How Wayfair Risks Can Lead to Opportunities
The landmark Wayfair case has had far-reaching impact, but along with the expansion of nexus comes planning opportunities for both income tax and sales tax.
The Supreme Court’s June 2018 decision in South Dakota v. Wayfair, Inc. was a significant reversal of the Court’s earlier judicial rulings, suddenly enabling states to impose economic nexus on remote sellers and requiring them to collect and remit sales tax if they met certain thresholds. This was a fundamental shift in how nexus had been interpreted, and it effectuated many reporting challenges for small and midsize businesses. No longer was physical presence required for sales tax imposition, and no longer was any state prohibited from taxing businesses it viewed as doing business within its borders. Because of this ruling, most states established economic nexus thresholds for sales tax. In addition, states have adopted economic nexus standards for income tax, which many states have enacted prior to Wayfair.
Today, a vast number of states impose economic nexus for income tax. However, unlike sales tax, it has been a much longer road for the widespread adoption of economic nexus for income tax. Wayfair overturned the 1992 Supreme Court case in Quill v. North Dakota, which had affirmed the “physical presence” requirement as the law of the land under the Commerce Clause. Back when Quill was decided, the Court explained that, “although we have not, in our review of other types of taxes, articulated the same physical-presence requirement…established for sales and use taxes, that silence does not imply repudiation of the…rule.” Many states capitalized on this, opening the door for states to augment economic income tax nexus standards into practice, either by statute, case law or interpretation. The outset of this movement is often referenced to the 1993 South Carolina case in Geoffrey Inc. v. S.C. Tax Comm’n, where it was determined the taxpayer established nexus, even though the taxpayer lacked physical presence in the state, but its licensing of intangibles was sufficient in establishing nexus.
As many states look to balance their budgets, with invoking “doing business” standards within broad income tax nexus provisions, businesses, in turn, have a filing requirement with any in-state sourced sales. Other states use bright-line thresholds, similar to sales tax economic nexus thresholds, which establish nexus when either factors of sales, payroll or property are exceeded in a state. Many businesses mistakenly assume only states with these bright-line factor presence thresholds result in economic nexus, but many other states are equally aggressive in enforcing broad economic nexus provisions on virtual presence.
Certainly, there are new risks in the landscape of state income tax with Wayfair. First, the evolving progression of economic nexus is amplified, signaling to all states that economic nexus is sound law. This has furthered states’ aggressiveness in enforcing broad nexus provisions. Second, with sales tax economic nexus, coupled with the trend of states imposing sales and use tax on services, more businesses are being required to register with revenue departments for sales tax. This has resulted in increased audit detection risks for income tax as more businesses register for sales tax. All told, the state income tax landscape has certainly been impacted as a result of Wayfair, resulting in an increased reliance of federal law protection, known as P.L. 86-272. However, such protection is limited to income taxes, not taxes such as gross receipts, and only to remote sellers of products, leaving service providers exposed.
Refocusing on Market Sourcing for Opportunity
With risks comes opportunity. As in-state sales could result in income nexus, the crux of the matter with sourcing in-state sales across the states often leads to many issues. Jurisdictions across the country use different sourcing rules for service industries, which are found to be both complex and vague, while often lacking adequate guidance. Frequently, businesses apply generic sourcing rules across states with similar methodologies. However, it is incredibly important to highlight that no state statute is the same, as each jurisdiction has their own case law, guidance and interpretations.
The adoption of market-based sourcing has been one of the most significant trends in state income tax in recent years. Conceptually, market sourcing assigns sales based on the location of the customer or where the customer receives the benefit of such services. The states’ rules attempt to identify the marketplace location for the service transaction. However, there may be countless sourcing rule variations across jurisdictions. These variations may include customer types (i.e., individual versus business), revenue streams and look-through rules (i.e., direct customer or ultimate consumer), in addition to cascading rules that many states employ that often lead to subjective sourcing application. This lack of uniformity could benefit businesses with planning opportunities. For example, does a service provider contracting with a health plan provider source its sales to the location of the health plan’s headquarters, the health plan provider’s offices where the services are delivered, by billing location or should it look-through to the ultimate beneficiary of the health plans? The divergence of rules could allow for planning opportunities to shift revenue into low-tax states and/or result in untaxed revenues for multi-state businesses.
Sales and Use Tax
With sales tax, to further confuse matters, states have different enactment dates, sales and transaction nexus thresholds, as well as different rules regarding taxability of products and services. Businesses that are unaware of these changes run the risk of under-collecting sales tax if not registered or not properly identifying the applicable tax rules. While automation and technology are available, full implementation may be a protracted process. Absent a thorough understanding of the countless solutions that are suitable for the business model, companies risk substantial assessments.
Although Wayfair afflicted businesses, there is some good with the bad. With many revenue streams comprising of services and digital products, its more crucial than ever that a taxability review is performed. As states are scarce with guidance, or employ ambiguous statutes, opportunities exist to assert non-taxability in many instances. Further, businesses should understand that vendors may be just as confused by the taxability. Therefore, businesses should review the taxability of their purchases with vendors to determine if a conventional position is being applied to an area of the law that might be grey.
Planning in a Wayfair World
Performing income tax and sales tax reviews in a Wayfair world may help alleviate some of the burden. These steps could assist in reducing tax liabilities, improving organizational cost efficiencies and determining potential refunds. In turn, such reviews may also identify exposures, enabling businesses to possibly mitigate liabilities to a defined look-back period with state amnesty programs or the like.
James A. Bartek
James A. Bartek, CPA, is a partner in the State and Local Tax Practice at Withum. He is a member of the NJCPA State Taxation Interest Group and the Department of Labor and Directors work groups.
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Jason Rosenberg, CPA, CGMA, EA, MST, is a senior manager in the State and Local Tax Practice at Withum. He is a member of the NJCPA Content Advisory Board.
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This article appeared in the July/August 2020 issue of New Jersey CPA magazine. Read the full issue.