Sales Tax Nexus
Sales tax nexus defines the level of connection between a taxing jurisdiction such as a state and an entity such as your business.
Until this connection is established, the taxing jurisdiction cannot impose its sales taxes on you.
Nexus determination is primarily controlled by the U.S. Constitution, in which the Due Process Clause requires a definite link or minimal connection between a state and the entity it wants to tax, and the Commerce Clause requires substantial presence.
In South Dakota v. Wayfair, the Court eliminated the physical presence rule within the Commerce Clause as the standard for creating nexus in a jurisdiction. However, physical presence will still create nexus and is the first consideration in determining nexus. In the lead up to the Court’s decision, many states enacted new types of economic nexus legislation to address how sellers conduct business today.
There is no specific shared definition of nexus across the 50 states. Moreover, definitions and rules for determining nexus change constantly, and most states are careful to give themselves room to maneuver in their definitions. This means that a business must look at each state individually when determining sales tax nexus and must stay constantly on top of a slew of changing regulations and interpretations.
Here are a few representative definitions of Nexus that most states would more or less agree with. As you read them, you can almost feel the steel jaws starting to clamp around you:
Other states may set their own economic nexus threshold, but it must prove to not impede on nor create an undue burden on interstate commerce. South Dakota v. Wayfair established what would be considered acceptable to the Federal courts as being constitutional. Therefore, a majority of states have set the $100,000 in sales or 200 separate transactions as their threshold. These definitions—which focus around having a business presence in a state—are just starting points for determining nexus.
There are innumerable details, timescales, vagaries, and state-by-state idiosyncrasies involved. The point is, if you have knowingly or unknowingly created nexus in a state, then you are subject to some very strict obligations.
Click-Through Nexus legislation typically requires that a remote seller meets a minimum sales threshold in the state in question resulting from activities of an in-state referral agent. The seller must be making commission payments to the in-state resident for any orders that come about as a result of the click-through referral from the resident’s website.
Affiliate Nexus legislation typically requires that a remote retailer holds a substantial interest in, or is owned by, an in-state retailer and the retailer sell the same or a substantially similar line of products under the same or a similar business name, or the in-state facility/employee is used to advertise, promote, or facilitate sales to an in-state consumer. The legislation may not always require common ownership. And it may not include activities related to sales, delivery, service and maintaining a place of business in the state on behalf of the out of state business to benefit the out of state business’ customers.
Marketplace Nexus legislation typically means that if an online marketplace operates its business in a state and provides e-commerce infrastructure as well as customer service, payment processing services and marketing, the marketplace facilitator is required to register and collect tax as the retailer rather than the individual sellers. This could also impose reporting requirements on the marketplace facilitator.
Notice and Reporting Requirements legislation typically requires that a retailer must notify buyers that they must pay and report state use tax on their purchases. The retailer may be required to send purchasers and the state an annual statement of all of their purchases from the retailer.
Economic Nexus legislation generally requires an out-of-state retailer to collect and remit sales tax once the retailer meets a set level of sales transactions or gross receipts activity (a threshold) within the state. No physical presence is required.
Economic nexus was a central issue in the United States Supreme Court case, South Dakota v. Wayfair. On June 21, 2018, the U.S. Supreme Court ruled in favor of South Dakota and overruled the traditional physical presence rule as a necessary requirement to impose sales tax and collection requirements on a remote retailer. This was the first Supreme Court decision on nexus since 1992. States now have the right to require tax collection from online retailers and other remote retailers with no physical presence in their state if they meet certain economic thresholds.
What is a Voluntary Disclosure Agreement?
A voluntary disclosure agreement (VDA) or Tax Amnesty Agreements (TAA) is a contractual agreement between your company and the state in which your company comes forward voluntarily to pay its tax obligations in exchange for state concessions in the form of reduced penalties and limitations on the number of years under consideration for outstanding tax liability.
States VDA programs are ongoing so you can apply anytime. Acceptance into a program will be contingent upon the fact pattern of your company’s noncompliance. Should your company consider a VDA? Check out potential benefits and drawbacks below.
Pros of Voluntary Disclosure Agreements
Limited exposure, tax liabilities, and penalties.
The greatest benefit by far and way of entering a VDA are the financial incentives to your company. The state will typically limit the “look-back” period for unpaid tax to three or four years for sales tax VDAs. For example, if your company did not collect sales tax for 10 years, the state will limit their assessment going back and you will only be required to report and pay tax on the 3-4 years included in the look-back period (vs. the full 10 years). This can result in significant savings for your company if your sales tax liability extends well beyond the look-back period. (However, this won’t apply if you’ve collected the tax but not remitted it!)
A VDA also typically reduces or eliminates penalties associated with the uncollected sales tax. A penalty abatement can also yield significant savings. Penalties accumulated over years of unpaid tax can really come back to bite you if your company is discovered in an audit. Interest on unpaid taxes may or may not be reduced depending on the state.
VDA negotiation is often anonymous.
You can usually enter a VDA anonymously through a representative such as a tax advisor, CPA, or attorney. Your third-party representative will initiate the VDA process with the state by either submitting a letter or an application form on your behalf. Your representative will negotiate penalty reduction, limiting the look-back period, and potentially setting up a payment plan for back taxes that works for your company.
Most states do not require your representative to disclose your company name during this early stage of communication. The representative will be able to determine your eligibility for the VDA program and the types of benefits you may receive while greatly minimizing any negative effect to your business. Anonymity gives you the option to reject the state’s offer.
If you choose to apply anonymously for a VDA in Washington state, you must disclose the business identity within 15 calendar days of the application date. You are only afforded protection from discovery by the Department of Revenue during that 15-day period.
New York is one of the states where anonymity is not part of the VDA process. In New York, you are required to disclose your company name and tax ID as part of the application process.
You have the opportunity to “come clean” and get right with the state when you realize a mistake.
When you enter into a voluntary disclosure agreement, you demonstrate that prior mistakes resulting in unpaid tax liabilities were not made maliciously, but out of error or a misunderstanding of tax rules.
A VDA allows you to come forward in a low-risk fashion, negotiate terms, get compliant with the state, and move forward in a cost-effective way due to a shortened look-back period and reduced penalties.
However, if the errors causing you to enter the VDA were found as the result of an audit, the situation will likely not result in such an ideal fashion. Once you realize any errors, you don’t want to wait around to be found during a sales tax audit. The penalties of noncompliance could be much steeper.
You cannot participate in a VDA if you have been contacted by the state about an audit or otherwise. If there was contact, the disclosure is nullified. In most cases, if you are already registered, voluntary disclosures are unavailable.
Cons of Voluntary Disclosure Agreements
Any missing details can void the VDA or result in ineligibility.
If you do not disclose all of the facts regarding your company’s situation, including nexus creating activities, and the missing facts are material or essential to the agreement, the VDA can be voided.
If you fail to disclose certain key details to your third-party representative during the early stages of the process, you may get to the point in the VDA process where your taxpayer identity is disclosed only to be deemed ineligible because of the impact of the missing information.
You should work closely and carefully with your representative, so you don’t blindside them (even if unintentionally) and potentially end up exposing your company’s identity to the state without being able to take advantage of the protections of a VDA.
Complete your due diligence, which may include a thorough nexus study, and gather all of the information relevant to the VDA process and application as indicated by the state. Which leads us to the second con…
States have varying requirements for VDAs.
Each state can determine its own requirements for the VDA process. This will directly impact how much work you must do and how much information you must gather.
Part of the VDA process includes disclosing your sales connected to your uncollected tax for the period under scrutiny for the VDA. Some states, such as Ohio and Tennessee, allow you to fill out a spreadsheet indicating typically the amount of taxable sales per period going back. Other states, like California and New York, will require you to complete tax returns for each period instead of a consolidated spreadsheet.
A component of determining tax owed from prior period sales is using the correct sales tax rate for the jurisdictions you made sales into. Some states will allow you to use a “blended” tax rate instead of requiring you to break your sales out by each jurisdiction within the state and the period the sale was made. Washington takes this approach and calls it a “pool” rate.
Another nuance among states involves eligibility. Most states will allow companies that have registered and filed for income tax in that state to enter a VDA for sales tax, but some states do not allow this.
Additional tax liabilities may be uncovered.
Most states require a VDA to include all taxes that your company is subject to, based on company activities. The types of activities uncovered, particularly those that impact nexus, could result in additional types of tax liabilities being due to the state. Sales tax nexus in a state is a decent indicator of nexus exposure for other tax types.
If you participate in a sales tax VDA and the facts you disclose indicate that your company should also be filing for income tax, the state will want you to initiate a VDA for income tax as well. In some states like Ohio and Washington, you may be on the hook for hybrid, shape-shifting gross receipts taxes.
What started as a mission to come into compliance for one type of tax may unfold differently than expected.
Is a VDA for you?
If your company qualifies, using a VDA to proactively come forward and pay what you owe is the most advisable option. Choosing to play the audit lottery once you discover noncompliance in your company is risky business. Penalties will be much steeper should an auditor find you. Additionally, the state tax agency can assess tax as far back as your nexus date without the protection of a limited look-back period of a VDA. Public companies subject to ASC450 provisions likely can’t avoid taking the corrective actions.
You must weigh the pros and cons specific to your company’s situation. Forgoing a VDA and registering through the standard registration process for sales tax may be the best fit for your company in the end.
Voluntary disclosure agreements aren’t the only option to get right with the state in a way that limits your liability and exposure. On occasion, states will offer a state tax amnesty program that allows taxpayers to pay back taxes without any penalties or interest if they register within the program timeframe.
Revenue shortfalls stemming from the pandemic mean states will be more vigilant in their pursuit of non-compliant companies. Sales tax experts hypothesize that states may begin to offer new sales tax amnesty programs in the coming months to encourage businesses to comply with economic nexus laws.