Understanding Economic and Physical Nexus in the United States
In the United States, businesses are subject to state-level tax and employment obligations based on the concept of “nexus.”
Nexus determines whether a company has a sufficient connection to a state to allow that state to impose:
• Corporate income or franchise tax
• Sales and use tax collection
• Employment and payroll obligations
• Regulatory and registration requirements
There is no single, uniform nexus test. Each state applies its own rules across different tax types.
The two core categories businesses must understand are physical nexus and economic nexus.
1. Physical Nexus
Physical nexus exists when a business has a tangible presence in a state.
Common triggers include:
• Owning or leasing property (offices, co-working space, warehouses)
• Having employees working in the state (even one remote employee can be sufficient)
• Storing inventory in the state (including via third-party logistics providers)
• Using company-owned equipment or vehicles regularly in the state
• Conducting in-person activities such as trade shows, installations, training, or sales meetings
Historically, physical presence was the primary test for state tax obligations. While economic nexus has expanded state authority, physical presence remains highly relevant especially for:
• Corporate income/franchise tax
• Employer withholding and unemployment insurance
• Workers’ compensation
• State and local business licensing
Each state interprets “physical presence” slightly differently. As a general rule, if you have people or property in a state, you should assume nexus analysis is required.
2. Economic Nexus
Economic nexus arises when a business exceeds certain sales or transaction thresholds in a state, even without any physical presence there.
This concept was solidified by the Supreme Court’s 2018 decision in South Dakota v. Wayfair, Inc., which allowed states to require sales tax collection based purely on economic activity.
Today, most states impose economic nexus for sales tax once a business exceeds a specified annual revenue threshold (commonly around $100,000–$500,000 in in-state sales, sometimes combined with transaction counts).
Many states also apply “factor presence” standards for corporate income or franchise tax meaning that sufficient in-state sales alone can create income tax nexus.
Why this matters:
You can trigger tax obligations in a state without an office, employee, or property there.
For digital businesses, SaaS providers, AI companies, and services businesses, this is particularly important.
3. Sales Tax vs. Income Tax Nexus
It is critical to understand that nexus differs by tax type.
Sales and Use Tax
You may need to:
• Register for a sales tax permit
• Collect and remit sales tax
• File periodic returns
Even if you have no employees in the state.
A further complication is taxability classification. SaaS, digital services, AI-driven platforms, and data processing services are treated differently by state. The way your product is described contractually and marketed can influence tax treatment.
Corporate Income / Franchise Tax
Many states now assert income tax nexus based solely on sales sourced into the state. Additionally, if you have:
• Employees
• An office
• Property
You will almost certainly create income tax nexus regardless of sales volume.
4. 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.
5. Practical Steps for Compliance
For companies operating or expanding in the US, we recommend a structured approach:
1. Map Your Footprint
Create a state-by-state overview of:
• Employee locations
• Revenue by customer state
• Transaction volumes
• Property or inventory
• Legal registrations
2. Identify Applicable Thresholds
Review:
• Sales tax thresholds
• Income/franchise tax standards
• Employment registration triggers
• Local licensing rules
Thresholds vary widely and change over time.
3. Register Where Required
Once nexus is clear:
• Complete foreign qualification
• Register for relevant tax accounts
• Implement sales tax collection where applicable
• Confirm withholding, unemployment and workers’ compensation compliance sits with your PEO.
4. Monitor Continuously
Nexus is not a one-time exercise. Use tools or software to track the above - revenue, transaction counts, thresholds and employee locations.
As you:
• Hire in new states
• Grow revenue
• Expand sales territories
You may create new nexus obligations.
Quarterly review of revenue thresholds and employee locations is strongly recommended.
6. Special Considerations for Remote-First and Digital Businesses
Remote-only teams can unintentionally create nexus in multiple states simply through employee location.
Similarly, SaaS and AI businesses must carefully assess:
• How revenue is sourced for income tax purposes
• Whether their services are taxable
• Whether marketplace or facilitator rules apply
The US does not operate under a single federal tax regime, each state functions almost like its own tax jurisdiction.
Conclusion
Physical nexus arises from people and property.
Economic nexus arises from sales and economic activity.
Both can create corporate tax, sales tax, and employment obligations and these obligations do not disappear when working with a PEO or EOR.
For companies expanding into the US, particularly international businesses, early planning is critical. Mapping your footprint, understanding state-specific thresholds, and aligning your employment structure with your tax strategy can prevent unexpected liabilities and penalties.
Businesses should approach US expansion with a clear strategy, leveraging expert advice and robust tracking systems to meet their obligations effectively.