Nexus. It can be an ugly word if it catches your business by surprise. For a business that operates in only one state, understanding state-level taxes is straightforward. However, what happens when your business crosses state lines? And more importantly, what if you don’t know your business “crossed” state lines? Understanding nexus is important for managing risks and identifying opportunities.
Manufacturers and distributors often cross state lines and are subject to tax in more than one state. Although this may complicate matters during tax filing season, it also offers opportunities to lower your company’s overall state tax liability, if you know the tax laws and plan accordingly.
The concept of “Nexus”
What is nexus? It’s a word you need to understand to protect your business. Nexus indicates you have a business presence in a state that triggers tax consequences in that state. However, determining nexus can be tricky.
While many states have similar approaches, each state has its own criteria to determine nexus. Common factors include owning or leasing property in a state, employing workers and/or independent contractors in a state, and marketing products or services in a state. Also, nexus can result from installing equipment, performing services, and providing training or warranty work in a state, either with your own workforce or by hiring others to perform the work on your behalf.
The factors that trigger nexus can be different from state to state. It’s not a one size fits all approach. For example, $300,000 of gross receipts sourced to Washington by an out of state business triggers nexus in Washington. However, the same amount sourced to Michigan would not trigger nexus in Michigan.
There is some good news, a minimal amount of business activity in a given state probably won’t create tax liability there. For example, an OEM that makes two tech calls a year across state lines probably wouldn’t be taxed in that state. But, it depends. As with most tax issues, you must consider all the facts and circumstances to determine whether you have nexus in a given state.
Does your company licenses intangibles or provides after-market services to customers? If so, you will need to consider “market-based sourcing” to determine state tax liabilities. What is market-baked sourcing? Simply put, if the benefits of a service occur and will be used in another state, that state will tax the revenue. “Service revenue” generally is defined as revenue from intangible assets — not the sales of tangible personal property. For market-based sourcing states, the destination of a service is the relevant taxation factor rather than the state in which the income-producing activity is performed (also known as the “cost of performance” method).
Not all states have adopted market-based sourcing. You’ll need to identify whether the states your business operates in use market-based sourcing. Also, states that have adopted market-based sourcing generally have slightly different rules, so it is important to consider the rules specific to a given state.
States that adopt market-based sourcing are looking to claim a percentage of any service revenue arising from residents (customers) within their borders. But there’s a trade-off: Market-based sourcing states sacrifice some in-state tax revenue because of lower apportionment figures. However, these states feel they’ll see a net gain as their pool of taxable sales increases.
Is your company considering another state? You’ll need to consider more than logistics and market viability. A nexus study provides insight into potential out-of-state taxes to which your business activities may expose you. Once all applicable income, sales and use, franchise and property taxes are factored into your analysis, the effect on profits could be significant.
The results of a nexus study may not be negative. If you operate primarily in a state with higher taxes, you may find that your company’s overall tax liability is lower in a neighboring state. In such cases, it may be advantageous to create nexus in that state by, say, setting up a small office there. In that situation, nexus could result in part of the company’s taxable income to be taxed at a lower state tax rate.
Understanding nexus can be complicated but talking with your tax advisor should be easy. Contact your MarksNelson tax advisor today to help you understand the risks and opportunities of crossing state lines.