Public Law 86-272, which restricts states from imposing income tax on out-of-state sellers whose only activities within the state involve soliciting sales of tangible personal property, is an essential protective measure heavily relied upon by businesses, particularly those in the manufacturing, distribution, and retail sectors. The law does not extend protection to service solicitations or industry types that do not deal in the sale of tangible personal property.
In recent times, a lot of businesses have evolved to include service subject matters related to the sales of property, such as repairs, installations, selling warranties and issuing credit cards. It is then no surprise that the entity that relies on this law the most, might just be the small- and medium-sized businesses. This group, arguably the biggest benefactors of Public Law 86-272, continue to grapple with the implications of the modernization and digitization of business processes on the applicability of this law.
For increased protection of small businesses under this law, it becomes crucial for states to adopt a proactive stance. An effective solution might lie with Congress and the introduction of safe harbor thresholds that must be reached before a state income tax filing requirement is triggered. The recent revision of its interpretation of the statute in August 2021 by the Multistate Tax Commission (MTC) has emphasized this need.
The MTC’s new interpretation stipulates that a business interacts with a customer within the customer’s state whenever it engages with the customer via its website or app. Extraordinary consequences may result from this interpretation, potentially sparking concern, as internet-based activity could create new taxation nexus, broadening the net for who may now owe more taxes. Detailed examples in the MTC’s interpretation guide this understanding, stating that customer post-sale chats or emails, uploading resumes for non-sales positions, and using internet cookies can all constitute sufficient grounds for creating this nexus.
Flow-through entities are common for small businesses as they help avert the potential of double taxation. However, adhering to state tax can be complex. Operating as a flow-through entity often requires multiple filings in each state: one at the organizational level, and then additional filings for each member of the organization. This layering of taxation inevitably increases the compliance cost and complexities of state income tax for small businesses. As these costs surge, smaller accounting firms might struggle with the sheer volume, forcing businesses to switch to larger firms which may escalate costs still higher.
With 11 states to date providing a threshold dollar amount of sales that must be reached before an income tax return is required, these thresholds ought to serve as firm safe harbors. Protecting small businesses means not only preserving the role of businesses that sell tangible personal property, but creating synergistic federal and state laws that set clear nexus standards to shield small businesses or businesses that have minimal contacts with the state.
Catherine Shaw, state and local tax partner at Cherry Bekaert, strongly advocates for the enactment of minimum factor-presence nexus standards by Congress to defend the small business community. Tax policy must be restructured to improve ease of compliance for such entities. In essence, the protections of interstate tax rules are not merely beneficial but necessary for the sustenance of small and medium-sized businesses.
This analysis is based on a write-up that first appeared on Bloomberg Tax.