Public Law 86-272 limits a state’s ability to impose income tax on out-of-state sellers whose only activities in the state consist of the solicitation of sales for tangible personal property.
The statute doesn’t protect the solicitation of services or other industry types not dealing in sales of tangible personal property. However, many businesses in the manufacturing, distribution, and retail sectors have heavily relied on this protection over the years.
Small and medium-sized businesses have arguably relied on the statute the most. More established companies have often branched out into service offerings related to the sales of property, such as repair and installation, sales of warranties, and issuance of credit cards.
States need to proactively protect small businesses in applying the federal statute. Ultimately, Congress should act by providing safe harbor thresholds that must be reached before a state income tax filing is required.
The Multistate Tax Commission revised its interpretation of the statute in August 2021 to interpret the federal statute and determine how the MTC’s signatory states would apply it to various business activities.
The revision on internet-based activity has caused the greatest concern, stating, “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.”
The statement provides examples of what would be deemed as creating nexus, such as post-sale chats or emails, invitations to upload resumes for non-sales positions, and use of internet cookies that are unrelated to customers’ shopping cart activity.
Small Business Impact
Many small businesses rely on the protection afforded by PL 86-272. Their activities haven’t really changed much over the years. They’ve always accepted resumes from across the country and taken phone calls for product issues, technical questions, or other non-sales-related matters. The only real difference is use of internet rather than phone or mail.
I’ve never experienced a state pursuing nexus when the taxpayer used the telephone or mail for these activities, when no other physical contacts existed with the state. Yet the MTC made the conscious decision not to address this very relevant issue.
Small businesses most often operate as flow-through entities to avoid potential double taxation. State tax compliance, however, isn’t easy for such entities. C corporations generally file one income tax return in each state where they have nexus.
When operating as a flow-through entity—a partnership, LLC, or S corporation—there are potentially multiple filings required for each state: one return at the entity level and additional returns for each owner. If any of the owners are flow-through entities, there will be additional layers of tax returns required.
State income tax compliance costs of small businesses will likely skyrocket. In addition, small businesses tend to use smaller accounting firms or solo practitioners to prepare tax filings.
But as state tax compliance grows, these practitioners may not be as experienced preparing numerous state tax returns. The necessary switch to larger accounting firms will raise compliance costs further.
Protecting Small Businesses
States must take steps to protect small businesses. Protection should extend to all small businesses, not just sellers of tangible personal property.
The introduction to the MTC’s statement of information recommends that states adopt a clearly defined factor presence nexus standard to “shield from taxation small businesses or businesses that have minimal contacts with the state.” Enacting reasonable bright-line thresholds will provide clarity to the small business community and ease the compliance burden.
To date, only 11 states have provided a threshold dollar amount of sales that must be reached before an income tax return is required. However, these thresholds don’t necessarily act as safe harbors. Internet activity alone shouldn’t create income tax nexus unless the thresholds are met.
Advising my small business clients has become more difficult and usually morphs into a penalty risk analysis. Does the state have minimum fees that apply? Are penalties assessed on only underpayments of tax, having no impact on clients in loss positions? What if they are audited in the future and tax returns are demanded to avoid arbitrary amounts of tax and penalties from being assessed?
Tax policy shouldn’t be this burdensome. Congress should enact minimum factor-presence nexus standards to protect the small business community.
This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.
Catherine Shaw is state and local tax partner at Cherry Bekaert.
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