Online sellers of a certain size may end up owing income tax in more than one state. Tax guru and small-business expert Barbara Weltman, founder of Big Ideas for Small Business, Inc., delved into this issue to see what merchants need to know about this complicated issue.
By now, most remote sellers are familiar with sales tax rules that may require collecting, remitting, and reporting state sales tax on transactions in states beyond their borders. These sales tax rules all have “small seller” exemptions, although they vary by location. But does remote selling mean you also owe state income taxes where the transactions occur? It’s problematic, here’s why, and what you should do.
Your ”nexus” for sales tax
Nexus is a legal term that means connection, which is what is required for a jurisdiction to tax you. If you are physically within New Jersey and do all your business there, then California can’t arbitrarily impose its sales tax on you. But if you sell remotely to customers in California, is this a sufficient connection to subject you to California taxes?
The trend in law has been moving from a physical presence to an economic presence, which may be established by online activities. The issue arose in connection with sales tax when the U.S. Supreme Court said a South Dakota law requiring remote sellers to register and collect sales tax there if, during the year, there were more than $100,000 in sales or more than 200 separate transactions in the state, was constitutional. There was sufficient nexus via online sales to allow a state to collect sales tax.
Your “nexus” for state income tax
In 1959, a federal law—the Interstate Income Tax Act—limited the reach a state could have over a remote seller. That was before the internet. Subsequent to the Supreme Court’s decision on sales tax, the Multistate Tax Commission (MTC) revised its Statement of Information with respect to state income tax to equate internet transactions with a physical presence. But does this automatically mean that every business that conducts online selling is subject to state income tax where the customer is located? If everything post-sale—fulfillment, customer support—occurs in your state, are you exempt in light of federal law from a sufficient nexus to trigger state income tax at the customer’s location?
While there is potentially a nexus through online selling, you have to look further:
• Extent of activities. According to the MTC, a business shouldn’t be subject to state income tax outside its physical location unless it meets any of the following thresholds in another state: $50,000 in property; $50,000 in payroll; $500,000 in sales, or 5% of total property, total payroll, or total sales. So, if your sales exceed $500,000 in a remote state, you may be subject to state income tax there. States have their own income tax nexus rules, which may subject even smaller online sellers to state income tax if they maintain a physical presence (e.g., a warehouse) within its borders.
• Nature of activities. The Statement of Information says that certain activities are not protected by federal law; these activities create a nexus with a state that triggers state income tax there. So, simply maintaining an online store for customers to make direct purchases probably shouldn’t cause state income tax issues, because this is an activity protected by federal law. But the nature of online activities, such as providing customer assistance using electronic chats or email, putting cookies on a customer’s use of a site to get information for marketing purposes, and providing streaming video or music, may result in unprotected activities and cause state income tax consequences. Some states, such as California, may put their own spin on the protection to online selling afforded by federal laws.
Income tax consequences of nexus to another state
If you have a nexus to another state, what does this mean for income tax purposes? Clearly, it requires filing a state income tax return for a nonresident. How much revenue must be reported to that state? It depends on “apportionment,” which is the portion of business income allocated to a state for state income tax purposes. There are different apportionment formulas, with most states using one of three formulas: one giving equal sales, payroll, and property within the state, a second using only sales within the state, and a third using the three factors but giving them different weight (e.g., more weight to sales than payroll or property).
What to do
Sellers that may be subject to state income tax based on their online sales need to consult with a tax expert to determine:
• Whether they have state income tax obligations to one or more states beyond their own.
• Whether there are estimated tax obligations to these other states.
• When they need to file state income tax returns.
• If subject to tax in other states, how to use apportionment rules to best advantage.
Conclusion
As technology evolves, so too does state law on taxes. State income tax obligations in the past may change. Know where you stand so you can avoid costly tax problems.
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