Key Takeaways
What is state income tax nexus?
Nexus exists when a business has enough activity in a state for that state to impose income tax, even without a physical business location.
Can third-party providers create nexus for your company in another state?
Yes. Activities performed by third-party service providers may be treated as business activities for nexus purposes.
Does nexus apply the same way in every state?
No. Income tax nexus standards vary by state and depend on specific facts and circumstances.
Why should businesses evaluate third-party relationships?
Because third-party activities may create income tax exposure and related reporting and compliance obligations.
Businesses based in one state, but with an operating presence in others, may be liable for income tax obligations in those additional states. This is known as nexus and applies when qualifying business activities meet a state determined threshold, permitting the state to impose tax even if the business is not physically present there. One area in which nexus has developed with increasing frequency involves business partnerships with third-party contractors or service providers that operate on behalf of said business.
Because third-party providers often perform activities connected to sales, fulfillment or ongoing operations, these relationships can carry state income tax implications that are not always immediately apparent. As states refine how income tax nexus is applied, understanding how these standards have evolved provides important context for evaluating potential tax obligations across state lines.
Why Are Third-Party Providers Important to evaluate for State Income Tax Nexus?
Historically, state income tax nexus depended on the physical presence of a business such as corporate headquarters, a branch or other property. However, a 2018 Supreme Court case, South Dakota v. Wayfair, ruled that states in which buyers reside could be required to collect sales tax as the result of an online transaction regardless of the retailer’s physical location.
While the landmark case addressed the collection of sales tax, it also contributed to a broader shift in state taxation away from a strictly brick-and-mortar presence standard and toward one based on economic activities, commonly referred to as economic nexus. These activities may include:
- Inventory storage
- Fulfillment services
- Sales activities
- Client services
- Related business services
As a result, businesses that contract with out-of-state service partners, or that are considering such partnerships for core operating, sales or market maintenance functions, may be subject to additional state income tax obligations.
One challenge in evaluating income tax nexus is the lack of uniform standards across states. Although the Multi-State Tax Commission adopted a nexus framework in 2002 based on qualifying levels of property, payroll, sales or total business property, the framework is not legally binding unless it has been specifically adopted into a state’s code or regulations. As a result, states apply different criteria when assessing nexus, making it important to consider how third-party activities may be evaluated on a state-by-state basis.
Which Third-Party Providers May Create State Income Tax Nexus for Businesses?
Certain third-party professionals, contractors and service providers perform activities that states may view as qualifying business operations for income tax purposes. The nature and scope of these activities can vary widely, and their impact on nexus depends on how individual states interpret and apply their own standards. The following categories highlight common third-party roles that may create income tax exposure for businesses operating across state lines.
Inventory Storage and Fulfillment Centers
Businesses that use third‑party storage facilities to hold inventory, including Amazon fulfillment warehouses, may be subject to income tax nexus. The fact that a warehouse is owned or run by a third party does not automatically eliminate possible tax liability. In many states, simply having inventory stored for sales purposes can be enough to qualify as a taxable business activity. Fulfillment centers that handle packaging and shipping under a service agreement may also be viewed as carrying out business activities on behalf of the company. To this point, in one recent case, the California Office of Tax Appeals ruled that a corporation’s decision to store inventory at a third‑party warehouse was sufficient enough to create income tax nexus.
Contracted Sales Representatives
Using contracted third‑party sales professionals is often part of a strategy to expand into new markets and increase revenue. When these sales representatives solicit customers or take part in contract negotiations, their activities may create nexus in the states where they operate. One important exception involves the solicitation of tangible personal property. Under the Interstate Income Act of 1959, also known as Public Law 86‑272, orders for tangible goods that are solicited within a state are not subject to income tax if approval and shipment take place outside that state. This protection does not apply, however, to the solicitation of services or other intangible products.
Maintenance or Installation Technicians
Although equipment or product installation technicians and maintenance contractors generally do not take part in sales or market development, the services they provide to customers may still be treated by some states as taxable business activity. This can include installation work, ongoing maintenance, repairs or warranty‑related services performed on behalf of the business.
Training or Technical Professionals
Similar factors apply to third‑party customer service and training professionals who support a business’s operations. In some states, these services may be considered qualifying activities for income tax purposes. Examples can include employee onboarding support, customer training or other educational and technical assistance programs.
How Windham Brannon Can Help
Until the last few years, qualifying income tax nexus activity depended primarily on a business’ physical presence. However, as digital commerce has expanded and businesses increasingly rely on service providers operating across state lines, many states will consider the role of third‑party service partners, contractors and other professionals when evaluating income tax obligations.
Because income tax nexus standards vary by state, informed guidance can be especially valuable. Our team at Windham Brannon helps business owners review current income tax nexus exposure and evaluate the potential implications of existing or prospective third-party relationships. This support extends to compliance with applicable reporting and filing requirements related to contracted professionals and service providers, allowing businesses to address income tax obligations while continuing to pursue strategic growth.
To discuss how these considerations may apply to your business, reach out to Tim Clancy or contact your Windham Brannon advisor.
