Editor: Lori Anne Johnston, CPA, J.D.
On June 21, 2018, the U.S. Supreme Court handed down its decision in South Dakota v. Wayfair, Inc., 138 S. Ct. 2080 (2018). In doing so, the Court effectively overturned over 50 years of Commerce Clause jurisprudence that had required a taxpayer to have a physical presence in a state before that state could compel the registration, collection, and subsequent remittance of its sales tax. States may now compel compliance with their sales tax laws based on a company's level of economic activity, as measured by certain sales or transaction thresholds. Companies of all sizes should understand the impact of Wayfair, coupled with a more service-driven economy, on their state and local tax footprint. This is especially true of companies that sell business and professional services, due to a gradual expansion of state sales tax bases, with potential impacts to income and franchise tax filings as well.
With Wayfair significantly expanding states' ability to reach out-of-state companies, it should come as no surprise that the vast majority of states with a sales tax have already enacted or adopted economic nexus laws. In just under 18 months from the decision, all but three states with a sales tax — Florida, Louisiana, and Missouri — have adopted and enforce an economic nexus law for sales tax purposes. Unfortunately, there is no uniformity among states as to how these laws are structured.
About half of those states have adopted the same sales tax economic nexus thresholds that South Dakota enacted and that were at issue in Wayfair ($100,000 in sales or 200 transactions with in-state residents in the previous 12-month period). Other states have established much higher thresholds of $500,000, such as California (Cal. Rev. & Tax. Code §6203(c)(4)) and Texas (34 Tex. Admin. Code §§3.286(a)(4)(I), (a)(4)(J), and (b)(2)). Many other states have set their thresholds somewhere in the middle. Moreover, the calculation of whether a company has met or exceeded a threshold is not entirely straightforward. Some states, such as North Dakota (see N.D. Office of State Tax Comm'r, Sales Tax Newsletter (June 2019), interpreting N.D. Cent. Code §57-39.2-02.2), do not include exempt sales in the calculation of whether a company has created economic nexus. Other states include both exempt and taxable sales of tangible personal property in the calculation but exclude sales of services, such as New York (N.Y. Tax Law §1101(b)(8)(iv)) and California (Cal. Rev. & Tax. Code §6203(c)(4); see also Cal. Dep't of Tax and Fee Admin., "Use Tax Collection Requirements Based on Sales Into California Due to the Wayfair Decision," available at cdtfa.ca.gov (no publication date provided)). Connecticut has indicated that all receipts are included in the calculation, including receipts from exempt sales as well as receipts from sales of services (Conn. Gen. Stat. §12-407(a)(12)(G); see also Connecticut Special Notice SN 2018(5) (June 26, 2018)).
In an additional area of development, many states are expanding their sales tax bases. Most state sales taxes have historically been imposed on sales of tangible goods, while sales of services are usually taxable only if a state has designated them as such. However, these laws originated at a time when tangible goods sales were the primary driver of the American economy, as compared with sales of services. Over the past 60 years, this dynamic has reversed, with services now making up a greater portion of consumer spending than sales of tangible goods.
In response to this development, states have gradually adopted laws that impose their respective sales taxes on receipts from certain services. The idea of taxing services is not novel. For instance, Hawaii has long imposed its sales tax on virtually all forms of economic activity, including even sales for resale (albeit at a reduced rate) and professional services (see, generally, Haw. Rev. Stat. §237-1 et seq.). But Hawaii is the exception, and services have not historically been taxed as often as sales of tangible goods. Besides Hawaii, a number of other states (including Iowa, New Mexico, New York, South Dakota, Texas, and West Virginia) impose a sales tax on broad categories of services.
Generally, however, states have been showing a trend toward taxing an increasing number of services. For example, in 2018, Kentucky passed legislation that imposed its sales tax on a number of previously exempt services, such as industrial laundry services and indoor skin tanning services (Kentucky H.B. 366, §37). Other states, including California, Nebraska, and Wyoming, have also proposed legislation in recent years that would increase the number of services specifically designated as taxable (see, e.g., California S.B. 993 (2018); Nebraska L.B. 507 (2019); and Wyoming H.B. 67 (2019)). Not all of these bills have been enacted, but the trend toward taxing more services shows no signs of slowing.
From a sales tax perspective, this wildly new and rapidly evolving landscape presents increasing compliance challenges for sellers of business and professional services, which can now create tax nexus through nothing more than exceeding a certain volume of sales into one or more states in a given year. To the extent that nexus is established, such a seller would need to determine whether its sales are taxable in the states with which nexus has been created. This taxability review would ideally be revisited often, as states continue to enact and change laws that increase the extent to which services are taxable. All told, sellers of business and professional services are now presented with a significantly altered sales tax world, and failure to monitor nexus and taxability developments can lead to potentially significant sales tax exposure.
Income and franchise taxes
Perhaps the most interesting potential development from Wayfair is the indirect impact on state income and franchise taxes. Using sales tax as a starting point, to the extent that a company creates economic nexus with a state and its sales are subject to that state's tax, a company will generally decide to register for, collect, and remit sales tax in that state. A sales tax can be passed along to a company's customers, and failure to collect the sales tax, if required, would create very real exposure for a company.
Faced with a decision to pass the tax burden along to its customers or allow the sales tax exposure of the company to continue to grow, most companies will choose the former. The main point is that most companies will choose to register for sales tax, which may put them on the radar of a state's taxing authority for any tax the state imposes, including income, franchise, and gross receipts taxes.
One area of state tax law that continues to develop, although not as quickly as sales tax economic nexus, is the application of economic nexus to income and franchise taxes. Prior to Wayfair, a handful of states had factor-presence thresholds in place, which function like economic nexus for income and franchise tax. For example, states such as California, New York, and Tennessee all had laws in place that required a taxpayer to file and pay income, franchise, and commercial activity taxes based on the existence of property, payroll, or sales.
While the concept of economic nexus for income and franchise tax purposes is nothing new, more states, now emboldened by Wayfair, are expected to adopt economic nexus standards for income and franchise taxes. In recent months, Hawaii (Haw. Rev. Stat. §235-4.2), Massachusetts (830 Mass. Regs. Code §63.39.1(3)(b)(8)), and Pennsylvania (Pennsylvania Corporate Tax Bulletin No. 2019-04 (September 2019)) have adopted economic nexus for income tax purposes. Effective for reports due on or after Jan. 1, 2020, Texas has adopted a $500,000 receipts threshold for the state franchise tax (Tex. Admin. Code §3.586(f)), matching the sales tax economic threshold. Though the trend of enacting economic nexus for income and franchise taxes is developing much more slowly than economic nexus for sales tax, this evolution of state tax law is likely to continue into the 2020 state legislative sessions.
Prior to Wayfair, most states did not have the risk of sales tax economic nexus and the related potential sales tax exposure to incentivize a company to file for income or franchise tax. That has all changed with Wayfair. With the risk of potential sales tax exposure causing companies to register, those same companies should simultaneously be considering whether they need to make an income or franchise tax filing as well.
Keeping close watch on exposures
The implications of Wayfair for sellers of business and professional services are significant. Because of potential sales tax exposure, companies are registering with far more states than before. Another strong trend among the states, though not discussed above, is the increasing number of states (more than 30) that have adopted market-based sourcing for income and franchise tax purposes for receipts derived from the provision of services. And, as has been the case since it was enacted, P.L. 86-272, the Interstate Income Act of 1959, offers sellers of business and professional services absolutely no protections. Ultimately, due to increasing enactment of market-based sourcing laws, combined with application of economic nexus principles to income and franchise taxes and the inapplicability of P.L. 86-272, all companies that sell business and professional services will be forced to more closely scrutinize their income and franchise tax filing decisions, with the likely outcome of having to file income and franchise tax returns in far more states than in previous years.
Accordingly, all business and professional service providers should review their state sales activity to determine where they have established state tax nexus due to the recently expanded economic nexus provisions. For sales and use tax, this includes determining the revenue streams and the total revenue and number of transactions from the prior 12 months in each state. Automation solutions for new tax compliance obligations should also be considered. For non-sales-and-use-tax purposes, staying up to date with new economic income tax nexus standards is paramount. Additionally, it continues to be important for a business to review its apportionment methodology annually. It is necessary to understand where a business has a filing requirement, since states could require prior-year returns to be filed back to the date nexus was established.
Lori Anne Johnston, CPA, J.D., is a manager, Washington National Tax for RSM US LLP.
Unless otherwise noted, contributors are members of or associated with RSM US LLP.