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Tax Update: Hang Onto Your Hat

If you drive south on I-93 from New Hampshire, you’ll eventually see a sign at the side of the road just past Salem that says, “Massachusetts Welcomes You.”

Unfortunately, state income tax rules don’t provide equally clear sign posts, and when they do, they aren’t always so friendly. It can sometimes be difficult to determine when a business in, say, New Hampshire has crossed the line and become subject to the tax rules of, say, Massachusetts -  or Maine - or New Jersey.

The states themselves don’t make it easy, even for taxpayers trying their best to comply. The array of tax rules — with unclear guidance, limited consistency, constant change, and no overall refereeing authority — is bewildering. Even after doing a careful analysis, taxpayers can be left scratching their heads: Have they missed something? Will they be held liable, long after the fact, for not filing prior-year returns?

Let’s get physical

The starting point in determining taxability in a given state is known as “nexus.”

Nexus is a connection, traditionally a specific physical connection, that establishes a business presence in the state and which can lead down the road to the business being taxable in the state.

• Nexus is usually established by owning or renting property in the state or by hiring an employee who works there, but it can also be established in other ways that involve even less contact. 

Under a longstanding federal rule, out-of-state companies must establish a minimum physical presence in another state in order to be taxable in that state. Certain states would like to bend or break the rule, but it’s still very much intact — and offers some protection to out-of-state companies. 

However, the rule is limited to companies selling tangible personal property in which customer offers to buy the property are accepted back in the home state, or at least in some other state. It does not apply to companies that sell personal services, to sales taxes, or to any other tax that is not an income tax.  

More revenue, please

A significant new development over the past few years is known as “economic nexus” — as states wishing to expand their ability to tax activities by out-of-state firms have nibbled away at the federal rule. Instead of the idea of physical connection, economic nexus is based on the idea that if a company uses the marketplace of a state for purposes of economic gain, then the company is taxable in that state.

This puts out-of-state companies on notice that it might not take much connection to a given state to be taxable there.

Massachusetts, through a series of court cases, helped pioneer this trend. The courts ruled that credit card companies exploiting the Massachusetts marketplace to earn credit card fees and related revenues were taxable despite having no property, employees, or other traditional connection to the state. The exploitation consisted of the companies advertising their products on television and other media. The earnings from these activities were significant; the connection was not. But the courts’ conclusions were in keeping with the trend. 

In Maine, out-of-state companies with economic nexus are subject to Maine’s income tax laws, and “all open periods may be subject to review” — meaning that if you didn’t file there, thinking you weren’t liable, then all years are potentially open to assessment.

Meanwhile, large numbers of other states are already on board or following suit.

All is not lost

Fortunately the idea of economic nexus has generally been applied to companies selling personal services and the use of intangible assets, not products. Selling tangible products still falls under the old federal rule in most circumstances.

• But what if a company sells a product and supplies a service along with it?
• What if a company advertises on television in Boston and viewers in Manchester pick up the broadcast? Has the company exploited the New Hampshire marketplace?

As you can see, there are many gray, ill-defined areas. Worse yet, because taxes not based on income are not protected by the federal rule, it is entirely possible to be immune from income tax nexus yet still be liable for sales tax and other taxes not based on income.  

Finding shelter

The potential for double taxation or an increased effective state income tax rate when filing multiple state returns must be strategically managed given the increasingly complicated nexus and related state income tax guidelines. For seasoned guidance through the storm, contact BerryDunn’s John Weaver or Mike Caouette.