Last week the Supreme Court ruled in South Dakota v. Wayfair that South Dakota’s law forcing Wayfair, an Internet retailer, to collect (and remit) sales tax to South Dakota (a state that it did not have physical nexus to) was valid. The decision overrides a previous Supreme Court decision called Quill Corp. v. North Dakota). There’s been plenty of excellent coverage on this ruling (see, for example, the Tax Foundation and Kelly Erb). But I’m wondering what this means for income tax and economic nexus.
A few states have passed laws stating that if you have economic nexus to a state you need to file a tax return to that state. California is one such state. Eventually, cases on economic nexus will go through the court system (and with a certainty the US Supreme Court will have the final say). While no one knows how the Court will rule on such cases, there are indications.
From a case called Complete Auto: “The Court will sustain a tax so long as it (1) applies to an activity with a substantial nexus with the taxing State, (2) is fairly apportioned, (3) does not discriminate against interstate commerce, and (4) is fairly related to the services the State provides.” In Wayfair, the Court ruled that “Physical presence is not necessary to create a substantial nexus.”
The key point is noted by Justice Kennedy:
The Court has consistently explained that the Commerce Clause was designed to prevent States from engaging in economic discrimination so they would not divide into isolated, separable units. See Philadelphia v. New Jersey, 437 U. S. 617, 623 (1978). But it is “not the purpose of the [C]ommerce [C]lause to relieve those engaged in interstate commerce from their just share of state tax burden.” Complete Auto, supra, at 288 (internal quotation marks omitted). And it is certainly not the purpose of the Commerce Clause to permit the Judiciary to create market distortions. “If the Commerce Clause was intended to put businesses on an even playing field, the [physical presence] rule is hardly a way to achieve that goal.” Quill, supra, at 329 (opinion of White, J.).
So four questions need to be answered for whether a state can tax a service business conducting no services within that state. Let’s assume there’s a tax preparation business in Nevada that has customers in New York, and New York passes a law saying that if you have any sales to New York residents you must pay New York state income tax and register your business in New York. The questions that must be answered are: Is their substantial nexus to New York, is the tax fairly apportioned, does it discriminate against interstate commerce, and is the tax fairly related to the services that New York provides. We’ll assume the tax is fairly apportioned.
Consider a Nevada tax professional who has one client in New York out of one thousand total clients. Is there substantial nexus? Almost certainly not, and it would be hard to see such a tax passing muster. Thus, some sort of de minimis rule is necessary. Note that in the instant case that the South Dakota law has such a rule.
Consider now a Nevada tax professional who has 200 clients in New York out his one thousand clients. We’ll assume that passes the de minimis hurdle. The two other questions (and I think they’re linked) come into play: Is the tax fairly related to services that New York provides and does it discriminate against interstate commerce?
The first of these questions has two sides. All of the work done here (remember, this is a service business) is being done in Nevada, not New York. That leads to a conclusion that New York income tax is not related to services provided by New York. (However, if New York had a sales tax on services the business would likely need to comply.) On the other hand, the person contracting for the services is a New York resident.
I think the first argument is the better one. The income being earned is based off of work done in Nevada, not New York. Nevada, not New York, has the right to tax its residents on income earned in the state. Because of this, I think that if New York were to tax such income it would discriminate against interstate commerce. (There is an other side to this argument, though. New York can argue that there would be a tax credit available, and that would eliminate the issue. Still, the filing of the return adds to the burden of the Nevada taxpayer, and is an issue.)
That there are two sides to this argument shows that there is no one right answer. In the end, the Courts will end up making the decision about economic nexus and income tax. Indeed, sometime around 2021 I expect a Supreme Court decision on this issue.
