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State Nexus Questions Persist Despite Internet Tax Guidance

Jan. 20, 2023, 9:45 AM

States are continuing to take action after guidance issued by the Multistate Tax Commission in August 2021 regarding whether a seller’s online presence creates nexus for state income taxes.

The MTC’s guidance discusses online activities that go beyond sales solicitation under Public Law 86-272, enacted in 1959 to exempt out-of-state sellers from state income taxes if activities in a state were limited to solicitation for sales of personal property. Online activities that go beyond sales solicitation include the use of certain cookies, taking applications for non-sales positions, and the existence of chat functions to answer post-sale questions.

States such as California, New York, New Jersey, and Oregon have started addressing these matters either through changes in statute or through other administrative means. This leaves many unanswered questions, and taxpayers should pay careful attention to activity concerning this topic since it could increase the state filing obligations for many businesses that sell goods.

The MTC’s Role

The MTC is an intergovernmental state tax agency whose mission is to promote uniform and consistent tax policy and administration among the states and clarify what activities go beyond solicitation. Over the years, it has issued guidance of existing law so states that follow the MTC could adopt these interpretations, which is what it has done with its August 2021 guidance on PL 86-272.

Some states require legislative action to change existing statutes, while others may simply adopt the MTC language without legislative action when auditing taxpayers. Some states, like California, are applying these rules retroactively without any need to change state statutes.

State Activity Toward Adoption and Legal Challenges

California has moved most quickly among the states, taking executive action to adopt the MTC guidance via a Technical Advice Memorandum. New York, New Jersey, and Oregon have begun adopting the MTC’s guidance by regulations, which means the typical period of releasing drafts of the new rules and receiving public comment will delay the timing of final guidance from those states. However, Oregon’s legislature has reached out to applicable stakeholders for feedback before taking further action.

California’s position includes retroactively applying the MTC guidance, meaning companies could be held liable for unprotected activities offered on previous versions of their websites, even if the functionality no longer exists. California and other states may be relying on historic versions of websites to track previous versions. Other states in the process of drafting regulations have yet to express any clear indications on whether they will apply the guidance retroactively.

Given the newness of the MTCs guidance, it’s not clear what the audit process will look like. Auditors already face a steep learning curve any time they undertake the examination of a specific business. And the added complexity of an IT component, such as the technology that companies use to connect to customers, may make the process more challenging.

Additionally, the American Catalog Mailers Association filed a complaint in the Superior Court in San Francisco, challenging California’s action as a wrongful expansion of the reach of state income taxes to out-of-state merchants with no physical presence in the state. This complaint is in the earliest stages of working its way through the courts, but its outcome is sure to play a critical role in determining the validity of California’s stance on this topic and could serve as a bellwether for other states looking to implement the MTC guidance.

Evaluating Your Business’s PL 86-272 Nexus Exposure

Businesses that have relied on PL 86-272 to exempt them from state income taxes should reevaluate those positions, considering the MTC’s updated guidance. It’s probably not time to start filing income tax returns in every state, but decision-makers should create models to understand potential liabilities based on aggressive state interpretations of this guidance.

Management of these issues requires more coordination between tax, marketing, and IT departments than previously needed, as well as input from third-party website designers, sales representatives, and logistics professionals. It may be necessary to hire a third-party consultant to set up a process going forward to confirm whether any current or future technological advancements don’t have an impact on the business’s state filing footprint.

Documenting website functionality will be critical, and consideration should be given to other digital channels between customers and sellers, such as apps and other property requiring periodic software updates. It may not be practical to train IT specialists on the legal subtleties of this process, but training them to identify possible functionalities that could cause a problem and seek advice on alternate features that might have more favorable tax outcomes could pay significant dividends.

As technology evolves, businesses will be hard-pressed to avoid the potential reach of this issue. It’s very possible that all businesses that use a website or provide software or applications as part of their offerings will have a nexus presence for state income tax purposes.

Next Steps

Businesses impacted by PL 86-272 should monitor activities in states where they ship products and evaluate if the services offered on their websites could trigger state income tax liabilities under the latest guidance. They may also want to consider modeling out the tax impact of various scenarios. On the positive side, careful analysis of sales sourcing could result in refund opportunities and lower future liabilities in some states.

The biggest concern for most businesses now is the high volume of unanswered questions. With only one state taking definitive action and three more starting the legislative process, there’s a host of uncertainty around this topic that will be addressed only as more states act and court challenges are resolved. In the meantime, it’s critical for businesses that could be affected by these new rules to monitor developments closely and stay in contact with their tax advisers to understand the compliance obligations.

If you have questions about the impact of PL 86-272 on your state and local filings, please contact your tax adviser to discuss your specific facts and circumstances.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Tony Israels leads Plante Moran’s National Tax Office’s state and local tax due diligence group. He has clients in manufacturing, the service industries, and private equity.

David Landwehr is a state and local tax manager at Plante Moran helping clients of all sizes and industries by minimizing tax exposure while remaining compliant in a dynamic and constantly evolving state and local tax world.

Jeanette Tolar is the leader of the state and local tax team for the Rocky Mountain region and is responsible for identifying clients’ state and local tax risks and opportunities, as well as finding solutions to minimize and manage their state and local taxes.

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