If you have spent any time looking into sales tax regulations — and if you’re reading this, chances are that’s the case — then you’ve come across the word nexus before. It’s a seemingly simple word, but one fraught with nuance and importance. Anyone concerned about sales tax, whether their interest is personal or more academic, must understand what nexus is and what it’s about.
What Do We Talk About When We Talk About Nexus?
Conceptually, nexus is pretty straightforward: it’s a connection, a crossroads where divergent paths meet up and interact. For sales tax, that connection is between a business and a state (or really, with a tax jurisdiction, which can be a state, county, city, or other region — but at this point it’s simplest to just talk at the state level). When that connection — nexus — reaches a sufficient level, it becomes legitimate for the state to require the business to collect and remit sales tax.
This is actually a pretty basic concept with wide ranging application in law: Texas can’t ticket you for speeding in California, and Virginia can’t tax you for sales made in Missouri. (In other, legalese, words, nexus is a form of personal jurisdiction: a state can’t touch you when it comes to enforcing laws unless you’re close enough to the state where it can legitimately say you’re in its remit.)
So, having nexus with a state means that you’re presence or activities are connected to that state in a sufficient enough manner. When that nexus happens — and it can happen in a moment, without warning — the state can require you to collect and remit tax on all sales you make in that state.
You Keep Using The Word “Sufficient.” What Does That Mean?
Once we get the basic idea — that nexus is the connection between a business and state — we have to get more nuanced: what does that “connection” actually look like?
The current standard for what constitutes a “sufficient connection establishing nexus” is physical presence: a business must be connected to a state through some actual, direct, physical interaction with that state in order for the state to be able to impose a sales tax obligation on the business.
This standard comes from two pivotal U.S. Supreme Court cases from the last half-century. In the first, Complete Auto Transit, Inc. v. Brady, 430 U.S. 274, (1997), the Court determined that a nexus is required for a state to impose sales tax obligations. In the second, Quill v. North Dakota, 504 U.S. 298, (1992), the Court upheld physical presence as the standard for establishing that nexus and that ancillary activity in a state (for instance, using the state’s mail system to distribute catalogs and fulfill mail-orders to state residents from an out-of-state business location) did not qualify as physical presence.
These cases, and Quill in particular, have had ramifications on sales tax regulations across the country, especially as eCommerce has become an ever bigger part of the U.S. retail market (note that Quill was decided in 1992, two years before Amazon was founded).
Because eCommerce so often involves sales across state borders, where the seller has no physical presence in the purchaser’s state, the physical presence nexus standard has severely hampered states’ ability to collect sales tax on eCommerce sales. (Also note that sales tax is collected in the state where the sale is completed (i.e. delivered to), not the state from which the sale originates. If a seller in California delivers to Texas, the sale is completed in Texas, and so Texas law applies.)
As such, this has led states to get rather creative over the years in finding more business activities as creating physical presence in the state. This is all terribly critical for all sellers, but in particular online sellers who may be inadvertently establishing nexus in a number of states they weren’t aware of.
In the moment that a business meets a state’s physical presence threshold and nexus is established, that business is required to begin collecting sales tax on all their sales in the state. There is no warning, there is no fanfare, the business has to be its own watchdog. Cause if the state catches that a business is failing to collect sales taxes when it is obligated to, then the state can force payment of all back taxes owed, plus interest, plus penalties — a very expensive outcome for the business.
So What Does Constitute “Physical Presence” Nexus?
At its heart, “physical presence” means what it says. A business must have some actual, tangible connection to a state in order to have nexus there, either through its property or personnel. As per Quill, ephemeral connections to the state like merely using the postal system or contacting instate customers, is not sufficient.
Property: The paradigm for physical presence is a brick-and-mortar store: a business owns or rents property and frequently avails themselves of instate services, so clearly is physical present. But this can range a little bit, so that any property connected to a business in a state creates physical presence. So a business can have nexus where its corporate offices are, where its flagship store is, where any outlet stores are, or anywhere that property is held in their name.
Inventory as Property: However, a business’s property isn’t limited to just land and buildings, but also all of their inventory and equipment. This has had a big impact on Amazon Marketplace sellers, as all of their unsold goods are still their property. So an Amazon Marketplace seller then has nexus (and a sales tax obligation) wherever that inventory is being stored — even if it’s being stored by Amazon and the Marketplace seller has no control of where it is being stored.
Employees: A business can also be “physically present” in a state based on any employees, contractors, or other agents they have in a state. Again, the principle is that by employing people in a state, the business is availing itself of instate resources, which it can be obligated to pay taxes on. Businesses with many branches and divisions across the country should be very aware of this type of nexus, especially businesses with large force of salespeople spread out in different states — you’re one remote employee likely means you owe sales tax on sales made in that employee’s home state.
Affiliates: Businesses can also accrue nexus through any and all of their related organizations. Even if a corporation is compartmentalized into different divisions and legal entities, their baseline association can be enough for each to impart nexus on the others. Back in 2005, Borders Bookstore ran into this issue when California determined that Borders Online had to collect sales tax on its sales to the state because of its affiliate connection to the brick and mortar stores, even though the online entity was separately incorporated.
Click-Through: Some states have gone even further with affiliate nexus to say that any business connection between an out-of-state vendor and an instate service provider can create nexus. Such instate services can include customer referral businesses, customer services support, and assistance processing returns. New York pioneered this type of nexus, and several states, including California, Pennsylvania, and Illinois have since adopted similar rules.
Cookies: In 2017 Massachusetts introduced a novel form of nexus, which expanded on Click Through. Along with shoring up the type of instate services that can create Click Through nexus, Massachusetts determined that installing any packets of data on instate computers constitutes putting property in the state, which it deemed sufficient physical presence to establish nexus. (Such packets of data, or “cookies,” are nearly ubiquitous in any Internet activity, and are integral to, among other things, saving the contents of shopping carts and storing customer information.) So far no other state has followed Massachusetts, but odds are that won’t last long.
But I’ve Heard That Nexus Rules May Be Changing?
Pretty much ever since the Quill ruling, states have been complaining about how terrible the decision was. Local businesses railed against being soaked by out-of-state businesses who could offer “tax-free” sales, and the states themselves bemoaned the lost tax revenue. (That Use Tax would still apply to these sales, meaning the customer was supposed to make up the difference personally, is often overlooked, though that’s partly because Use Tax is almost never actually paid — but that’s all a story for a different day.)
As such, states have been looking to change the rules around nexus for decades. The way the Quill case was decided, this could come from two places: a decision by the U.S. Supreme Court to overturn Quill, or an act by Congress. Congress has been noticeably unable to pass a bill addressing nexus, so current efforts to replace Quill have been working through the courts.
And just in April, the Supreme Court heard oral arguments in the case South Dakota v. Wayfair. This case arose after South Dakota passed a law establishing what is called Economic Nexus, wherein a business would have a nexus connection to the state if it made more than $100,000 or 200 individual transactions in the state in a year, regardless of where the business was physically located. Since this directly contravened Quill, a court challenge was inevitable.
However, the oral arguments revealed how much uncertainty there is among the Court as to whether Quill is still good law or not — much of which reflected concerns by the Court as to the harmful impact that overturning Quill could have on small online sellers. This put some cold water on the general sense pre-oral arguments that Quill was doomed, and the only question was how far the Court would go. We should expect the Court’s decision sometime around the end of June 2018.
But even if the Court rules in favor of Wayfair, and keeps Quill in place, states are still doing everything they can to stretch physical presence nexus. This includes adopting new rules, like Click Through nexus and Cookie nexus.
Many states are following Colorado and passing what are called Notice-and-Report rules. Under these rules, all non-sales tax collecting businesses (i.e. any without nexus) selling over a certain amount in the state are required to send notices to their customers indicating that sales tax was not collected (and therefore the customer needs to pay use tax) along with an annual report to the state identifying their customers which residents the state should expect use tax payments from.
The alternative to this costly, and possibly embarrassing situation (after all, which business wants to tell customers that they owe more money on what they just bought), is to become a sales tax collector in the state. So nexus or not, states have ways to get their sales tax.
Sales tax regulation can get very tricky, and it always helps to have someone there to support you in dealing with states. Nexus (and this article) is just the tip of the iceberg; once you know where you owe tax, you’ll need to get licensed, begin collecting, and file everything correctly. And you can expect more articles from us on all these topics in the coming weeks.
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