If you’re planning to or already starting to do business across states, you’ve got to know what’s going on from an income tax perspective. A multistate income tax is different from a sales tax. And a multistate income tax can have a lot of different names attached to it depending on the state.
A multistate income tax can be complex, but it should not make you pay too much more in overall additional taxes. You're just going to be moving around what you pay to different states. There are a few caveats too that we'll discuss. The good news, there's always help out there as you navigate through all the potential pitfalls that are out there.
Understanding the franchise tax and the factor nexus
Back before the internet, Congress created public law 86-272. This law provides that if you sell from outside of state into that state, that state can't tax you on the sales. And the key is that selling into the state would not create any sort of income tax nexus, physical presence nexus, economic nexus, or factor nexus.
So life was pretty good, but along came the internet. Along with that came this little startup organization in the nineties, called Amazon. All of a sudden, all the rules changed. It took the states a little while to catch up to them, but they're pretty much caught up to them now.
Some states decided that if they couldn't tax income, they would find some way to tax you. So they created something called a franchise tax. They decided to make you pay this franchise tax if you have one of these types of nexus, even if you don't have a physical presence.
For example, with a factor nexus in California, you may not have a nexus in any other way, but if you have sales in that state of $500,000 or more, that's called a factor nexus with them, and then they start wanting to tax you. But public law 86-272 prevents them from doing it if you're shipping directly to the end user because you don't have a physical presence nexus there. They can still hit you for that franchise tax because of it. So, it's not a tax on the amount of income, it's usually structured in a way that's not specifically that.
The three types of nexus
The difference between the three types of nexus.
A physical nexus means you have, in some shape, form, or fashion, a physical presence in that state. The physical presence of a person, place, or thing that's tied to your business. That physical nexus may be an employee in that state, a sales rep that you have traveling into that state, or an installation, repair, or maintenance crew that goes in there on your behalf. It could also be if you have an office in that state. In some cases, it could be employees or contractors.
Next is the economic nexus. And with the economic nexus, you may not have employees or anything there, but you may have a large enough presence. You created something within that state. You may own a copyright in that state or have something there that you're doing that's kind of creating an asset economically for the state. It could be that you've been given a license to do something there. We don't come across that one quite as much with our clients, but we have seen that one.
Then the third one is factor nexus. That's just simply where the state creates a threshold under which they're not going to tax you, but where they're going to say, you've got nexus here because you've got this much activity or commerce in our state, regardless of how it’s generated.
The minimum requirements for different states
One of the things we've learned over the years is that we had to engage our clients and talk to them on an annual basis about doing that multi-state income tax analysis because it's really hard for us to know as tax professionals what that actually looks like. And, when we do that income tax analysis, it's just really a prediction. It's not an actual number until you prepare the return. There is kind of a due diligence process to get prepared for it, then understand what you have to do yearly.
Once you're in the state, you're kind of in the state. It's really hard to get that state to change its mind. Some states won't require you to register as a foreign agency with the Secretary of State's office for that state, but some will.
If the state does not require you to register and you don't happen to have any sales at the end of the year in that state, you may not have a filing requirement, but a state like California will require you to do it. And once you're registered in the state, whether you have sales for that year or not, you're going to file the return and, at a minimum, you're going to pay that franchise.
We went through the whole list once about the minimums you would have to pay into the state(s) when you kind of exist. Some are pretty hefty, like California, which has at least a minimum of $800. There are a couple of other states that are right up there and one state where it is five figures.
The need for protective language in all your agreements
We discovered that if your contract specifies that the services you provide to someone in California are executed and considered received at your headquarters, where you're located and not in California, then it would not necessarily have to be considered in California.
Again, as long as you don't have that physical nexus there. So, if you're a service provider, you might want to make sure your contracts specify that, unless otherwise stated, all services are deemed to be created, provided, and received in your state and not in some other state.
We talked about public law 86-272 above, but we want to note that it only applies to products. It does not apply to services. That's why those services might otherwise be taxable in those other states, and that's why you want that protective language in all your agreements.
If you want to learn more about building a team across multiple states, check out Episode 104: Multistate Income Tax: Understanding It and How to Get Prepared for It.
