Wayfair and Factor-Based Nexus for Income Tax: The New Two-Step

Wayfair and Factor-Based Nexus for Income Tax: The New Two-Step

You’ve likely heard the expression “waiting for the other shoe to drop.”  By some accounts, the origin of this phrase can be traced to early 20th century tenement buildings where bedrooms on one story were located directly atop those on the lower story.  You knew when your upstairs neighbor came home because you could hear her shoe drop.  This left you waiting for the sound from the drop of the other shoe.   

So it is with the application of economic nexus as validated by the 2018 SCOTUS decision in South Dakota vs. Wayfair, Inc.  At this time, reactive economic nexus rules among states that impose a sales tax is nearly universal.  Many states have simply adopted the particulars of the South Dakota statute as if it was model legislation.  Specifically, nexus exists if a putative taxpayer enjoyed annual sales volume of at least $100K or engaged in at least 200 transactions in the state during the year.  That’s the first shoe.

When the Court’s decision was young during the heat of summer in 2018, before the flurry of legislative activity, many practitioners noted that nothing inherent in the Wayfair ruling would preclude states from following the same principles for income tax that were laid out for sales tax.  There has been no shortage of speculation that states would quickly recognize this and begin generating similar rules for their income tax schema.  While it is somewhat surprising that this has not occurred, I’d caution anyone against thinking that their upstairs neighbor wears only one shoe.

Factor-Based Income Tax Nexus 

There’s nothing novel about applying economic nexus to state income taxes.  Since 1993 when SCOTUS declined to review the South Carolina Supreme Court decision in Geoffrey v. South Carolina, emboldened states have enacted a panoply of rules intended to exact more income tax from taxpayers with no physical presence.  A more recent iteration of this is represented by so-called “factor-based nexus.”

There’s nothing novel about applying economic nexus to state income taxes.  Since 1993 when SCOTUS declined to review the South Carolina Supreme Court decision in Geoffrey v. South Carolina, emboldened states have enacted a panoply of rules intended to exact more income tax from taxpayers with no physical presence.  A more recent iteration of this is represented by so-called “factor-based nexus.”

Today, only nine states impose factor-based corporate income tax nexus, including Massachusetts as of 2019. Massachusetts applies nexus for companies that have sales of $500,000 or more in the state.  Colorado’s guidelines are more typical – that state presumes nexus if the company has $50,000 in annual property or payroll, or $500,000 in sales, within the state. 

As applied by states, factor-based nexus generally represents a hybridization with physical presence nexus.  The property and payroll dollar thresholds are just plain old physical presence.  It is unclear why these provisions are even necessary, as no corollary exists:  when the subject amounts are below the threshold, there is no presumption that nexus does not exist. 

The sales volume threshold, on the other hand, is directly analogous to the economic nexus now being applied for sales tax by so many states.  Why, then, have we not seen more states enact factor-based nexus for income tax?  And, when might we see that begin to change?

Why Sales Tax? And Why Not Income Tax?

Clearly, economic sales tax nexus gives a lot more bang for the buck than would similar rules for income tax.  With the average sales tax in the US hovering between 8.5 and 9 percent, revenue can rack up quickly for states who enforce economic nexus to sales tax.  

Moreover, applying economic nexus for income tax doesn’t necessarily result in increased state tax revenue from every business caught in the net.  A company may be in a loss position, in which case it’s technical filing responsibility would not result in material additional tax revenue.  Similarly, credits or loss carryforwards may cancel out tax amounts.  Another factor may be that factor-based nexus for income tax has not yet been blessed by SCOTUS.  However, in the wake of the pandemic, as less exigent legislative concerns again surface, more states may consider applying factor-based nexus to income tax.  This seems reasonably likely, if only to help cover the shortfall from unforeseen COVID-related expenditures and lost tax income from the associated business downturn. 

The Second Shoe

Watch this space as more and more states look for ways to increase their tax base.   It will be critical for your company to plan ahead and anticipate the second shoe dropping as you develop proactive tax strategy planning.  

If you have questions about how this may affect your company, or if you want to learn more about nexus, Wayfair, and the ways different scenarios may affect your tax burden, contact our office

author avatar
Carl Roscoe

croscoe@gagnontax.com

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