The Surprising Benefits of Nexus: Multistate Taxation Actually Can Lower a Company's State Income Tax Bill
Howard, Bruce, Journal of Accountancy
The U.S. economic landscape consists mostly of small businesses. In 1997, of the 5,541,900 businesses in the United States, 98.3% had fewer than 100 employees. To keep abreast of the constantly changing tax rules in the 50 states where these companies might do business requires resources most of them don't have. Instead, they must depend on their accountant to help them avoid a potentially dangerous pitfall--the franchise or business privilege taxes some states impose on nonresident businesses that have an economic presence in the state. CPAs may find that, under the right circumstances, these taxes actually can end up creating overall tax savings for their clients or employers.
A CASE IN POINT
The single business tax (SBT) the state of Michigan imposes on companies that do business there is a good example of a tax that can cause problems for out-of-state enterprises. This tax has been the focus of considerable controversy over the last several years: The Michigan Department of Treasury has begun to apply a nexus standard retroactively in a manner inconsistent with the guidance it previously had provided. Businesses that thought they were exempt now find they have tripped the state's SBT nexus standard. (A business has nexus when it has sufficient presence in a state to allow the state to legally impose a tax.)
One of my clients had a difficult time with Michigan. The state's treasury department contacted the company in the early 1990s and asked it to respond to a standard nexus questionnaire. All the client's property and payroll were concentrated in one location outside of Michigan. As a result all its income was taxed in that one state. The only business presence the company had in Michigan was a sales representative who entered the state a few times each year to call on customers and solicit orders for home office approval. The client claimed protection from Michigan's SBT tax under public law 86-272 and heard nothing in response until the state contacted it for an audit in 2000. (Public law 86-272 generally restricts a state from imposing a net tax on a company's income derived from interstate commerce within its borders if the company's only business activity in the state is soliciting orders it sends outside the state to be accepted--or rejected--and filled. Net income taxes includes a franchise tax based on net income.) Michigan's treasury department officially changed its position on nexus in 1998 and decided to apply a 10-year, look-back period reaching back to 1989 for purposes of assessing SBT tax, interest and penalties.
Although Michigan's SBT tax base begins with net income, companies are not protected by public law 86-272 because technically the SBT is not considered an income tax. Michigan successfully levied this tax on out-of-state companies that solicited only occasional orders in the state. Michigan's voluntary disclosure program provided no relief to the client since the state already had contacted it for an audit. The company did indeed have to pay 10 years of tax, interest and penalties.
This otherwise dark cloud, however, had a Silver lining. The experience motivated the client to ask for a thorough review of possible nexus issues in other states. As it turned out, the company had franchise tax exposure in nine other states. Unlike income taxes, franchise taxes are imposed for the privilege of doing business in a state and are not covered by public law 86-272. The mere fact a company has sales representatives soliciting orders in a state is often sufficient to establish nexus for franchise tax purposes.
SOLVING THE PROBLEM
The client's next step was to contact the nine states and take advantage of voluntary disclosure programs that limited the look-back period to three or four years. The company filed franchise tax returns and paid the appropriate taxes and interest. (In all the voluntary disclosure cases, the states waived penalties and, in one case, interest. …