The Income Tax Nexus Battle and Federal Public Law 86-272

calendar iconFebruary 1, 2022

In my 35 years of practicing in the State and Local Tax (“SALT”) arena it seems the topic of nexus is always at the forefront. Nexus for SALT purposes describes the presence of a business within a state that is sufficient to cause the business to pay tax in that state.  In South Dakota v. Wayfair, Inc., 138 S. Ct. 2080 (2018), the U.S. Supreme Court expanded a state’s ability to apply nexus to impose sales tax collection requirements on out-of-state sellers when relatively minimal sales are made into the state.  During the last three years, this decision has had an extraordinary impact on businesses assessing, collecting, reporting and remitting sales tax.

Economic Nexus and P.L. 86-272

Long before Wayfair, states have been successful in imposing economic activity indicators to establish nexus for income tax purposes. An out-of-state business receiving revenue from in-state customers can be deemed enough presence to create an income tax filing obligation. Of course, along with economic presence there must also be a “substantial” connection with the taxing state under Constitutional principles. The Multi-State Tax Commission (“MTC”) and its member states defined “substantial” back in 2002 as $500,000 or 25% of a company’s sales. However, most states have not adopted a specific sales threshold for “substantial.” The lack of a minimum sales threshold is used by states to their advantage in pursuing taxpayers for underreported income tax. Now Wayfair has emboldened states to be more aggressive and consider an even lower sales threshold than the MTC recommended.

Within this aggressive nexus environment, there is still one protection left in the taxpayers’ arsenal under the right circumstances: Federal Public Law 86-272 (“P.L. 86-272”).  Enacted in 1959, P.L. 86-272 protects sellers of tangible personal property from imposition of income taxes outside its home state.  No state income tax can be imposed when these three conditions are met:

  • the only activity “within” a state consists of the soliciting sales of tangible personal property,
  • such sales are approved by the home office outside of the customer’s state, and
  • the tangible personal property is shipped to the customer from outside of the state.

P.L. 86-272 was meant to be temporary until further legislation could be passed, but it is still in use today.  From the law’s inception, states have worked hard to narrowly interpret its application and limit the number of eligible taxpayers.

Many companies rely on P.L. 86-272 to limit their state income tax filing obligations. In fact, a company may be reporting “no-where” sales in the state apportionment factors used to apportion taxable income among the states where a business does have taxable nexus.  Understanding this fact and considering that states have made substantial gains in asserting nexus for sales tax as a result of Wayfair, the MTC determined it was time to revamp its interpretation of P.L. 86-272, especially considering the internet age we all live in.

MTC Guidance

On August 4, 2021, the MTC adopted revisions to its “Statement of Information Concerning Practices of Multistate Tax Commission and Supporting States Under Public Law 86-272”. Within its guidance the MTC provides examples of protected and unprotected activities under P.L. 86-272.  Protected activities fit within the three conditions noted above, and unprotected activities are outside of these guidelines and therefore may indicate a taxable business presence in a state.  It is important to note that the MTC’s statement is an interpretation of the law and is not necessarily binding in and of itself.  However, the statement provides guidance as to how its sixteen Compact Member states, and likely other states may interpret P.L. 86-272’s protection from state taxation.

The most troubling aspect within the MTC’s revisions relates to activities occurring over the internet, as described in the following excerpt:

Article IV, Section C (in part):

As a general rule, when a business interacts with a customer via the business’s website or app, the business engages in a business activity within the customer’s state. However, for purposes of this Statement, when a business presents static text or photos on its website, that presentation does not in itself constitute a business activity within those states where the business’s customers are located.

The statement goes on to indicate that post-sale assistance provided through an Internet chat feature, and the ability of a prospective non-sales employee to upload a resume are included in the activities that may result in a loss of federal law protection. Basically, any activities conducted through the Internet, other than assisting with the sale of tangible personal property (i.e., listing products, shopping cart), may now create nexus for out-of-state sellers.

What Does the Future Hold?

This is a monumental change in the states’ view on nexus for income tax purposes, and one that is certain to be broadly applied. To build customer loyalty, most companies want to connect with customers in various ways. In the past, many of these activities occurred over the telephone and were never challenged as unprotected activities.

Using the MTC’s new interpretation of P.L. 86-272, economic nexus standards may become less important in determining business presence for companies selling tangible goods.  If internet-based activities are now unprotected as the MTC’s statement suggests, a state may impose its “doing business” standard of nexus without having to revert to a “minimum sales threshold” economic nexus to assert income tax on a business. There are no sales thresholds needed when business activity is conducted in the state.  Such a position could place a burden on a small business with very few sales and no physical activity in a state, but which does have a robust and interactive digital experience with customers and fans in that state.

In addition, because the MTC’s statement is an interpretation of existing law, there is nothing to prevent a state from applying this interpretation of unprotected activities retroactively.  One would hope such significant changes would be applied on a prospective basis only, but companies could see it raised in an audit.  Either way, expect more challenges and litigation now that states have this new interpretation to apply.

If your business relies on Federal Public Law 86-272 to shield the business from state income tax, it’s time to take a hard look at what specific company activities (physical, economic, and digital) are occurring, or are presumed to be occurring, in each state. If during this review you discover areas of concern, now is the time to address them. If prior exposure is discovered, most states offer very favorable terms for stepping forward to resolve past issues. If you need assistance in reviewing your nexus positions, or any other area of tax, please reach out to your Cherry Bekaert advisor or a member of the Firm’s State and Local Tax team.

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