Internet is not tax-free.

Everyone loves a good deal, including tax practitioners. Ordering goods tax-free over the Internet sounds like an idea that is too good to be true and, unfortunately, it is.

The Internet Tax Freedom Act of 1998 did not forbid the taxing of e-commerce but rather forbade the imposition of new and discriminatory taxes. As a result, existing taxes are still in force, as are all the traditional rules of nexus and mail-order taxation.

When setting up an Internet operation, the following should be investigated and considered as part of a nexus analysis:

* How the revenue stream is being generated;

* Who is doing the work;

* Where the work is being done; and

* How the product or service is being delivered.

Revenue Streams

E-commerce income may or may not follow a company's current revenue stream. If the income is identical to the company's current business, nexus will most likely follow the same jurisdictions in which filings are currently made. However, with the expansiveness of the Web, it is also possible to inadvertently create nexus in new states.

In one situation, a franchising company wanted to sell a service over the Web. The franchiser had nexus only in one state, although the franchisees had nexus in multiple states. In the core business, customers contracted directly with the franchisees for the services. The franchisees attracted business through local advertising and yellow page ads. However, in the Internet business, the franchiser sold the service to the customer, then directed the customer to a franchisee, who the franchiser reimbursed for providing the service. The customer did not have a choice of where to go for the service performed. Because the franchiser controlled the transaction from beginning to end over the Internet, it now had nexus in many more states. The franchiser's solution for preventing additional nexus would have been to use a separate legal entity for the Internet-based company, with appropriate safeguards for creating a true arm's-length relationship to the original core business.

Performance of the Work

In the current business climate, virtually every function a company requires can be outsourced. In particular, e-commerce activities lend themselves to this by way of call centers, customer support centers and fulfillment distribution centers. It Can be disconcerting while doing nexus planning to discover parts depots around the country, inventory docking taking place at a shipper or showrooms in large cities (all of which create nexus).

It is imperative to carefully question the various operations from marketing to customer service to logistics, to determine whether nexus has occurred (or will occur) through outsourcing of various job functions. Also, the operational efficiencies of outsourcing often outweigh the added tax costs that may result from nexus. For example, the locations of a company already located in several unitary states may be the most desirable tax sites for outsourcing. If operations are in a limited number of states, a separate entity for the outsourcing in a nonunitary state may produce the best solution.

One of the best ways for a company to understand how Internet activities will actually occur is for it to run through the process from start to finish. For example, while ordering and returning product to a new Internet subsidiary located only in Minnesota, the tax department may discover that a local fulfillment center uses a Tennessee location to respond to customer issues, complete with a letter that has the company's name over the Tennessee address. This type of activity creates agency relationships and, subsequently, nexus.

Work Location

This may seem obvious, but the entity generating the Internet sales will have nexus in at least one state and will need to collect sales tax, self-assess use tax, register for payroll withholding and pay state income taxes in the state of operations. Whether or not nexus exists elsewhere will depend on what other operations are commingled within that legal entity and the locations of their physical facilities. Telecommuting is a great tool for attracting employees who might not want to relocate, yet provide needed expertise to an employer; unfortunately, it can also create nexus if the employees are providing anything other than sales solicitation. It may be necessary to register and file returns in the telecommuting employee's state.

In addition to the location of company-owned facilities, agency relationships are another area that a state can use to successfully attack an Internet operation and assert nexus. A company with other subsidiaries in the taxing jurisdiction may heighten the jurisdiction's suspicion that there is a sham or alter-ego transaction solely for tax-avoidance purposes. There are times when such agency is desirable and, as a result, it may be necessary to register for taxes based on other subsidiaries' activities. A national retailer that sells over the Internet recently made an operational decision to collect taxes that allow Internet purchasers to return goods to their neighborhood stores and thereby maintain good customer relations.

There are however, competitive issues in not collecting taxes if rival vendors are selling tax-free over the Internet. To sell tax-free requires separate legal entities and strict enforcement of policies to avoid agency relationships with brick-and-mortar facilities located in the same state.

Use of third parties for installation, warranty performance or equipment maintenance can also create nexus for the Internet seller. Multistate Tax Commission National Nexus Bulletin 95-1 contends that the use of third parties to fulfill computer warranty and installation contracts creates nexus for both sales and state income taxes. Although this has not been challenged in court, many states have incorporated this into their charters either by reference or by using similar wording. Several years ago, a group of states assessed a major computer manufacturer who sold only through retail distributors on the basis of the warranty performance taking place at the retail stores. It is likely that Bulletin 95-1 could also be expanded to apply to any durable goods manufacturer who provides a warranty with its product.

Goods and Services 

Delivering the sales made to customers opens another Pandora's box of tax problems. If a common carrier delivers hard goods, P.L. 86-272 will continue to apply; new nexus should not be created. If company-owned trucks make deliveries, nexus could result, depending on the rules of the various states. Downloading software over the Internet changes the character of a product, and some states do not tax downloads. Downloading music is an untested area; it remains to be seen if the states will view it as a hard good (similar to books) or an intangible good (similar to software), provided, of course, that they can establish nexus over the Internet vendor.

Drop shipments also remain a thorny area. Many states are aggressively requiring a resale certificate for every ship-to state, even if the wholesaler does not have nexus in those states. These states can hold the drop shipper responsible for failure to collect taxes in lieu of receiving a valid resale certificate. California, Wisconsin and Massachusetts have especially targeted this area during sales tax audits. Further, if the Internet is used to sell to wholesale distributors or other exempt customers, it is essential to have a tight process for checking the receipt and validation of exemption certificates before the product is shipped. Although this is required of any seller, the automation of sales by using the Internet may require a manual step to ensure exemption certificate compliance.

FROM NANCY N. SMIEGOWSKI, CPA, MINNEAPOLIS, MN