Multistate Income Tax: Simplifying the Complexities

• Chapter 0 - Overview
  • Course Objective
  • Introduction
  • Why a National Multistate Income Tax Course?
    • Who Should Take This Course?
    • How Your Business or Practice Will Benefit
  • Tax Formula for Multistate Corporate Taxpayers
  • Irregular Corporate Tax Structures
    • Michigan
    • Ohio
    • Texas
    • Washington
    • Capital Stock and Franchise Taxes
    • Conclusion
• Chapter 1 - Interstate Activity and Nexus
  • Learning Objectives
  • Introduction
  • Nexus Defined
    • Due Process
    • Commerce Clause
    • Public Law 86-272
    • The Continuing Questions about Nexus
• Chapter 2 - Calculation of State Taxable Income: Modifications
  • Learning Objectives
  • Introduction
  • Additions
    • American Recovery and Reinvestment Act of 2009
    • American Jobs Creation Act of 2004 (the Act)
    • Depreciation, Depletion, and Amortization
    • Related Party Royalty and Interest Payments
    • State and Municipal Interest Income
    • State Income Taxes
    • The Federal Net Operating Loss
  • Subtractions
    • Deduction for Federal Income Tax Paid
    • Deduction for State Income Taxes Paid
    • Expenses Related to Nontaxable State and Municipal Interest Income
    • Interest Income Earned on Federal or U.S. Obligations
    • Refunds of State Income Taxes
    • Deductions Disallowed by Federal Credits
    • Dividends Received Deduction (DRD)
  • Appendix - Multistate Tax Commission - Model Statute Requiring the Add-back of Certain Intangible and Interest Expenses
• Chapter 3 - Filing Methods for Multistate Taxpayers
  • Learning Objectives
  • Introduction
  • Separate, Consolidated, or Combined Filing
    • An Incredibly Simplified Example
    • Combined Reporting
  • The Landmark Cases
    • The Three Unities Tests
    • The Contribution/Dependency Tests
    • Factors of Profitability Test
    • Taxpayer Victories
    • Flow of Value Test and Worldwide Combination
    • Should the Unitary Business Principle Be Abandoned?
    • Pulling It All Together
  • Multistate Tax Commission
• Chapter 4 - Apportionment and Allocation
  • Learning Objectives
  • Introduction
  • Current Rules
    • Business versus Nonbusiness Income
    • Two Tests or Three
    • Attempts to Define Business versus Nonbusiness Income
    • Problem Areas
    • Gains and Losses from Real or Tangible Personal Property Dispositions
    • Patents, Copyrights, and Trademarks
    • Interest Income
    • Income from Stock Sales
    • Dividend Income
    • Other Income
    • Section 338(h)(10)
  • The Hercules Cases
    • Illinois
    • Kansas
    • Maryland
    • Minnesota
    • Utah
    • Wisconsin
  • The Supreme Court - Once Again
• Chapter 5 - Apportionment Formulas and Factors
  • Learning Objectives
  • Introduction
  • Payroll, Property, and Sales Factors
  • The Payroll Factor
  • The Property Factor
    • Property Included in the Factor
    • Property's Value
    • Computational Problems
  • The Sales Factor
    • Definitions
    • Problem Areas
    • Destination Sales
    • Dock Sales
    • Throwback Sales
    • Service Sales
    • Specialized Industries
    • The "Relief Provision"
  • How Much Distortion is Enough?
  • The Treatment of Factors in Partnerships
    • 25137-1. Apportionment and Allocation of Partnership Income
  • Appendix - State Apportionment Formulas and State Corporate Income Tax Rates
• Chapter 6 - Basic Ideas of Multistate Income Tax Planning
  • Learning Objective
  • Introduction
  • Identifying Goals and Methodologies
    • General Planning Goal
    • Specific Tactics
    • Unique State Provisions
• Chapter 7 - Audit Defense Strategies
  • Learning Objectives
  • Introduction
  • Audit Selection
    • Formulas and Statistics
    • Prior Audits; Data from Outside Sources
  • The Pre-Audit
    • Whom to Contact
    • Type of Tax; Audit Period
    • Required Documentation
    • Time and Place of Audit
  • Initial Meeting and Audit Work
    • Controlling the Flow of Information
    • Avoiding Commitments
    • Limits on Time and Distance
    • Be Professional
  • Closing Conference
    • Conclusion
• Chapter 8 - Latest Developments
• Appendix A - Steve's Pharmaceutical Company for Cats
  • Answer Key to Steve's Pharmaceutical Company
• Appendix B - Public Law 86-272
• Appendix C - Uniform Division of Income for Tax Purposes Act
• Appendix D - Wisconsin vs. Wrigley
• Appendix E - Geoffrey, Inc. v. South Carolina Tax Commission
• Appendix F - AICPA State Corporation Income Tax Return Checklist

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Chapter 1 - Interstate Activity and Nexus

Learning Objectives

• Identify nexus issues.
• Distinguish between income tax and sales tax nexus.
• Understand the constitutional issues that drive nexus decisions.
• Identify the limitations of Public Law 86-272.
• Define nexus through affiliation, attribution, and agency.

Introduction

Nexus is the beginning issue in any multistate activity. Unless you are doing business in, i.e., have nexus with a political jurisdiction, there is no obligation to file a return with that jurisdiction.

The word "nexus" comes from the Latin word "nexum" referring to obligations between contracting parties. More simply, in the state and local tax context it refers to both the quantity and quality of contacts, links, or connections between a taxpayer and a political jurisdiction sufficient enough to subject the taxpayer to the jurisdiction of the state. Or to put it even more simply, are you doing business in our ________ (fill in the blank: town, county, or state)?

The nexus issue is becoming increasingly volatile and complex in light of the states' attempts to broaden their tax base and increase their tax collections. States are pressing out-of-state companies, with the most slender of connections to the state, to file returns and pay income tax. The rapid growth of E-commerce and the Internet has added to this complexity, making proper tax planning in this area more critical than ever.

Nexus Defined

Nexus is the contact that must be established with a taxing jurisdiction before that jurisdiction can require a business to collect its tax, or otherwise subject it to its taxing authority. Generally, states extend their taxing authority as far as constitutionally possible. Consequently, it is with the U.S. Constitution that we must begin our discussion of nexus.

Please note, however, that nexus may be different for different taxes. In analyzing income tax issues, be careful not to confuse nexus for sales and use tax purposes with nexus for income tax purposes. For instance, most businesses are concerned with three types of nexus when doing business in surrounding states or states outside their domicile's taxing jurisdiction. Most common are nexus for sales and use tax purposes, nexus for income and franchise tax purchases (if this tax applies in a state) and nexus for purposes of registering or qualifying to do business in a state. Nexus conditions for all three of these are generally different.

The two clauses of most importance in the U.S. Constitution for defining the taxing jurisdiction of states are the due process and commerce clauses.

Due Process

The Fourteenth Amendment to the Constitution prohibits states from denying any person "life, liberty, or property, without due process of law." Since taxation is regarded as depriving someone of their property, a state cannot exact such tolls without due process of law.

Due process relates essentially to questions of fundamental fairness, to "traditional notions of fair play and substantial justice." "That test is whether property was taken without due process of law, or if we must paraphrase, whether the taxing power exerted by the state bears fiscal relation to protection, opportunities and benefits given by the state. The simple but controlling question is whether the state has given anything for which it can ask return." Wisconsin v. J.C. Penney Co., 311 U.S. 435.

The Due Process Clause of the Fourteenth Amendment imposes two hurdles a state must overcome before it can impose a tax. First, there must be "a ‘minimal connection' or ‘nexus' between the interstate activities and the taxing state, and second, there must be ‘a rational relationship between the incomes attributed to the State and the intrastate values of the enterprise.'" Exxon Corp. v. Wisconsin Dep't of Revenue, 447 U.S. 207 (1980), (citing Mobil Oil Corp. v. Commissioner of Taxes of Vermont).

Some commentators have recently questioned whether or not due process is really a serious hurdle. Why? Because the Supreme Court has ruled that the due process hurdle is cleared whenever a company "purposefully directs" it business activity or solicitation toward a state's residents. The "minimum connection" for a company need be no more than "purposefully avail[ing] itself of the benefits of an economic market in the forum State," or engaging "in continuous and widespread solicitation of business within a State." In other words, the due process clause does not require physical presence. Thus, a mail-order company, whose only contacts with a state were catalogues and goods sent through the U.S. mail satisfied the nexus standard for due process. See Quill Corp. v. North Dakota, 504 U.S. 298 (1992).

Commerce Clause

The second applicable constitutional provision is the commerce clause which provides for Congressional regulation of interstate commerce. The commerce clause of the Constitution provides that "Congress shall have the power to regulate Commerce with foreign Nations, and among the several states, and with the Indian tribes." U.S. Constitution, Art. I, Sec. 8, Cl. 3.

The commerce clause has been interpreted as not only conferring power on the national government to regulate commerce but also as limiting the states' power to interfere with commerce even where Congress has not acted. Under this "dormant" commerce clause principle, taxes that have been found to unduly burden interstate commerce have been declared unconstitutional.

The key state tax case interpreting the commerce clause is Complete Auto Transit v. Brady, 430 U.S. 274 (1977). In that case the Supreme Court established a four-prong test for determining whether a state tax unconstitutionally burdens interstate commerce.

The tests are as follows:

• Nexus – The tax must be applied to an activity with substantial nexus (author's emphasis).
• Fair apportionment – The tax must be fairly apportioned.
• Nondiscriminatory – The tax must not discriminate against interstate commerce. The commerce clause prohibits taxes which favor local or intrastate business over interstate business.
• Fair relation to the benefits – The tax must be fairly related to the services provided by the state. The services provided may include a stable market, police and fire protection, a trained work force, mass transit, public roads, or more generally, the advantages of a civilized society.

It is important to note that the nexus requirements for the two constitutional hurdles, due process and the commerce clause, are not the same; a point emphasized by the U.S. Supreme Court in Quill. "[North Dakota] contends that the nexus requirements imposed by the Due Process and Commerce Clauses are equivalent and that if, as we concluded above, a mail-order house that lacks a physical presence in the taxing State nonetheless satisfies the due process "minimum contacts" test, then that corporation also meets the Commerce Clause "substantial nexus" test.

We disagree. Despite the similarity in phrasing, the nexus requirements of the Due Process and Commerce Clauses are not identical." Quill Corp. v. North Dakota, 504 U.S. 298 (1992).

In summary, the due process clause requires only (1) "minimum contacts" (physical presence not necessary), and (2) a rational relationship between the income and the state. The commerce clause requires (1) substantial nexus, (2) nondiscrimination, (3) fair apportionment, and (4) some relation to the services provided.

Let us look at an example to see how the preceding case law and rules work in practice. For example, Crystal City Computers has one small store in Denver, Colorado, but sells most of its computers and peripherals over the Internet and through catalogues. It has no employees, sales reps, or facilities other than the Denver store. A farm girl from Kansas, named Dorothy, orders one of the company's computers over the Internet. Crystal City ships the computer to Dorothy by common carrier. Crystal City does not have any obligation to collect sales or use tax from Dorothy on the sale because it does not have any nexus with the state of Kansas. Nor does Crystal City have any obligation to file an income tax return with Kansas.

Would our answer be any different if Crystal City has maintenance agreements with several Kansas computer service repair shops that provide warranty repair in case Dorothy's computer fails? Perhaps. Many states have adopted a rule (discussed later in the text) asserting that warranty repair services provided by third-party independent contractors will create nexus for a remote vendor. The rule continues to be hotly debated.

Suppose Crystal City delivers the computer in its own truck rather than using a common carrier. Would that create nexus? If the deliveries were infrequent and sporadic, the seller would probably not be deemed to have created nexus. However, if the deliveries are significant in number, most states will claim that sales tax, but not income tax, nexus has been created between it and the remote seller.

Suppose Crystal City had one sales person who made only two trips into Kansas during the past 18 months. Would the physical presence of the salesperson create a filing obligation on the part of Crystal City? Probably not. It is not enough physical presence.

The questions about deliveries, the extent of physical presence, and the actions of agents are part of the continuing debate over nexus. But before we look at those issues, let us stop for a moment and distinguish sales tax nexus from income tax nexus. People often confuse the two.

Public Law 86-272

Due process and interstate commerce are the constitutional hurdles. But there is also a bit of federal legislation which adds yet another hurdle to establishing nexus, but only for income tax nexus. That legislation is Public Law (P.L.) 86-272.

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