Every business that sells products and services beyond its home state or has a location in another state should understand the meaning of nexus. As a business owner, it is important that you know what nexus is, why it is important, and if you have nexus in other states.
I recently presented a webinar on this topic for CPA Academy, and I want to share the information here as well. If you’re an accountant or tax advisor, knowing how to determine nexus in a state will help you when offering guidance to your clients. If you’re a business owner, having a grasp on nexus and its implications for your company will help ensure you keep your business in good legal standing.
An Introduction to Nexus
Nexus implies that a company is connected to a state in some way. When nexus is established, it generally means a business must register to collect or pay taxes in the state. Unfortunately, no universally shared definition of nexus exists, so the rules for what constitutes nexus vary across the 50 states. And states regularly change their rules for what determines nexus. Because of those variabilities, business owners must research each state’s rules individually and keep up with any changes.
That said, generally, a business will be considered to have nexus when:
- It has a physical presence — such as an office, store, or warehouse — in the state.
- It has a certain degree of economic activity or income — without a physical presence — in a state. Most states have monetary or transaction thresholds at which nexus is established. For example, many consider a company to have nexus and require it to pay sales tax if it has more than 200 sales transactions or $100,000 in sales within the state annually.
- It has employees working in another state.
The Different Types of Nexus
Here are some additional details about the various flavors of nexus.
Physical nexus exists when a company has employees, agents, brokers, representatives, or subcontractors working on behalf of their entity in another state. Other instances of physical nexus are the presence of tangible property — e.g., a brick-and-mortar store, office, real estate, vehicles, warehouses, etc. — physically located in the state. As with other types of nexus, the qualifying criteria for physical nexus vary by state.
Examples of physical nexus:
- A company based in Ohio has employees located in Ohio, California, Colorado, and Georgia. The business would be considered to have physical nexus in all of those states.
- A company located in Ohio has contracted with a dropship vendor in California. Physical nexus exists in both Ohio and California.
- A business in Ohio has tangible inventory stored in a warehouse in Alabama. The company has physical nexus in Ohio and Alabama.
Economic nexus is also known as sales tax nexus. What is sales tax nexus? It is when a business in one state reaches a certain annual sales revenue threshold or a number of sales transactions in another state, requiring the company to collect and remit sales tax in that other state. Many states consider a business to have economic nexus when it has 200 sales transactions or $100,000 in sales revenue annually in their jurisdiction.
Most states have enacted nexus laws that affect remote sellers, including marketplace facilitators (like Amazon) that may have an e-commerce infrastructure, customer service center, marketing operations, and payment processing services in the state. Typically, remote sellers and marketplace facilitators — not the individual sellers that use their platforms to sell products — that meet the state’s nexus criteria must obtain a seller’s permit and collect and remit the state’s sales tax on taxable purchases.
Sales tax regulations vary by state, with each state setting its own rules, registration process, and tax rate for out-of-state retailers that reach economic nexus in their jurisdiction.
Examples of economic nexus:
- A business is located in Ohio and has annual sales over $100,000 in Arizona and Colorado. The business would have nexus in all three states.
- A business is located in Ohio and has received 200 orders annually in Arizona and Colorado. The business would have nexus in all three states.
If a business has employees working in another state, even if they don’t live there, then the company has income nexus in that state. In other words, nexus occurs when an employee conducts work in a different state, whether or not the individual resides in that state.
Employers must comply with the state’s payroll tax rules where the employee performs their work. For example, CorpNet has employees who live and work in other states, so we have to have tax accounts in all of the states and calculate withholdings for those out-of-state employees according to their state’s tax rates and laws.
If an employee lives in one state and works in another, the individual might owe state income tax in both states. Fortunately, some states have reciprocal agreements with other states whereby the employee will only owe tax in their state of residence. For example, Arizona has reciprocal taxation agreements with California, Indiana, Oregon, and Virginia. Those agreements allow for residents in those states who conduct business in Arizona to request an exemption from income tax withholding in Arizona.
If no reciprocity agreement exists and an employee works in the state where their employer is located but lives in a different state, the employer typically makes payroll withholdings according to the business’s state’s tax laws. But the employee might also be responsible for reporting and paying income tax in their home state.
Affiliate nexus might apply when an out-of-state company has affiliates in another state who directly or indirectly refer business to the out-of-state company for a referral fee or commission. Affiliate nexus can apply even if a business doesn’t have a substantial physical or economic presence in the state.
The most common affiliate nexus is click-through nexus. Click-through nexus is established when an out-of-state business makes significant sales through referrals from individuals or businesses in another state. Typically this occurs through affiliate links to the company’s website.
When a business has affiliate or click-through nexus in a state, it must register to collect and pay sales tax there. As with other types of nexus, states’ rules and thresholds for affiliate nexus change often, so it’s important to double-check the requirements regularly.
Examples of affiliate nexus:
- A business is located in Ohio and receives annual sales of over $2,000 via affiliate links in Connecticut. The business would have nexus in both states.
- A business is located in Ohio and receives annual sales of over $10,000 via affiliate links in New York. The business would have nexus in both states.
Keep Learning: Dig deeper into nexus with our state-by-state guide on nexus.
When Foreign Qualification is Required
Does having nexus in a state require foreign qualification? It might! If an LLC or C Corporation is considered to be conducting or doing business in any state beyond the state where it was legally formed (where it is regarded as a domestic entity), it may have to seek permission to operate as a foreign entity in those other states. Foreign qualification means a business has obtained legal permission (Certificate of Authority) to operate in a state other than its home state.
What is considered conducting business? The definition varies by state. Below, I’ve listed the general criteria.
If a company has one or more of these characteristics, it will likely determine it’s doing business and requires foreign qualification:
- Has a physical presence (office, warehouse, or retail store) in the state.
- Holds in-person meetings with clients or customers in the state.
- Is structured as an LLC, corporation, or limited partnership in the state.
- Has applied for a business license in the state.
- Has employees living/working in the state and is paying state payroll taxes there.
- Has reached the economic (sales tax) threshold in the state.
Certain business activities on their own do not constitute doing business:, and therefore, would not require foreign qualification:
- Defending or settling a lawsuit in the state.
- Handling internal LLC or corporate business (such as member meetings) in the state.
- Having a bank account in the state
- Working with independent contractors in the state.
- Conducting a one-time transaction completed within 180 days.
- Securing or collecting debts from customers in the state.
A business contends with some significant risks if it fails to foreign qualify in any states where it’s considered to be doing business or has nexus.
Possible penalties for failure to foreign qualify:
- Payment for missed filing fees.
- Payment of back taxes for when the company was conducting business in the state but hadn’t yet foreign qualified.
- Interest on any fees and taxes due during the time the company was doing business in the state but wasn’t foreign qualified.
- No legal standing for bringing suit in the state (i.e., unable to sue in the state).
Nexus and Out-of-State Employment Tax
Since the COVID pandemic, more companies than ever before have remote workers. And many businesses have remote workers located outside of their company’s home state. So, you may be wondering, does having an employee in a state create nexus? In most circumstances, the answer is yes.
Employers must withhold and deposit not only federal taxes but also state taxes to the state where the remote employee lives and works. That involves:
- Registering with the state’s tax agency.
- Acquiring a state income tax withholding number.
- Obtaining a state unemployment insurance number.
- Withhold income tax and remit to the appropriate state agency.
- Registering with the state’s department of labor and following the state’s employment laws (e.g., minimum wage, disability insurance requirements, workers’ compensation rules, etc.)
Here’s an overview of the various types of employment and payroll taxes businesses may need to pay to the government or withhold from employees’ pay:
- Income Tax Withholding – Taxes withheld from employee pay for federal or state income taxes owed by the employees. The amount is determined by the employee’s W-4.
- FICA Tax – Social security and Medicare taxes, called FICA (Federal Insurance Contributions Act), are federal taxes shared between employees and employers.
- Medicare Tax – An employer must withhold part of social security and Medicare taxes from employees’ wages. The employer also pays a matching amount for this federal tax.
- FUTA Tax – The Federal Unemployment Tax Act (FUTA) provides for payments of unemployment compensation to workers who have lost their jobs. This federal tax is paid for by the employer.
- Self-Employment Tax – Self-employment tax (SE tax) is a social security and Medicare tax primarily for individuals who work for themselves. This is a federal tax paid for by the employee.
- Unemployment Insurance Tax – State unemployment instance (SUI) tax is similar to FUTA, but controlled at the state level. Amounts, requirements, and ownership vary by state. This tax is paid for by the employer.
- Disability Tax or Insurance – Disability tax (or insurance) is controlled at the state level. Amounts, requirements, and ownership vary by state. This is a state tax paid for by the employer.
- Worker’s Compensation Tax – Worker’s Compensation provides temporary benefit payments to workers for non-work-related illness, injury, or pregnancy. Requirements varies by state and this is paid for by the employee.
- State and Local Income Tax – State income tax (SIT) and local taxes vary by state, county, or city. This is a taxa paid for by the employee.
Payroll Withholdings in States With Reciprocity Agreements
As I mentioned earlier, some states have reciprocal agreements with each other that allow employees that work in one state (but live in another) to only pay income taxes to their state of residency.
Employees must complete a non-residency certificate to the employer to have income tax withheld for their resident state instead of the state where they work.
Here is a list of states that have reciprocity with other states:
- Arizona – California, Indiana, Oregon, and Virginia
- Illinois – Iowa, Kentucky, Michigan, and Wisconsin
- Indiana – Kentucky, Michigan, Ohio, Pennsylvania, and Wisconsin
- Iowa – Illinois
- Kentucky – Illinois, Indiana, Michigan, Ohio, Virginia, West Virginia, and Wisconsin
- Maryland – Pennsylvania, Virginia, Washington, D.C., and West Virginia
- Michigan – Illinois, Indiana, Kentucky, Minnesota, Ohio, and Wisconsin
- Minnesota – Michigan and North Dakota
- Montana – North Dakota
- New Jersey – Pennsylvania
- North Dakota – Minnesota and Montana
- Ohio – Indiana, Kentucky, Michigan, Pennsylvania, and West Virginia
- Pennsylvania – Indiana, Maryland, New Jersey, Ohio, Virginia, and West Virginia
- Virginia – Kentucky, Maryland, Pennsylvania, Washington, DC, and West Virginia
- Washington, DC – Maryland and Virginia
- West Virginia – Kentucky, Maryland, Ohio, Pennsylvania, and Virginia
- Wisconsin – Illinois, Indiana, Kentucky, and Michigan
While reciprocity agreements pertain to income tax withheld from employees’ pay, they do not affect the employer’s unemployment tax liability, which is typically determined by their employee’s work address.
Setting Up a Formal Payroll Process
Having an established payroll process helps ensure all a business is in compliance when hiring both in-state and out-of-state employees.
Here are some general steps to get started with payroll processing:
- Obtain an EIN and state tax ID numbers.
- Register for EFTPS — the federal government’s online tax filing system — and state online filing systems.
- Collect the employee’s information — e.g., name, start date, social security number, date of birth, compensation details, Form I-9, Form W-4, required state forms, etc.
- Choose a pay period.
- Calculate your tax requirements per employee or use a payroll system (e.g., Gusto or Paychex) to do the calculations for you.
- Report and pay employment taxes and fees according to the IRS’s and states’ rules and deadlines.
Businesses must file employment-related tax returns and deposit payroll taxes according to federal and state (possibly even local) government deadlines. Failing to make timely deposits or file returns can result in financial penalties and interest. Moreover, a company’s staff members might be held personally liable if they fail to deposit monies withheld from employees’ paychecks.
While payroll can be managed manually, business owners can streamline the process and reduce the risks of human errors by using automated payroll software, such as Gusto, Patriot, or Fingercheck. Another option is outsourcing payroll processing to a professional employer organization (PEO) that handles various human resource tasks, including payroll and benefits management.
Keep learning: Read our article on payroll processing to continue your educational journey.
Nexus and Sales Tax Obligations
While I’m on the topic of taxes and nexus, I’d be remiss if I didn’t talk about what’s involved in handling sales tax obligations. When a business in one state sells taxable services or products and reaches economic nexus in another state, it must register to collect and remit sales tax in the other state. Note that most states collect some form of sales tax. Some local jurisdictions — e.g., counties and municipalities — levy sales tax, too.
Sales tax is a pass-through tax, meaning that the business collects the tax at the point of purchase when selling goods or services to customers and later remits the tax monies collected to the government agency.
Every state has its own tax rates and process for setting up a sales tax account. It’s essential for business owners to verify the rates and rules that apply to them at the state, county, city, and zip code level in any state where they have nexus.
The general steps involved in sales tax processing include:
- Register for sales and use tax by applying for a Sales Tax ID Number, Seller’s Permit, or a sales tax permit.
- Calculate and collect sales tax from the customer at the time of purchase.
- File a sales tax return and remit sales tax collected to the proper tax authorities.
Resources to Help You Stay Compliant
Although nexus may not be an enthralling concept to think about, it’s very important to understand what creates nexus in a state. A business that has nexus in a state cannot lawfully do business there if it doesn’t comply with the state’s rules and regulations.
Business owners should consider consulting with an attorney to determine nexus compliance obligations and legalities. Accountants and tax advisors can also help by providing insight into the tax aspects of having nexus. Also, CorpNet has tools and resources to help businesses conform to nexus laws — foreign qualification, registered agent services, sales tax registration, payroll tax registration, and more.