Not Flat: State Income Tax Nexus

Ease of cross-border business activity has led to what Thomas Friedman describes as a flat world. However, our quagmire of state nexus rules leaves domestic commerce in a non-flat world.

June 26, 2008
by Annette Nellen, CPA/Esq.

PL 86-272 provides that if the only in-state activities a business has is the solicitation of orders for tangible personal property that is approved and filled from outside the state, the state may not impose a net income tax on the business. States set the rules, within due process and commerce clause constraints of the U.S. Constitution, for businesses that sell services or intangibles.

States tend to take broad approaches. A 2007 Illinois Department of Revenue ruling notes that "as a general rule, the Department interprets the concept of nexus as broadly as possible (No. IT 07-0033 (PDF), September 2007)."

Below, we'll review recent income tax nexus rulings and proposals for improving guidance.

Selected Developments

In May 2008, the Oregon Department of Revenue (DOR) adopted Rule 151-317.010 (PDF) to clarify that a corporation can have substantial nexus in the state for corporate excise and income tax purposes without having a physical presence there. "Substantial nexus exists where a taxpayer regularly takes advantage of Oregon's economy to produce income for the taxpayer and may be established through the significant economic presence of a taxpayer in the state."

To determine if substantial nexus exists, the DOR may look at the regularity of contacts in the state, deliberateness of marketing to Oregon customers, and significant gross receipts from Oregon customers or from the use of intangible property in Oregon. Also relevant is whether the business is protected by Oregon laws, has court access, uses state roads, benefits from Oregon's educated workforce, or receives "police and fire protection for property in Oregon that displays taxpayer's intellectual or intangible property."

In Florida Technical Assistance Advisement 07C1-007 (October 2007), the DOR held that a financial services firm providing various services to retailers in Florida had substantial nexus for income tax purposes despite lack of a physical presence. For example, T, licensed with the Florida Department of Financial Services, has a number of authorized retailers in the state.

The DOR relied on Wisconsin v. J.C. Penney Co., 311 U.S. 435, 444 (1940): the "simple but controlling question is whether the state has given anything for which it can ask return." Florida had provided T a license, access to Florida laws and courts, and "an orderly and regulated marketplace." T would not be able to operate in Florida without its retailers and made "purposeful direction towards the Florida market."

The DOR applied the tests of Complete Auto Transit, Inc., 430 U.S. 274 (1977) to determine that the commerce clause posed no problem.

The DOR relied on cases from other states that held that the physical presence standard of Quill (504 U.S. 298 (1992)) does not apply for income tax purposes. It also noted that the U.S. Supreme Court had declined to hear a state case on this issue. The DOR found these cases to be "persuasive, especially given the fact that the U.S. Supreme Court declined to hear the cases." While not mentioning the cases, the DOR was likely referring to MBNA, 640 SE2d 226 (2006) and Lanco, 188 NJ 380 (2006), cert. denied (June 2007). In these cases, the courts held that for commerce clause purposes, a "significant economic presence test" was appropriate to determine if a business had a substantial nexus in a state for income tax purposes (MBNA).

A 2008 ruling by the Virginia Department of Taxation (DOT) reminds us that nexus may not be a concern if the business has no income apportioned to the state. In Ruling No. 08-63 (May 2008), a credit card company headquartered outside of Virginia sought guidance on whether it had nexus for income tax purposes. The company had no property or employees in the state. From outside of the state, the company used mail, telephone and Internet ads to solicit credit card customers in Virginia.

Per the ruling, a corporation can have Virginia source income if it has sufficient business activity in-state such that the apportionment factor is positive. The ruling avoided the nexus issue by noting that even if the company has nexus, it is unlikely to have income apportioned to Virginia. With over 70 percent of the company's income derived from interest and credit card processing fees, it is a financial corporation which, under Virginia law, must apportion income using a cost of performance measure. Without property or employees in the state, the costs of performance occur elsewhere.

Similarly, a 2008 Nebraska ruling (24-08-1) stated that trucking companies without a business location in the state that use Nebraska roads are subject to income tax. However, if a company's Nebraska activities are de minimis, it need not apportion any income to the state and thus owes no income tax.

In Nebraska a trucking company must apportion income to the state if the company "owns or rents any real or personal property in this state, other than mobile property; makes any pick-ups or deliveries within this state; travels more than 25,000 mobile miles within this state or the total mobile miles within this state exceed three percent (3%) of the total mobile miles traveled in all states; or, makes more than 12 trips into this state."


These rulings illustrate challenges some companies face in determining where they owe income taxes. Businesses not covered by PL 86-272 must review the law in every state in which they have customers, employees, agents or any activity. Where it has any physical presence, it must review the law to determine if it is enough (for example, how many miles its trucks drove in the state). Even without physical presence, it must determine if it derived some benefit in the state (for example, a sign displaying a trademark) or generated more than de minimis receipts.
If the company determines it has nexus, it must review the state's apportionment rules to determine if any income is taxable.

Lack of uniformity among states generates uncertainty and costs for businesses.


S 1726 and HR 5267 (110th Congress) would expand PL 86-272 to apply also to services and intangibles. They require a physical presence for a business to be subject to income tax. The bills generally define physical presence as including employees, an exclusive agent or tangible property. Presence of less than 15 days or to conduct limited or transient business activity is ignored.

Congressman Rick Boucher (D-Va), a co-sponsor, suggests that this approach will "not diminish the ability of states and localities to collect tax revenue … [but instead] rationalizes and makes more predictable the process of doing so. (Cong. Rec. February 2008, E137 (PDF))" In February 2008, the House Small Business Committee held a hearing on tax and nexus issues small businesses face that "significantly inhibit their ability to engage in commerce."

On another front, National Conference of Commissioners on Uniform State Laws (NCCUSL) appointed a drafting committee to review the Uniform Division of Income for Tax Purposes Act (UDITPA). The committee's rewrite work could include nexus.

Uniformity among states will not be guaranteed through a UDITPA revision because states are not required to adopt the act, although Congress could provide some incentive for doing so. Federal legislation would provide uniformity, but agreement among legislators, states and businesses on what that uniformity should be remains elusive (see links).


Reaching a flat world in U.S. commerce depends on reaching appropriate nexus rules that enable businesses to easily engage in domestic commerce and for states to have the resources to serve the needs of citizens and businesses.

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Annette Nellen, CPA, Esq., is a tax professor and Director of the MST Program at San Josť State University. She is also a fellow with the New America Foundation. Nellen is an active member of the tax sections of the ABA and AICPA. She is a member of the AICPA's Individual Taxation Technical Resource Panel. She has several reports on federal and state tax reform and a blog.