Welcome to SALTy Bits! I'm Will Clark, a director in our Kingsport, Tennessee office, and I recently sat down with Jared Brown, a partner in our Bristol, Tennessee office, to walk through the basics of two concepts that come up constantly in state and local tax work: nexus and apportionment. Here's a recap of what we covered.
Jared asked me to start with a simple definition. Nexus is a legal connection between a taxpayer and a tax authority or jurisdiction that allows that agency or jurisdiction to tax the taxpayer's income.
That sounds simple enough on its face, but there's a bit more to it than that one sentence.
Jared asked whether nexus requirements vary between income tax and sales tax, and across different localities. My answer was, essentially, “yes”: there's a great deal of variation in the way each state defines nexus and even in how each state defines nexus for each specific type of tax they administer. For example, sales tax nexus is often defined differently from income tax nexus, and there can be further differences for taxes like franchise tax or franchise-type taxes in many states.
For sales tax, the most common standard we see is economic nexus, generally defined by a certain dollar volume of sales or a number of transactions sourced to a given state. There is also marketplace nexus and affiliate nexus, among other variations, but economic nexus is a very common standard for sales tax purposes.
For income tax purposes, the analysis is broader. You have to consider physical presence, meaning whether the business actually has people or property located in a given state. You also have factor nexus, which, similar to economic nexus for sales tax, is defined by having a certain dollar volume of sales or number of transactions sourced to a state. Physical presence and factor nexus are the two biggest types of income tax nexus, though other forms of economic nexus can also apply, depending on the locality.
Jared summarized it well: physical presence nexus can apply to both sales tax and income tax. Economic nexus tends to be more of a sales tax concept, while factor-based nexus is its sister concept for income tax purposes. That's an accurate way to think about it. I'd also add something important: it's entirely possible for a business to have nexus for one type of tax, like sales tax, while not having nexus for another, like income tax.
We kept this discussion to the basics, so we didn't dive into every definition of “nexus” out there—things like cookie nexus, affiliate nexus, marketplace nexus, and many others; those are all very real, important concepts, but they're a topic for another day.
From there, Jared and I moved into apportionment. Before diving into apportionment itself, I wanted to draw a contrast with a related concept: allocation. Allocation is directly earmarking, or considering, a certain type of income, specifically non-business income, as being sourced to a particular state. Non-business income generally means things like unearned income, interest, and dividends, and I agreed, adding that it can also include rental income.
Apportionment works differently. Instead of earmarking specific income to a specific state, you take the entire pool of business income a taxpayer has generated and divide it among the states based on a mathematical formula.
So, what actually goes into that mathematical formula? States commonly use three factors to apportion income: sales, property, and payroll.
Sales and payroll are relatively straightforward. Sales are the gross revenues or gross receipts derived from, or sourced to, a given state. Payroll is typically the gross wages paid to employees performing services in a particular state.
Property factors are a bit broader. They can include what a business pays in rent for real or tangible property used in a state, but also the cost basis of property the business owns there. For example, if a company owns a warehouse in a particular state, the cost of that warehouse is part of its property factor.
We also touched on sourcing sales, essentially, figuring out how a product is sold and shipped in order to determine where the sale is sourced. Sourcing rules vary widely between different tax jurisdictions, and that alone could be an entirely separate topic down the road.
I walked Jared through the main approaches states take when weighting these three factors:
Naturally, Jared asked about our home state. Tennessee has recently converted to a single sales factor. It used to be a three-factor apportionment state, but over the past several years it has been increasingly weighting the sales factor, to arrive at its current single-sales-factor approach.
To wrap up, here's what I'd want folks to remember. On nexus: it's the relationship that subjects a business to tax in a state. That mostly means it subjects you to a filing requirement, not necessarily an actual tax bill. Whether you owe tax in a given state depends on a lot of different factors. Keep in mind there are three main types of nexus to watch for: economic nexus, most commonly associated with sales tax; physical presence nexus; and factor nexus (both relevant to income tax).
On apportionment: it's driven by mathematical formulas, so if we're talking about apportionment for income tax purposes, at least part of a taxpayer's income will be taxed in a given state. Depending on the specific factors and formulas involved, it's possible for a taxpayer to end up paying tax on more than one hundred percent of its taxable income when you look across every state where it operates and has nexus.
That's a lot of ground to cover, and it's easy to see how this can get confusing quickly. As always, reach out to your SALT group with questions, and thank you for following along with SALTy Bits.