Understanding Economic and Physical Nexus in the United States
In the United States, businesses are subject to state-level tax obligations based on the concept of "nexus." Nexus determines whether a company has a sufficient presence in a state to be required to comply with its tax laws, including corporate income tax, sales tax, and employment tax. The two types of nexus are physical nexus and economic nexus, and both play critical roles for businesses entering the US market.
1. Physical Nexus
Physical nexus is established when a business has a tangible, physical presence in a state. This presence can include:
- Owning or leasing property (offices, warehouses, or retail locations).
- Having employees who work within the state.
- Storing inventory in a state.
- Regularly attending trade shows or conducting in-person business activities in the state.
State-Specific Physical Nexus Examples:
- California: Physical nexus is triggered if a business owns property, leases office space, or has employees performing work in the state.
- Texas: Physical presence is established through inventory storage, employee activity, or property ownership.
- New York: Physical presence includes maintaining property, conducting business activities, or employing individuals within the state.
- Florida: Storing inventory, owning property, or having employees in the state creates physical nexus.
Each state interprets physical presence differently, so clients are advised to consult professional tax advice to verify their obligations with state-specific guidelines.
2. Economic Nexus
Economic nexus arises when a business exceeds certain revenue or transaction thresholds in a state, even if it has no physical presence there. The concept was solidified by the Supreme Court's decision in South Dakota v. Wayfair, Inc. (2018), which allowed states to impose sales tax obligations based on economic activity alone.
State-Specific Economic Nexus Thresholds Examples:
- South Dakota (model for Wayfair case):
- $100,000 in gross sales or 200 separate transactions annually.
- California:
- $500,000 in annual sales to California residents.
- Texas:
- $500,000 in gross revenue from sales to Texas customers.
- New York:
- $500,000 in sales and 100 separate transactions.
- Florida:
- $100,000 in annual sales with no transaction threshold.
- Colorado:
- $100,000 in annual sales with no transaction threshold.
- Georgia:
- $250,000 in gross revenue or 200 transactions annually.
- Washington:
- $100,000 in cumulative gross receipts from retail sales.
Economic nexus laws vary widely, and thresholds can change, so clients are advised to consultant professional tax advice and regularly review state tax department publications to stay compliant.
3. Nexus and working with a PEO or EOR
For companies entering the US market, partnering with a Professional Employer Organization (PEO) or an Employer of Record (EOR) can simplify many administrative tasks, particularly around employment compliance. However, there are specific nexus considerations when engaging through a PEO or EOR.
Key Considerations:
- Nexus Creation by Employees:
- Employees located in a state can create a physical nexus, even if the company itself has no physical assets there. This applies if employees are hired directly through a PEO arrangement.
- Hiring employees through an EOR arrangement can shield the client from direct employment tax liabilities and reduce the chance of triggering physical nexus in a state by not employing employees directly. However, it does not eliminate physical nexus obligations triggered by other tests of business presence.
- Clients are advised to consultant professional tax advice to evaluate the tax and compliance implications of having employees in specific states.
- Role of the PEO or EOR:
- A PEO co-employs workers and handles payroll, benefits, and compliance, but the client company is the legal employer.
- An EOR acts as the legal employer of the workers and assumes all compliance responsibilities.
- Sales and Economic Nexus:
- Even when using a PEO or EOR, the client must track its revenue and transactions to ensure compliance with economic nexus laws. PEOs and EORs do not monitor sales activity.
- State-Specific Regulations:
- Each state has unique nexus laws and thresholds. Clients must research the states in which they plan to operate or sell products/services to understand their obligations.
- Registration and Reporting:
- Clients must ensure they are registered to do business in all states where they have triggered nexus. Registration in another state (outside of the formation state) is known as foreign qualification.
- Clients using a PEO must have their own legal entity and federal employer identification number (FEIN) and must register to do business in each state they plan to hire employees.
4. Practical Steps for Compliance
For clients operating in the US, we recommend the following steps:
- Conduct a Nexus Analysis:
- Assess physical and economic activities to determine where the business has nexus.
- Choose States Strategically:
- If possible, focus on states with favorable tax environments and clear nexus guidelines.
- Consult Experts:
- Engage tax professionals and legal advisors for independent expert advice.
- Monitor Activity Continuously:
- Use tools or software to track revenue, transaction counts, and employee locations.
- Maintain Documentation:
- Keep detailed records of all business activities to substantiate nexus determinations if audited.
Conclusion
Economic and physical nexus are critical considerations for businesses operating in the US, and these obligations do not disappear when working with a PEO or EOR. Understanding the nuances of these nexus concepts and planning accordingly will ensure compliance and help avoid costly penalties. Businesses should approach US expansion with a clear strategy, leveraging expert advice and robust tracking systems to meet their obligations effectively.