2014-Issue 11—The lawyers just registered one of your entities to do business in 20 states. Now what? Traveling employees have been visiting states you did not know about. The company’s “independent contractors” are everywhere, and they act as agents. Your company just attended a trade show in a state that has no trade show exemption. You have sales factor presence, you have trailing nexus, affiliates are donning your logo, you are licensing software all over the country, and then you wake up.
A lot has been written about nexus (the connection allowing a state to impose tax on you), but nexus seems to be coming in many more forms recently. The following is a brief summary of some of the concepts to keep in mind and some strategies to consider.
Registration and Incorporation
When some of these troubling surprises arise, it is helpful to remember some basic principles. Registration to do business alone does not generally give an entity nexus. It may require an income tax filing and a minimum tax in some states, depending on the type of legal entity. Examples of minimum tax filing states are New York and California. In California, for example, corporate and most partnership entities must pay the $800 minimum tax and file returns until they are formally withdrawn from the state or dissolved. A general partnership, however, does not owe the minimum tax and may not have a filing requirement. On the other hand, incorporating or organizing an entity in a state generally does cause nexus. Michigan goes so far as to assert that corporations incorporated, or entities or persons organized, within the state have physical presence in Michigan.
Sales Factor Nexus
One of the growing trends for income tax and gross receipts tax nexus is the “factor presence nexus standard,” which sets thresholds of activity for property, payroll and sales. About six states have currently enacted these standards. The sales threshold is the most troubling, as it is a pure economic nexus concept. The most common enacted version of the rule states that having sales of over $500,000 to a state (sometimes less) causes nexus. Note that when shipping from states with this rule, throwback sales may be reduced when the threshold is exceeded in a destination state.
Public Law 86-272
Public Law 86-272 might help, but it applies only to income tax and then only related to the sale of tangible personal property. P.L. 86–272 was enacted in 1959 by Congress to prohibit a state from imposing a net income tax if a company's only state activities are solicitation of orders for sales of tangible personal property that are sent outside the state for approval or rejection and are filled from outside the state. Thus, it is generally of no help with sales tax, capital tax, gross receipts tax or income tax derived from sales of intangibles or services.
Trailing nexus is a concept asserted by a handful of states that the taxpayer continues to have nexus for a period of time after the taxpayer has left the state and ceased any nexus-creating activity. While it is hard to imagine that a trailing nexus rule could withstand a constitutional challenge based on the Quill physical presence standard, especially for sales and use tax, these rules are still out there and being invoked. The most notorious of these rules is on the books in Washington State, where the trailing nexus period is one year for the business and occupation tax (B&O) and a whopping four years for the sales and use tax. Typically, other states have trailing nexus rules limited to 12 months or less.
Online retailers must keep an eye on the ongoing expansion of click-through (or Amazon) nexus. These rules assert (sales tax collection) nexus on remote sellers that enter into an agreement with a resident of the state where the resident, for a commission or other consideration, refers potential customers via a link on its website or other means. Generally, these are rebuttable presumptions. As we have noted previously, the results of these rules have generally not resulted in an increase in sales tax collections but have resulted in a decrease in affiliate and resident agreements.
Online retailers should also be mindful of the ongoing expansion of affiliate nexus laws that could impute the presence of an affiliate member of a controlled group on the remote seller. Additionally, sales tax notification requirements have come and gone in a few states.
Failure to file and/or pay sales and use or income taxes can result in a company paying substantial penalties and interest in addition to the unpaid tax. Penalties could run anywhere from 5 to 50 percent of the tax amount owed to the taxing jurisdiction.
I. Voluntary Disclosure Agreement
If the amount of unpaid tax is substantial, a company may want to consider voluntarily disclosing the unpaid tax to the taxing authority. Most taxing authorities have a program in place that allows a taxpayer to voluntarily disclose unpaid taxes through a process known as a voluntary disclosure agreement, or VDA.
The requirements to qualify for a VDA vary by state. Some authorities require that the taxpayer not be previously registered for the tax in which it is requesting the VDA — but will likely require the taxpayer to become registered as a condition of granting the VDA. Others require that the taxpayer not have been previously contacted by the jurisdiction for audit or not be undergoing an audit for the tax involved. Additionally, most authorities reserve the right to void the VDA if the error is found to be as a result of fraud.
If the jurisdiction involved does not have an official VDA program or if the taxpayer does not meet the requirements, the state or local tax authority may be willing to work with the taxpayer to gain the tax revenue. Regardless of whether the VDA is requested through a formal VDA program or not, it is advised that the taxpayer remain anonymous until the VDA is approved and signed by the taxing authority.
A VDA provides several advantages for taxpayers. Most taxing jurisdictions will limit the look-back period to the same statute of limitations period that would be open under audit. However, taxing jurisdictions may not freeze the statute if the tax was collected from a third party on behalf of the jurisdiction but not remitted. Most taxing jurisdictions will waive penalties related to the tax in error, and some will forgive interest or a portion of the interest related to the outstanding tax liability.
Prior to executing a VDA, the taxpayer needs to be fully aware of all issues that could be discovered under audit for all taxes administered by the taxing jurisdiction. Therefore, it is important for companies to perform some sort of self-audit prior to executing the VDA. This will ensure there are no surprises and that the taxpayer can take full advantage of the VDA program.
II. Tax Amnesty Programs
If your timing is good, there may be an amnesty program available in a state where you have a problem. Generally, tax amnesty programs are offered by states for specific taxes and for a limited period of time. An amnesty program allows taxpayers to come forward to pay back taxes, with the state typically forgiving all or part of penalties and/or interest due. Delaware, Ohio, Puerto Rico, Tennessee and Vermont currently have active amnesty programs in place for various taxes.
Most of the advantages of amnesty programs are similar to those of a VDA, as most states waive all penalties and limit the period to the current statute. In addition, many states will waive interest or a portion of the interest. The program is typically open to taxpayers who are already registered with the state for the taxes in question. Even if a company is currently under audit by the state, it may be possible to negotiate with a state regarding the amount of sales or use taxes being assessed in an ongoing audit, in addition to the state granting forgiveness of penalties on top of any tax due. It is important to note that some states may seek to impose additional penalties on companies not participating in the amnesty program that were found to owe additional taxes that would have been eligible for amnesty but not paid during the amnesty period.
III. Managed Audit Program for Sales and Use Tax
A managed audit is a program that allows the taxpayer to report unpaid sales or use taxes by conducting a self-audit. The audit results are ultimately reviewed by the taxing jurisdiction. To qualify for a managed audit program, most tax authorities require that the taxpayer have the knowledge and resources to complete the audit in a timely fashion. Also, most authorities require that the taxpayer have complete records for the audit. They will take into account the taxpayer’s size, the complexity of its industry and the taxpayer’s filing and audit history before granting permission to a company to perform a managed audit.
The advantages of the managed audit program include waiver of penalties and sometimes interest or a portion of the interest related to the liability. The program allows the taxpayer to control the audit, including the timing for conducting the self-audit, something that can keep the audit from dragging on for years. A managed audit also gives the taxpayer the opportunity to look for overpayments to offset the liability while conducting the audit.
The drawbacks are the added workload and resource requirements. Also, the taxpayer has a responsibility to disclose any known issues. Since the taxpayer obviously has a better knowledge of its business than a taxing authority auditor, the taxpayer could identify a larger liability than if the tax authority conducted the audit. Note that some jurisdictions without managed audit programs may still be open to entering into some type of agreement similar to a managed audit.
IV. Self-Remittance Option for Sales and Use Tax
Another potential option is to accrue and remit the tax related to the error on the taxpayer’s upcoming tax return, if they are already permitted for sales tax purposes. This method is the least intrusive option and requires much less time and resources. However, detailed documentation relating to the remittance should be maintained in the event of an audit. Be aware that if the amount is substantially more than previous filings, it could cause the taxing authority to take a look at the taxpayer’s account, thereby triggering an audit.
Alvarez & Marsal Taxand Says:
There is no foolproof cure to avoid waking up in a cold sweat over a nexus scare. But keeping an eye on the risky trouble spots and being mindful of the varied and newer nexus theories being used might help you make it to the alarm.
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