Nexus: It’s all about Physical Presence. Or is it?

By Michael J. Fleming

Nexus, it’s a fairly simple five letter word that the Miriam—Webster dictionary defines as a connection or link. At first glance the word doesn’t appear very scary, mystical or confusing, but when used in the context of taxes it is often one of the most misunderstood, misinterpreted and underestimated issues; making it a very common cause of tax problems. Why does this seemingly non-threatening word generate such heartburn in multi-state businesses?? Start with the US Constitution, add a couple federal laws and Supreme Court cases, multiply that by the laws passed in the each of the fifty states, then apply that to different categories of taxes, factor in states hungry for revenue and top it off with an ever evolving economy and you have your answer. Nexus is not static; states are constantly pushing the nexus envelope trying to increase their tax base. So even if you are a nexus expert (a Nexpert?), nexus is a topic that requires continuous monitoring and updating of knowledge.  The following discussion is intended to provide a glimpse into some of the basics of nexus and the role of physical presence.

To start off our discussion we should enhance our simple nexus definition to one that best fits our state tax context. A generic definition I like to use is; the minimum connection or link necessary, that allows a state to tax you or force you to collect taxes on it’s behalf. This minimum link can vary from state to state as well as from tax to tax. Perhaps the best way to delve into nexus is by examining it within the context of the three different major types of state taxes and some of the primary legal influences affecting nexus for those taxes. These taxes are; sales & use tax (SUT), corporate income tax (CIT) and the third group which is neither SUT nor CIT, but closer to a mix of the two. For a lack of a better term we’ll call the third group, “Neither/Nor Taxes” (NNT).  The third group consists of taxes like the Washington Business & Occupation Tax (B & O), the Ohio Commercial Activities Tax (CAT), the Michigan Business Tax (MBT) and the Texas Franchise Tax, among others.

Sales and Use Tax (SUT)

To understand the evolution of nexus for sales and use tax it is important to start with the U.S. Constitution; more specifically the Due Process and Commerce Clauses. The Due Process Clause states that no state shall deprive any one of life, liberty, or property, without due process of law and the Commerce clause states that congress shall have the right to regulate commerce among the several states. What this has evolved to mean is that before a state can subject you to its laws you must have a link or nexus with that state. The Supreme Court has held that when it comes to the Due Process Clause, there must be a “minimal connection” (nexus) before a state can tax you. However when it comes to the commerce clause, the Supremes have declared that there must be a “substantial connection” (nexus). Since it is fairly easy to create the minimal connection required by the Due Process Clause, we will concentrate on the Commerce Clause and its substantial nexus.

It has been just over 70 years since the Supreme Court, in Nelson v. Sears Roebuck and Wisconsin v. J.C. Penney, defined the concept of “Substantial Nexus”. Since that time it has been widely accepted that substantial nexus requires more than the slightest physical presence.  What has not been as clear is exactly what constitutes physical presence and exactly at what point does one cross the line from “slightest” to “more than the slightest” physical presence to create substantial nexus.   Although the Supreme Court has decided a number of cases over the last 50 years providing some guidance, since it can only rule on the facts in the instant case, no definitive, all inclusive answer can come from them. They have (properly)  deferred the matter to Congress instead. So until Congress decides to exercise its powers under the Commerce Clause, nexus will continue to be a complex grey area where states will continue to push the envelope. In the meantime we will have to rely on what little guidance the Supreme Court has provided. And don’t hold out too much hope that even if Congress does act that all of a sudden things will immediately clarify.

One of the earliest cases to expand the scope of physical presence is the 1960 case, Scripto, Inc. v. Carson. In this case it was decided that independent sales representatives, even if they are not exclusive to a company, create substantial nexus. The Court stated that it was not important what these representatives were called but rather what they did for the company. This is the first time we see the phrase “establishing and maintaining a marketplace for the company”.  The Court visited this issue again in the 1967 case Tyler Pipe Industries, Inc. v. Washington Dept. of Revenue. The Court held that even one part time employee or independent agent can create Nexus. It went on to add that the critical test was to see if the activities performed on behalf of a taxpayer are significantly associated with the taxpayer’s ability to establish and maintain a market. Following this line of reasoning you can see how installation, maintenance, warranty services, etc.,  are just as important to establishing and maintaining a market as sales, and therefore can also create nexus even if performed by third parties.

Perhaps the most important or at least the latest (1992) of the important Supreme Court Cases is Quill Corp v. North Dakota. In Quill the State argued that three diskettes were enough of a physical presence to create nexus for Quill’s catalog business. The Court decided for Quill, stating that a taxpayer must have a more than the slightest physical presence in a state in order to require the collection of sales or use tax. The Court’s reasoning was partially based on the fact that, due to the immense number of sales tax jurisdictions, imposing an obligation to collect sales tax would create a burden that could be said to effectively restrict interstate commerce.

This brings us to where we are today. We know that third parties performing activities that help establish and maintain a market can create nexus. We also know that it takes more than the slightest physical presence to create nexus. It’s safe to assume that offices, warehouses and employees all exceed the slightest physical presence. But where is the line drawn? In Quill three diskettes was not sufficient; but could it be four, five or six?  Since the Court decided not to quantify we will remain in this complex grey area reacting to the pushing of the envelope by states until Congress decides to act.

10 Nexus Creating Activities for Sales & Use Tax

1. Ownership of real property (stores, warehouses, offices, etc.).
2. Ownership of personal property (machinery, equipment, etc.).
3. Leasing of real property (stores, warehouses, offices, etc.).
4. Leasing of personal property (machinery, equipment, etc.).
5. Maintaining of an inventory, whether consigned, stored or carried by sales representatives.
6. Travel of employees into a state to conduct sales, training, deliveries, installations, repairs etc.
7. Use of independent sales or manufacture’s reps even if they are not exclusive.
8. Use of sub-contractors for repairs, maintenance, installations, etc.
9. Allowing employees to telecommute or use a home office.
10. Advertising in local media or phone directories.

Corporate Income Tax (CIT)

When it comes to corporate income tax the role of physical presence has become somewhat less paramount. In some instances the state’s authority has been limited and in others increased. Sometimes these results are by design and sometimes they are the result of the law of unintended consequences.  Let’s take a look at two of the biggest influences.

In February 1959, the U.S. Supreme Court decided Northwestern Cement v. Minnesota. In its opinion The Court affirmed a state's power to tax income generated from interstate activities. They went on to say that such a tax is valid if it does not discriminate against interstate commerce and is properly apportioned to activities within the state that create nexus. Congress began to worry that unclear nexus guidelines as well as complex compliance issues, could cause some companies, particularly smaller ones, to limit their interstate activities. Congress moved quickly to pass legislation, Public Law 86-272, seven months after the Supreme Court decided the Northwestern Cement case. The major thrust of PL 86-272 is that a state is prohibited from imposing a net income tax if a company's only activities in a state are the solicitation of orders for sales of tangible personal property which are sent outside the state for approval or rejection and are filled from outside the state. The Senate noted that the legislation was not a permanent solution and was intended to be a temporary fix while further studies were made of the problem. Yet here we are fifty-two years later with no further action and an environment even more confusing than back then. Nowadays, companies sell services and intangibles sometimes even combined with tangible personal property. This law is now one of the factors confusing the nexus situation even more.  The protection of PL 86-272 applies to independent agents as well as employees.  However when relying on these protections it is important to remember the narrow confines of the activities covered.

Another influence on CIT comes from the unintended consequences of the Quill decision. In Quill, the Court expressly talks of physical presence in the context of SUT. Many states have taken the position that the courts narrow language in Quill referencing SUT means that the requirement for physical presence is superfluous when referencing other taxes. This opened the door for a concept called “Economic Nexus.” This concept basically defined is that states have jurisdictional authority to tax any company that takes advantage of the state’s markets without regard to physical presence and can be measured in ways such as receipts generated from the state or numbers of customers within the state. To date there have been many lower court and state supreme court cases affirming the concept of economic nexus with the U.S. Supreme Court refusing to take sides. The result is a confusing mix of nexus rules with some states requiring physical presence and others not.

Neither/Nor Taxes (NNT)

As mentioned earlier these taxes are neither SUT nor CIT, but closer to a mix of the two. The Neither/Nor group consists of taxes like the Washington Business & Occupation Tax (B & O), the Ohio Commercial Activities Tax (CAT), the Michigan Business Tax (MBT) and the Texas Franchise Tax. Since neither/nor taxes are not income taxes they are not afforded the protections of PL 86-272. Conversely since they are not SUT, they are in the states’ minds, not subject to the physical presence requirements of Quill. Of the four taxes mentioned above, only TX does not have an economic nexus provision.

Conclusion

Physical presence has and does play a role in nexus. How big that role is depends on the type of tax and the state in question. What qualifies as physical presence also varies widely as states continue pushing the envelope looking to increase their tax base. It’s a situation that promises to get more confusing as time goes by. The ultimate solution probably rests with congress and their ability to regulate interstate commerce. However, since they have been reviewing the situation for 52 years, a congressional solution does not seem to be on the near-term horizon. . For now we are on our own.

Here is a list of survival tips that may help.

Top Ten Nexus Survival Tips

1. Do not underestimate nexus – Not knowing about nexus can have a devastating effect on you and your company. If a state determines you have nexus there is generally not a statute of limitations on how far back they can audit you. In theory they can go back to the date you started to do business in the state, although in reality they usually stay in the 7-10 year range. But 7 to 10 years is still a long time, obviously.  Then, not only can you can end up paying back taxes but they tack on  penalty and interest as well. The dollars can start to add up quickly, especially if the states share information. In some extreme cases criminal penalties may also apply.
2. Educate yourself - Learn about nexus and see how it applies to your company’s operations. Stay abreast of nexus changes as well as changes in your business. There are a number of resources that are available but free webinars are a good place to start. There are also a handful of firms that can help.
3. Do not assume you are OK – Just because you have not been contacted by a state yet doesn’t mean you are OK.  You may be OK or it may mean that the state just hasn’t found you yet. Some common ways states find you are through audits of your vendors or customers, disgruntled employees reporting you or your competitors turning you in. There are many other way but these are three of the big ones. 
4. Do not assume that your current CPA’s fully understand nexus – CPAs are usually very good at what they do. The problem is that many of them don’t focus on state and local taxes and some of those that do only focus on a handful of states. You may be surprised to learn that their knowledge of multi-state nexus issues is no better than yours. Question your CPA about how much of this type of work do they do? How do they stay on top of the evolving issues in each of the states? You may have a great nexus resource in your CPA -- then again you may not.
5. Do not assume that your employees are keeping you compliant – Ask your employees how they stay abreast of nexus changes. Do they monitor operations and see how changes in the way you do business impacts nexus? How do they educate themselves? Who do they go to for answers or clarifications? Are you giving them the tools that they need?  If you have doubts consider doing a nexus consultation and analysis; it can be done internally or by a third party.
6. Do not assume that your competitors are approaching nexus correctly – This is a perfect example of something my father told me over and over, “Just because everyone else is doing it doesn’t make it right.” How true this is. Maybe your competitor has it right, but maybe not. Maybe they just haven’t been discovered yet. This may become a case of the blind leading the blind. How do you know that your competitors are not following you? Where are your competitors getting their information? Perhaps the best question to ask is if the state finds you will your competitor pay the money you owe. I would say no, therefore educate yourself.
7. Do not stick your head in the sand – If you have nexus do not wait for the state to find you. The longer you wait the greater your liabilities grow as there is no statute of limitations. The second reason is that there is a program called a Voluntary Disclosure Agreement (VDA) that states offer to entice you to come forward. The VDA program usually limits the period a state will look back to 3-4 years as well as waiving penalties and/or all or part of the interest. The drawback is that if the state finds you before you come forward, then you are usually not eligible to participate in the program. 
8. Do not answer a nexus questionnaire without fully understanding your exposure – When a state becomes aware of you they will usually send out a questionnaire about your activities in the state. Before you answer the questionnaire you should not only understand what your exposure is but what options are available. Once you return that questionnaire, your options may be limited.
9. Do not just get registered if you find out you have nexus – This may seem counter intuitive, but remember that there is no statute of limitations if you have not filed the monthly returns. Once you come forward and get registered, you’ve lost the one small advantage and leverage you had. The state now knows who you are and the state can go back and audit you for all the past periods. You will definitely want to look at a VDA or amnesty program.
10. Do not panic – If you think you might have nexus or have been contacted by a state do not panic. There are programs you can take advantage of and a handful of firms that can help. You are not alone and are not unique. You can rest assured that many before you have had the same problems and have been helped. Just remember not to ignore this issue. Not only does it not go away, it gets worse with time.

I have mentioned throughout the article that there are a handful of firms that may be able to help. I am partial to one in particular, my employer, Peisner Johnson & Company. Peisner Johnson, founded in 1992, is the largest national CPA firm that is focused entirely on solving state and local tax issues. Peisner Johnson is comprised of former state auditors and other professionals with years of state and local tax experience. Peisner Johnson has worked with clients of all sizes, in all industries and currently works in all 50 states, U.S. territories and Canadian Provinces. We work with many CPAs who find us to be a perfect complement to their business since we concentrate exclusively on state and local taxes. We do nothing else. If you would like information on any of our free webinars, free chart services or would like to learn how we may be able to help, you may contact Russell Gordon at 800-940-9433 ext. 716.

As a Leader of a CPA Firm, What Keeps You Up at Night?

The AICPA Survey Lists CPA’s Top Five Concerns, But Did They Ask the Right Question?

And the Survey Said?

In a recent survey, the AICPA polled some 577 CPA firms with the question of “what is your chief business concern?”  A compelling question to be sure, and the answers are telling of our current economic situation.  However, in our review of the survey and the accompanying analysis by the AICPA, we began to wonder if the survey was asking the wrong question.  As evidenced by the survey itself, the issues brought up by the firms are indicative of the times we’re in.  But, based on a review of prior surveys, this year’s top concerns probably won’t be the same as next year’s concerns (just take a look at the top concerns in 2009 or 2007).  In order to find out what really troubles CPAs, instead of asking what concerns them, we might ask a more specific and telling question.  How about this: “As a leader in a CPA firm, what issues keep you up at night?”  Likely the answer to this question is far different than simply “What are your biggest concerns as a CPA?” Now, that would be an interesting survey.

I’ll tell you one thing that sometimes keeps me, as a leader of my CPA firm up at night is a worry that we made a mistake on something, or we missed some issue we should have caught. We don’t do attest work; we are state and local tax consultants—that’s all we do.

What Keeps You Up at Night?

I’d be willing to bet it’s not state and local tax—and that’s understandable. But let me tell you why it might need to be especially for your attest clients and what you can do about it.

Don’t get me wrong, all in all, we did find the article very useful, and a near comprehensive list of what we would call the top concerns CPAs have (to view the survey, click here).  For example one of the major concerns especially for smaller firms, is dealing with the ever growing and evolving complexity of tax law. And they’re probably referring to changes in the federal tax law. I sympathize with CPA’s on this. We haven’t kept up at all with the federal law in the last 20 years. We focus all our attention on state and local tax and it’s hard enough to keep up with this area.  Merely staying on top of these changes is a full time job, let alone spending time using that knowledge in performing client work. To go along with the knowledge of the law, we must be knowledgeable about the various solutions that technology provides.  When new and innovative technological solutions present themselves, we can find ourselves out of touch and out of a client when we fail to inform ourselves about new available software solutions. 

Another concern that ranked in each category of the survey was the concern to remain competitive with fees and the pricing of services.   In addition, firms were concerned with the compressed nature of the tax season that takes place in the weeks and months preceding the April due date for personal income taxes.  And while these concerns are relatively constant throughout the years, the most important concern to CPAs in the 2011 survey, at least to firms in the 2-20 professionals’ size range, was bringing in new clients.  For firms larger than 20 professionals, new clients ranked as the second major concern, and for sole proprietors, it ranked as the third major concern.

Contrast these outcomes with that of the 2009 survey and the results are interesting.  In 2009, the survey recorded a unanimous number one concern across the board—retention of current clients.  While client retention remains an important priority in 2011 (it ranked no lower than 3rd in all groups) the change leads us to make some interesting observations.  To quote the AICPA release about the survey, “Whereas survival was the top priority in 2009, at the height of the recession, the seeking and signing of new clients has taken on greater importance across the board as firms attempt to find growth opportunities in an uneven economic recovery.”

But, What Else Should CPA’s be Worried About That Wasn’t on the List?

Now, we’re not disputing that growth is an important concern right now, however we mentioned one concern that we feel should be added to the list.  And as far as concerns go, this one is big.  To put it another way, how many of the concerns previously listed, whether complexity of the law, new technology, pricing of services, the seasonal nature of the business, or even client retention and growth, would you potentially lose sleep over?  Probably none.  Yet many of us have experienced that awful, restless night after the realization of a material mistake.  Now because they don’t happen every day, they don’t always jump to the front of your mind in that quarterly strategy/growth meeting, but they are absolutely a major concern.  That gnawing, nagging concern that lingers and hovers over all we do as CPA’s.  And when it comes to what gets our heart rate up, or spikes our blood pressure, nothing gets us going quite like this.  After all, if we mess up it’s our fanny in the fire.

Specifically the mistakes I’m referring to have to do with attestation work.  Attest work is a type of service CPA’s offer—attesting to the veracity and accuracy of financial statements.  It is a heavy burden.  One major reason why companies hire CPA’s to do attestation work is because they’re required to do so, either by a bank or other creditor or by some other party.  Companies don’t usually hire a CPA to do attestation work for their own internal review purposes.  It’s because they’ll be using the documents for a third party.  CPA’s know this and that’s why CPA’s are extra concerned when it comes to attest clients. 

When CPAs do attestation work or audits, the last thing they want to know is that they missed something.  What would they be worried they are going to miss? Revenues? Sure. Revenues must not be overstated or “managed” artificially.  What CPA’s are usually even more worried about though, is missing or understating some liability—some liability that isn't on the balance sheet, but should be.  It's easy to review things already on the balance sheet.  The company says, “Yes we've got this inventory, and we have these accounts payable.”  CPA’s can confirm those.  But what if you miss liabilities that aren't on the balance sheet?  And what if those liabilities are material to the financial statements?  That’s the big worry.

Case Study -- CPA Firm Misses Multimillion Dollar Liability for Small Attest Company

We knew a CPA firm who had a 30 year client. (Please note: We’ve changed the facts so that neither the firm nor their client is recognizable, and the good news is that the situation was caught and resolved in time. This client was a family-owned distributor business.  The CPA firm did audit work for them for 30 years because the company maintained certain loans with the bank where they had to maintain certain covenants or the bank could call in the loan.  Everything had been going fine.  That is until their client was approached by another company with a buyout offer. 

They Didn’t Realize They Had Nexus All Over the Country

While performing their due diligence, the buyout firm issued a nexus questionnaire to the company and discovered they had nexus for sales tax all across the nation based on the activities of independent sales reps.  At this point the buyout firm asked, “Don’t you know that independent reps give you nexus and you should have been collecting sales tax all along?”

Nexus Means a State Can Force a Company to Collect Sales Tax

If a company sells something that’s taxable and they have nexus in a state, they need to be licensed to collect the appropriate tax. And they need to actually collect it and remit it. If they don’t collect it from their customers at the time of the transaction, the state will eventually find them and get the money from the seller. When this happens, it’s often too late or too difficult to go back to the customers and the liability shifts to the selling company. Many companies are unaware of this fact. And one thing they’re also shocked to find out is that the state can legally go back to day one and many in fact routinely go back 10 years if they find you.

In this case, the buyout firm went and checked back over the previous three years and found the company’s exposure was around $15 million.  For purposes of simplification, let’s estimate that $15 million was roughly half the sales price of the company.  There you have roughly half the worth of the company being eaten up by a potential liability of $15 million, and that only goes back three years!  And really, with the company not being registered, realistically you could calculate roughly 7-10 years of liability which would have made the whole company insolvent.

CPA Firm Has Palpitations

Now put yourself in the shoes of the CPA firm.  You’ve been giving clean opinions all along for the last 30 years.  It makes your stomach turn.  If that liability is real, you are in a world of hurt because now you know about it, and are duty, ethically and possibly legally bound (think of Enron and Arthur Andersen) to disclose the liability and insist the client put it on the balance sheet which may mean they are in violation of the loan covenants, which may mean the bank has to call their loan.  If the bank can’t collect the loan they’re going to come to you.  In addition, you have to face the extremely difficult conversation that will inevitably come where your client asks, “Why didn’t you tell us the activities we were performing gave us nexus and we should have been collecting tax?”  There is no good answer to that question.

It Ended Well

Thankfully, all’s well that ends well and this situation was resolved satisfactorily because of a series of actions including taking advantage of the SSTP amnesties and strategic voluntary disclosures that we were able to recommend. But, in some respects, the client was lucky that they met some pretty stringent requirements, and lucky is probably the best description for how they dodged this bullet.

So how can you avoid this potential disaster?  Well hopefully the solution is obvious.  Get informed!  Learn more about how the changing environment regarding nexus could be threatening your clients. Learn about the biggest tragedy in sales tax and why nexus is even an issue and what are the typical nexus creating activities. All of these resources are available at no charge.

State and Local Tax Concerns Shouldn’t Keep You Up at Night

Returning to the AICPA survey, firms ranging from the sole proprietor to firms of 20 professionals listed “keeping up with changes and complexity of the tax laws” as one of their top ten concerns.   Why is this a top concern?  Because it relates to a bigger, underlying concern, the concern that transcends good and bad economies, the one that keeps us up at night—that we could potentially miss something big.  No one wants to miss a material item.  Thankfully in this case getting informed is just as simple as employing a simple nexus questionnaire, similar to the one given to the manufacturing firm.  If you would like a copy of a questionnaire, let us know and we would be happy to make one available.  Or for more information about nexus in general, feel free to contact Peisner Johnson & Company at our website, attend one of our complimentary webinars on nexus, or just give us a call at 800-940-9433 ext. 716.