Nexus for non-net-income-based taxes.

Tax advisers should be aware that the level of clients' multistate business activities may be such that a client is not protected from being taxed in those states that have non-net-income-based taxes other than sales/use taxes (such as a franchise tax, capital tax, license tax, gross receipts tax or net worth tax). States have implicit jurisdiction to tax, subject to three principal limitations--those imposed by the U.S. Constitution, P.L. 86-272 and those that states voluntarily impose on themselves.

Most practitioners are aware that P.L. 86-272 allows a company to have certain minimal activity within a state without establishing sufficient nexus requiring a tax return to be filed. Specifically, this minimal activity level is limited to the physical presence of a salesperson (whether an employee or independent contractor) in a state (either living in the state or merely traveling to it), as long as the salesperson's activities are limited to the solicitation of orders of tangible personal property. It is important to note that P.L. 86-272 does not protect the sale of services. In addition, the law only protects taxpayers from taxes measured by net income, not taxes measured by some other factor (such as book income, retained earnings, capital stock, etc.).

Taxes Not Measured By Net Income

States that impose tax based on a measurement other than net income are not subject to P.L. 86-272. These states can develop their own nexus standards (within the restrictions of the Commerce and Due Process clauses of the U.S. Constitution), which tend to be more restrictive than P.L. 86-272. Several states have enacted legislation providing for a non-net-income-based tax in addition to a tax based on net income. In those states, even having a salesperson or an independent contractor in the state will likely create nexus for purposes of that state's non-net-income-based tax.

Following are some of the states that impose a tax based on a non-net-income measurement or in addition to a net-income-based tax. The list is not all-inclusive, and the summary is intended only to introduce the nature of taxes not based on net income. There are a number of other states that have a non-net-income-based tax (see Exhibit 1 on pp. 240-241). Practitioners should take a proactive approach with their clients to make them aware that strict adherence to the traditional tenets of P.L. 86-272 is not sufficient to completely insulate clients from many states' taxing authority. In today's environment, most companies engage in multistate activities; there are numerous tax traps for the uninformed. Taxpayers' potential exposure for back taxes, penalties and interest can be substantial.

Exhibit 1: Corporate tax base--Franchise v. net income by state

Corporate tax assessed:

State                     Method

Alabama                   Net Income Based
                          Franchise Based On Employed Capital
Alaska                    Net Income Based
Arizona                   Net Income Based
Arkansas                  Net Income Based
                          Small annual franchise tax
California                Franchise Tax Based
                          Upon Net Income ($800 min.)
Colorado                  Net Income Based
Connecticut               Net Income Based
Delaware                  Net Income Based plus
                          Franchise tax based upon shares o/s
D.C.                      Franchise Tax Based
                          Upon Net Income ($100 min.)
Florida                   Franchise Tax Based
                          Upon Net Income
Georgia                   Net Income Based plus
                          Franchise tax based on net worth
Hawaii                    Net Income Based
                          Financial Institutions subject to
                           Franchise tax based on Net Income
Idaho                     Franchise Tax Based
                          Upon Net Income ($20 min.)
Illinois                  Franchise Tax Based Upon Net Income
                          plus Annual Franchise Tax
Indiana                   Greater of Gross Income or
                          Net Income Tax
Iowa                      Net Income Based
                          Financial Institutions subject to
                           Franchise tax based on Net Income
Kansas                    Net Income Based
Kentucky                  Net Income Based plus
                          Franchise Tax ($300 min.) and License tax
Louisiana                 Net Income Based plus Franchise
                          tax based on net worth ($10 min.)
Maine                     Net Income Based
                          Financial Institutions subject to
                           Franchise tax based on Net Income
                           and assets
Maryland                  Net Income Based
                          Financial Institutions subject to
                           Franchise tax based on Net Earnings
Massachusetts             Excise based on net income or a Net
                           worth Tax ($456 min.)
Michigan                  Single Business Tax
Minnesota                 Franchise Tax Based Upon Net Income
                          (minimum tax based on MN property,
                          payroll and sales)
Mississippi               Net Income Based plus
                          Franchise tax based on net worth
Missouri                  Net Income Based plus
                          Franchise tax based on net worth
Montana                   Franchise Tax Based
                          Upon Net Income ($50 min.)
Nebraska                  Net Income Based plus
                          Financial Institutions subject to
                           Franchise tax based on Avg. Deposits
Nevada                    Business Privilege Tax
                          ($25 per employee)
New Hampshire             Business Profits Tax and
                          Business Enterprise Tax
New Jersey                Franchise Tax Based
                          Upon Net Income
New Mexico                Net Income Based plus
                          Small annual franchise tax ($50)
New York                  Franchise Tax Based
                          Upon Net Income
North Carolina            Net Income Based plus
                          Franchise Tax ($35 min.)
North Dakota              Net Income Based
Ohio                      Higher of Franchise Tax based
                          upon Net Income or Net Worth
Oklahoma                  Net Income Based plus
                          Franchise Tax ($10 min.)
Oregon                    Excise Tax Based
                          Upon Net Income
Pennsylvania              Franchise Based on Net Income, Capital
                          Values Tax ($300 min.) and Loans tax
Rhode Island              Net Income Based Tax, possibly
                          Franchise tax based on Net Worth
South Carolina            Net Income Based plus
                          License Fee ($25 min.)
South Dakota              No Tax
Tennessee                 Excise Tax Based on net Income plus
                          Franchise Tax Based on Capital ($10 min.)
Texas                     Stated Capital (franchise) or
                          Net Earned Surplus (net income)
Utah                      Franchise Tax Based
                          Upon Net Income
Vermont                   Franchise Tax Based
                          Upon Net Income ($250 min.)
Virginia                  Net Income Based
Washington                Business and Occupation Tax
West Virginia             Net Income Based plus
                          Franchise Tax ($50 min.)
Wisconsin                 Franchise Tax Based
                          Upon Net Income ($25 min.)
Wyoming                   Corporate License Tax ($25 min.)

Corporate tax assessed:

State                     Cite

Alabama                   Sec. 40-18-2
                          Sec. 40-14-40
Alaska                    Sec. 43.20.011
Arizona                   Sec. 43-1111
Arkansas                  Sec. 26-51-205
                          Sec. 26-54-104
California                Sec. 27
                          Sec. 23151 and 23153
Colorado                  Sec. 39-22-301
Connecticut               Sec. 12-214
Delaware                  Sec. 1902
                          Sec. 503
D.C.                      Sec. 47-1807.2
Florida                   Sec. 220.11
                          Sec. 220.63
Georgia                   Sec. 48-7-21
                          Sec. 48-13-72
Hawaii                    Sec. 235-71
                          Sec. 241-2 and 241-3
Idaho                     Sec. 63-3025
Illinois                  35 ILCS 5/201
                          805 ILCS 5/15.45
Indiana                   6-2.1-2-2 and 6-2.1-2-4
                          6-2.1-2-5
Iowa                      Sec. 422.33
                          Sec. 422.60
Kansas                    Sec. 79-32,110
Kentucky                  Sec. 141.040 and 136.505
                          Sec. 136.510 and 136.070
Louisiana                 Sec. 47:287.11
                          Sec. 601
Maine                     Sec. 5200
                          Sec. 5206
Maryland                  Sec. 10-102
Massachusetts             Sec. 32
Michigan                  Sec. 208.31
                          Sec. 208.6
Minnesota                 Sec. 290.02
                          Sec. 290.0922
Mississippi               Sec. 27-7-5
                          Sec. 27-13-5
Missouri                  Sec. 143.071
                          Sec. 147.010
Montana                   15-31-403
Nebraska                  Sec. 77-2734.02
                          Sec. 77-3802
Nevada                    Sec. 364A.140
New Hampshire             Sec. 77-A:2
                          Sec. 77-E:2
New Jersey                Sec. 54:10E-2
New Mexico                7-2A-3
                          7-2A-5.1
New York                  Sec. 209
North Carolina            Sec. 105-130.3
                          Sec. 105-122
North Dakota              Sec. 57-38-30
Ohio                      Sec. 5733.05
Oklahoma                  Sec. 2355
                          Sec. 1201, 1203 and 1205
Oregon                    Sec. 318.020
                          Sec. 317.061 and 317.090
Pennsylvania              Sec. 1
                          Sec. 402 and 602
Rhode Island              Sec. 44-11-2
                          Sec. 44-12-1
South Carolina            Sec. 12-6-530
                          Sec. 12-20-50
South Dakota
Tennessee                 Sec. 67-2-102 and 67-4-903
                          Sec. 67-4-904 and 67-4-907
Texas                     Sec. 171.001
                          Sec. 171.002 and 171.0011
Utah                      Sec. 59-7-104
                          Sec. 59-7-201
Vermont                   Sec. 5832
Virginia                  Sec. 58.1-400
Washington                Sec. 82.04.220
West Virginia             Sec. 11-24-4
                          Sec. 11-23-6
Wisconsin                 Sec. 71.23
                          Sec. 71.27
Wyoming                   Sec. 17-16-1630

Arkansas. Tax is based on 0.27% of the par value of a corporation's capital stock apportioned by the value of real or personal property in Arkansas to the total value of real or personal property (with a minimum tax of $50 and a maximum tax of $1.075 million).

Georgia. Tax is based on the annual corporate net worth of all corporations doing business or owning property in Georgia, for the privilege of carrying on a business in Georgia in the corporate form. The tax is imposed on the apportioned net worth of foreign corporations, with net worth defined as the sum of issued capital stock, additional paid-in capital and retained earnings. (The tax ranges from a minimum of $10 to a maximum of $5,000.)

Illinois. Foreign corporations are subject to tax for the privilege of exercising their certificates of authority to do business in Illinois. The tax is technically based on the right "to be" rather than on the right "to do," which in effect attaches it to the holding of a charter or a certificate of authority, rather than on the actual exercise thereof. Although a multistate corporation may elect to base its franchise tax on total paid-in capital, the amount of paid-in capital to be allocated for Illinois purposes is generally determined by formula apportionment. Paid-in capital is multiplied by a fraction composed of the sum of the value of the corporation's property located in Illinois, plus the gross receipts from business in the state, over the sum of property and receipts everywhere. (The tax ranges from a minimum of $25 to a maximum of $1 million.)

Indiana. An income tax is imposed on the receipt of taxable gross income derived from activities or businesses or any other sources in Indiana by a taxpayer who is not a resident or a domiciliary of Indiana. The tax rate is determined by the type of transaction from which the taxable gross income is received. Indiana has a very broad nexus standard and its provisions require careful study.

Kentucky. Every foreign corporation owning or leasing property located in Kentucky or having one or more individuals receiving compensation there must pay Kentucky an annual license tax of two dollars and ten cents ($2.10) on each thousand dollars ($1,000) of capital employed in the business. The term "capital" includes capital stock, surplus, advances by affiliated companies, intercompany accounts, borrowed moneys or any other accounts representing additional capital used and employed in the business. "Capital employed" in the case of corporations with property or payroll both in and out of Kentucky, means apportioned capital using a three-factor formula with double-weighted sales. (The minimum tax is $30, with no maximum.)

Massachusetts. Massachusetts imposes tax on any corporation deemed to be "doing business" in Massachusetts. The definition of "doing business" includes (among other things) the employment of labor and the execution of contracts. Because the Department of Revenue has officially adopted a broad interpretation of the term "solicitation," it appears that a taxpayer could easily find itself "doing business" in Massachusetts and subject to a net worth tax, even while protected from the excise tax by P.L. 86-272.

Michigan. Michigan's single business tax (SBT) is a value-added tax imposed on business activities carried on within the state. The Michigan SBT has been held by courts not to be a tax "measured by" net income. Consequently, the restriction imposed by P.L. 86-272 does not apply to taxes imposed under the Michigan SBT. As a consequence, it is very easy for a company, with even the most de minimis contact, to find itself liable for the Michigan SBT.

Texas. Even without gross receipts from operations in Texas, corporations can find that they have nexus for purposes of the franchise tax measured by net taxable capital. For purposes of the taxable capital component of the franchise tax, even the solicitation of sales is sufficient to exceed the nexus threshold. Taxable capital is a corporation's stated capital (capital stock) plus surplus. (Surplus is the net assets of a corporation minus its stated capital.) The tax rate on taxable capital is 0.25% per year of privilege period. The amount of tax can be significant, depending on the corporation's stock and retained earnings.

Sales/Use Tax

One of the most potentially costly non-net-income-based taxes is the sales/use tax. If a company has established nexus for net income tax purposes, that company clearly has nexus for sales/use tax collection purposes. Sales/use tax nexus is established by any physical presence within a state. Therefore, it is very common for a company to have sales/use tax nexus in a state, even though it may not have net income tax nexus in that state. Unlike net income tax nexus, Federal law does not govern sales tax nexus. U.S. Supreme Court cases and the limitations of the Commerce and Due Process clauses of the U.S. Constitution have provided most of the guidance on sales taxes.

Because any physical presence within a state establishes sales/use tax nexus, even a salesperson's activity protected by P.L. 86-272 from nexus for net income tax purposes can cause sales/use tax nexus. This is true regardless of whether the salesperson lives in a state or merely travels to that state. Independent contractors/agents/representatives will also create sales/use tax nexus, no matter what their capacity. In addition, while several states permit company trucks to make occasional deliveries without creating sales/use tax nexus, only common carrier deliveries are clearly protected. Attending trade shows or conventions as a vendor will normally establish sales/use tax nexus.

Once sales/use tax nexus is established, sales/use tax registration will generally be required. In addition, the company will then be required to collect and remit sales tax on every taxable delivery or shipment into the state. Some of a taxpayer's sales may be exempt from sales tax because of various provisions provided by individual states (manufacturing equipment exemptions, resellers, etc.). A taxpayer would not need to collect sales tax if he obtains proper exemption/resale certificates from customers. Taxpayers should request from their customers (and maintain on file) individual state exemption/resale certificates for all sales for which they are not charging sales tax (and have sales tax nexus with the state of sale). States will typically assume every sale within its state is subject to sales tax, unless a taxpayer can establish that he obtained a valid exemption certificate (taken in good faith) from a customer.

The sales/use tax is a tax imposed on the nonexempt sale, not the purchase. State law allows a seller to collect reimbursement for the tax from a buyer; however, it is the seller's responsibility to remit the tax. State sales/use tax laws can vary dramatically in many areas. One element common to all states that impose a tax on sales is that the seller will be treated as a retailer in all cases in which the seller cannot demonstrate that the sale was made to a reseller or that the sale meets a specific state exemption. With lookback periods ranging from six to 10 years, the potential for uncollected back taxes, penalty and interest can be substantial.

Drop shipping is a sales tax issue that is complicated and can have various results, depending on a seller's sales/use tax nexus and registration in each state. If a seller has sufficient sales/use tax nexus, registration would be required; the seller will (1) charge sales tax to its customer (provided there is no type of exemption available) and (2) need to provide a resale exemption certificate to a drop shipper on its purchase of the components. Under another scenario, if a seller does not have sufficient sales/use tax nexus, but a drop shipper does, some states may require the drop shipper to charge sales tax on its invoice to the seller. Finally, if neither a seller nor a drop shipper has sufficient sales/use tax nexus, a use tax will be imposed on the ultimate purchaser.

Summary

Multistate tax is an ever-changing landscape with enough challenges to test even the most diligent practitioner. While the manufacture and sale of "widgets" will always remain, many products blend the tangible with the intangible. Sales of intangibles continue to grow by leaps and bounds, and the constraints of time and space no longer limit exploitation of markets. As states step up their efforts to collect taxes from those "doing business" within their borders, taxpayers will find it increasingly difficult to avoid falling prey to ever-expanding nexus standards.

In an effort to increase tax revenues, states are entering into information-sharing agreements with each other, paying fees to outside agencies to locate companies "doing business" within their borders and investing large sums to improve their computer technology. Taxpayers' multistate tax planning should not depend on a "let them catch us" approach. Proactively working with taxpayers to analyze their multistate activities will allow them to minimize their risk and limit their exposure, while planning appropriately to pay the least amount of state tax allowed by law.

FROM HELEN YOUNG, CPA, PASADENA, CA