Sales and use tax nexus: To file or not to file, is it really a question?
A look at the broader implications of nexus evaluation and compliance
Some questions around sales and use tax nexus are rather concrete. For example, a company with physical retail locations in 12 states needs to collect and remit sales and use tax in all 12 states, assuming all 12 impose such a tax. The process for doing so efficiently may be more complicated, but the determination of that requirement and decision to comply are fairly straightforward. In other cases, companies make interpretations of nexus that may lead them to either assume they are exempt or to elect non-compliance. This creates a different set of questions and situations to consider.
Let us assume a company is based in state A and has an employee who provides technical support and resides in state B. Further, assume this employee’s activities are sufficient to create nexus for sales and use tax purposes. As a reminder, nexus is the current measure for establishing a connection between a seller and a state that is sufficient to require the seller to register, collect and remit the state’s sales and use tax. Some common examples of activities that create sufficient nexus in a state are:
- In-state employees or agents
- Installation services
- Traveling employees (non-resident) or agents representing the company
- Use of subcontractors
- Inventory or property
In our example, the employee is both a traveling employee and performs services, though not always installation services, and, therefore, nexus is established. The next issue for consideration is whether the company should file in state B for sales and use tax purposes. This seems to be a rhetorical question–since the activities within state B generally would be considered sufficient nexus, the company should file. However, experience has shown that many companies take a step back at this point and analyze the situation from a business perspective. In the case of our example, the business owners determine that the costs of compliance would exceed the tax risk and decide not to file. Additional reasons for not filing often include the assumption or determination that a company’s customers or products are typically exempt, or that the company will address nexus issues next month, next quarter, next year, etc.
In other words, for a variety of business reasons, companies determine that they will not comply with sales and use tax requirements despite having demonstrated sufficient nexus in a state. If not actively monitored, this can lead to some material deficiencies. Before making the business decision to not register or comply, companies should consider some additional, long-term issues.
Unless a company has done some research to determine if its product or customers are exempt in all locations, it may be creating exposure with every transaction. For example, janitorial services are exempt from tax in Georgia, but are subject to tax in Florida. A company that is expanding such services from Georgia to Florida may improperly assume the requirements are the same for each state. In addition, if portions of a company’s customer base consist of state and local governments, it is important to know which states exempt these sales and what documentation is required to support the exempt sale. Even if all sales are exempt, without the supporting documentation, many state auditors will assess tax. Further, if a company has established nexus but has not registered with the state, the statute of limitations does not apply. In an audit situation, states may go back to when nexus was first established or they may limit the look-back period to 8 to 10 years.
A comprehensive review of nexus triggers will include thoroughly understanding a company’s business operations and the variations of sales and use tax regulations by jurisdiction. This research will provide a true view of the cumulative risk of non-compliance, which may create a business case for a more conservative approach.
Oftentimes, a company will find it desirable to seek an outside investor, such as a private equity group, to obtain additional capital. Typically, these investors will perform some due diligence to determine a valuation as part of the investment process. This due diligence regularly includes some form of nexus review. If it is determined that nexus exists, investors will then attempt to estimate the liability. The fast-paced equity environment does not always provide sufficient time to accurately estimate the potential exposure. In an effort to protect the investor, a worst case scenario is frequently used to arrive at the valuation. For example, the assessor may calculate nexus liability as all sales to a state, multiplied by the tax rate, plus 12 percent interest and 25 percent penalties. If the resulting number is significant, it may even impede a deal.
The same situation would be applicable to a closely held company that is considering exit strategies for key owners. Companies seeking to attract investors or planning for buy-outs should carefully consider the future implications of non-compliance, as these implications can grow exponentially in relation to the actual annual tax liability.
It is important for a company to know its tax footprint and to continue to monitor activities to avoid creating unwanted exposure. Tax departments should schedule periodic reviews with the sales department and payroll department to determine if new employees have been added in states where no physical presence previously existed. In addition, for states where physical presence has been established, but for business reasons the company has chosen not to file sales tax returns, a periodic review of the activities and exposure should be evaluated to ensure effective management of the potential risk.