the statutory threshold such as $50,000 in property or payroll or $500,000 in sales or a taxing state sales factor of 25% or more. The constitutionality of such an approach has not been settled. 

Qualitative and Quantitative Approach to Analyzing Nexus Issues 
One approach to analyzing nexus issues is to examine a company’s contacts (or lack thereof) with a state. This can be done by reference to a state nexus questionnaire such as, for example, Kentucky Department of Revenue Form 41A800, Corporation and Pass-Through Entity Nexus Questionnaire. 

Also, because apportionment determines how much income is apportioned to a state for income tax purposes and the traditional apportionment factors are often indicative of the potential for activity in a state, this same information can be used to gauge the potential for nexus issues as well as their scale and scope. In this regard, it can be helpful to review the states in which a company has property (owned and rented), payroll (especially unemployment wages) and sales (where the company’s customers are and to where its products or services are delivered). 

Resolving Nexus Issues 

Tax practitioners are often left with their predecessors’ determinations regarding nexus. So, what do you do when you discover a potential nexus issue? First, quantify it. Next, analyze it to determine and provide support for the basis for the company’s position. Consider getting assistance from someone knowledgeable in nexus matters.

If it is determined that the company has or may have nexus with a state or multiple states in which tax returns were not filed, consider resolving it via a voluntary disclosure program, which many state departments of revenue offer. It is often best to do this anonymously through tax practitioner. Amnesty programs authorized by statute are another option, though these are only available sporadically when enacted by the applicable state legislature. There are many options. 

“Nexus, huh?” Hannibal Chew in Bladerunner (1982) 
The concept of nexus can seem incomprehensible at first. But, understanding the basics is a great start to appreciating the finer points of nexus.



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