The modern concept of “nexus” – from a state income/franchise tax perspective – has been around since at least 1977 when the U.S. Supreme Court (the Court) heard the case of Complete Auto Transit V. Brady. In that case, a unanimous Court established the first legal precedent in terms of what the federal government considers interstate commerce and what it considered to be matters that should be left to the states. In Complete Auto, the Court held that states have the power to regulate commerce that occurs in their state or impacts their state so long as such activity does not interfere with or discriminate against interstate commerce. The Court's decision established four criteria for a state tax to be valid and not an unreasonable burden on interstate commerce. The tax must: (1) be on an activity with substantial nexus to the state, (2) be fairly apportioned, (3) not discriminate against interstate commerce, and (4) be fairly related to the services provided by the state. The lack of specificity around what these four criteria entail meant that there was a lot of room left for interpretation. This allowed the states to develop their own unique rules and regulations, often making it difficult for a multistate business to understand exactly when and where it would be deemed to have nexus.
Criteria number one in Complete Auto runs parallel to the minimum contacts requirement under the Due Process Clause. Specifically, under the due process requirement, there must be some definite link, some minimum connection, between a state and the person, property or transaction it seeks to tax. Until 2018, the Court imposed a relatively narrow interpretation of the minimum contacts test – generally requiring physical presence in order for this to be met. Notably, the two Court cases that dealt with this matter (National Bellas Hess, Inc. v. Department of Revenue  & Quill v. North Dakota ) were specifically related to sales and use taxes. As a result, the door was left open for states to continue their own interpretations of nexus for income and/or franchise tax based on Complete Auto – which made no mention of a physical presence requirement.
In 2018, with its South Dakota v. Wayfair decision, the Court ultimately reversed its position in National Bellas Hess and Quill, thereby rejecting the physical presence standard. The Court listed various reasons for its reversal, most notably that the existing standard was overly formalistic and did not align with the realities of our modern e-commerce society. When considering the impact of Wayfair, the initial reaction would be that it has very little effect on income and/or franchise tax nexus. Wayfair’s direct impact was eliminating the physical presence requirement for state sales and use taxes. But as alluded to above, states have already argued for years, often successfully, that the physical presence rule was confined to sales and use taxes and that state income and/or franchise tax nexus laws faced no such barrier. As such, nonphysical (or more commonly referred to as “economic” nexus) is not a new concept. However, Wayfair certainly empowered states to further expand on economic nexus for income/franchise tax – a concept that until then had mostly centered around intangible holding companies and financial institutions – and many have taken full advantage of doing so.
So, what does all of this mean? For starters, it means that virtually any business activity which seeks to derive income from or exploit a customer or marketplace in a given state, may very well be creating nexus. Where the business is actually located is no longer a determining factor. We must now consider factors well beyond that. It also represents somewhat of a convergence, or perhaps even an order reversal of nexus and apportionment (the method used to assign the portion of a business’s income that is related to a given state). Traditionally, a business would first analyze whether it had nexus in a state and only if it did, then proceed to compute its apportionment and ultimately its tax liability. Now, the first consideration may be to compute the apportionment (specifically the receipts factor) in order to determine if an economic connection may exist which would trigger nexus – including under the “factor presence” (i.e., bright-line) standards that several states have implemented over the last several years. In doing so, the specific rules for sourcing receipts in each state (particularly for sales of other than tangible personal property) will be vital to the ultimate conclusion.
Additionally, we have seen and will continue to see the expansion of economic nexus principles and related interpretations by the states. Market-based sourcing (i.e., looking to where a customer receives a service rather than where it is actually performed) continues to permeate the country. Beyond the proverbial low-hanging-fruit of simply deriving income from a state without a physical presence, also we expect states to gradually start to scrutinize other fast-growing areas of our digital economy such as online marketplaces, intermediaries or the impact of mobile/remote workforces, to name just a few. It’s inherently difficult to isolate activities by jurisdiction in these areas, and states will undoubtedly push hard for their piece of the pie. Controversies are inevitable.
We recommend taxpayers along with their state and local tax practitioners perform a “sanity check” of their current state nexus determinations. In situations where a review of business activity and applicable nexus rules results in outstanding tax exposures, it’s important to remember that remediation options are available. Just about every state offers some type of voluntary disclosure agreement (VDA) program. To be eligible, you generally must not have been contacted by the state prior to application. In other words, these programs are intended to reward taxpayers that come forward voluntarily, not those who are “caught.” A VDA will most often waive any penalties that would otherwise be assessed. A few states even waive a portion of the interest due – an added benefit. In addition to VDAs, states will offer amnesty programs. These are similar to VDAs but are open to all taxpayers (even if you’ve already been contacted by the state). The catch is that amnesty program offerings are usually few and far between, generally offered only during economic downturns. It should also be noted that if amnesty is offered and the taxpayer chooses not to participate (i.e., the taxpayer decides instead to wait and see if the state will catch them), there will often be additional penalties assessed in the event of an assessment. Of course, materiality and management’s appetite for risk will also weigh heavily here.
Taxpayers and practitioners should remain cognizant, if not outright cautious, of the ease in which state nexus can now be asserted. Any and all business activities in a state, no matter how seemingly trivial, should be reviewed and consideration given to how they may impact a nexus determination. Modern technologies continue to provide ways for businesses of all sizes to interact with and sell to customers all over the world. And let us not forget, states are investing in technology, too. Such opportunities are a blessing for growth and prosperity but may also come at the cost of a larger state tax footprint.
Thirty-six states and one locality have enacted pass-through entity tax filing elections (PTET). As a reminder, PTET elections are in response to the state and local tax (SALT) deduction limitation which was enacted under the 2017 TCJA legislation. Currently, individual taxpayers are only allowed a maximum deduction of $10,000 on federal Schedule A for all state taxes paid. A PTET allows the entity to pay state taxes and deduct them for federal income tax purposes thus reducing the overall federal tax liability.
Throughout 2023 state legislative sessions we noticed a number of trends in state PTET tax laws. Since enacting these taxing regimes, states have lacked guidance for taxpayer execution. Multiple tier pass-through entity structures have been particularly challenged with understanding what tier can make an election and how upper tiers should report previously taxed income or credits on their respective state income tax returns. Many states first enacted laws only allowing elections to be claimed by an entity who had individual owners. This excluded lower tier entities from making elections and forced the consideration to an upper tier. This was unfavorable for individual owners who owned a direct interest in a lower tier PTE.
This year, states began to revise their definition of “qualified entity” to allow elections at these lower levels. For example, Minnesota’s definition of "qualified entity” previously excluded PTEs from making an election if one or more owner was itself a PTE during the tax year. In 2023, Minnesota updated their definition to allow otherwise nonqualified entities to make an election, but requires the PTE to exclude income distributable to nonqualifying owners (i.e., PTEs) in the PTET calculation. This change provides an opportunity for lower tier entities to re-evaluate whether elections are beneficial for PTEs previously ineligible for elections. Careful planning should be considered in multiple tier structures to fully understand the impact, calculation and benefit at each tier.
States who haphazardly enacted PTE laws without consideration for the technical differences between S corporations and partnerships are also updating their rules for apportioning income based on the residency of the partner or shareholder. S corporations have a rigid structure and require pro-rata distributions on behalf of their shareholders. When apportionment of income is different for residents and nonresidents or when not every shareholder of an S corporation chooses to participate in the election, you can wind up with lopsided economic effects. To address these issues, states are altering rules to calculate PTE taxable income. For example, effective for the 2023 tax year, Minnesota will require S corporations to apportion income for all shareholders regardless of residency. The state still allows partnerships to allocate 100% of resident income in the PTET calculation.
Partnerships who do have resident and nonresident partners, or profit and loss partners, should evaluate whether their partnership agreements have been appropriately updated to address special allocations of tax deductions and credits. Without amendments to partnership agreements, partners may find their deduction for PTET paid by the entity is not equitable in relation to the amount of partner income taxed in the PTET calculation.
For example, Partnership A has two partners each owning 50%. Partner Z is a Minnesota resident; Partner X a Wisconsin resident. Without an amendment to the partnership agreement, Partnership A would compute Minnesota income tax on 100% of Partner Z’s distributable income, but only allocate a deduction for 50% of the total PTET tax it computed and paid. If Minnesota’s apportioned income was anything less than 100%, Partner Z’s allocated deduction would be lower than its PTET credit.
PTET elections are particularly beneficial in a year of material income or gain. They have become a defined point in transaction planning, whether it be the isolated sale of a business asset or complete sale of a business. As such events generally lead to noteworthy gains and federal/state taxes, PTET elections can produce significant savings for owners who would otherwise be limited to a state tax deduction.
If a partnership is preparing for a sale, it may prefer to structure the transaction as a sale of partnership interests. If its owners are individuals, generally the gain is recognized and reported on their federal personal income tax return. As a result of this structuring, partners will carry the burden of taxes individually and may forego any benefit of PTET elections or a state tax deduction. PTETs may consider different transaction structures or compute the lost benefit of the state tax deduction if adverse structure is being dictated by the buyer.
As you may recall in previous tax planning letters, the timing of elections is state-dependent. A selection of states require that an election be made during the tax year, not on a timely filed state income tax return. For example, historically, Michigan required a PTET election to be made by March 15th of the tax year. What happens if the entity who made the election went through an IRC 368(a)(1)(F) F reorganization after March 15th? So at the end of the tax year, the entity who holds the ability to make a PTET election is now a disregarded entity for federal and state income tax.
Informally, Michigan has released guidance indicating the successor S corporation subsumes the PTET election of the predecessor S corporation and should fulfill any payment and filing obligations for the remainder of the original three-year election. While steps are needed to execute this, Michigan is a state who will allow a successor to resume the benefits of a PTET election, but what if the new owner does not want to bind itself into Michigan’s three-year election? This should be considered if planning for a transaction in the near future. Please be aware Michigan has changed its election timing starting with the 2024 tax year.
While we are years into PTET, we continue to uncover additional planning points and considerations of the elections on the entity and its partners or shareholders. While it is unknown what the IRS will do with its $10,000 state tax deduction as we approach the 2025 sunset date, we do know proper modeling and planning should be given over the next two years to fully utilize the benefits and understand the pitfalls of making PTET elections.
The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely. The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.