Tax Nexus

What’s the Connection?

The Far-Reaching Implications of Tax Nexus

by Robert L. Rojas and J. Michael Pusey

Reprinted from  Tax Notes State, April 15, 2024, p.  207

1. General
2. Nexus at Its Root

The term “nexus” basically deals with connections and when a taxpayer or the taxpayer’s entities have tax paying or reporting responsibilities. With the sales tax, the business is not the taxpayer but the collector and remitter of the tax. These nexus responsibilities usually focus on paying or collecting tax, but the concept can also address when reporting or filing is necessary. One dictionary source defines nexus as “a bond, link, or junction; a means of connection between things or parts; (also) the state of being connected or linked.”1 In our context, nexus is basically the point at which you (or yours) and taxes get connected. The term might be seen as the “tie that binds” the taxpayer to the tax collector. Arizona, for example, defines the term as “the connection required to exist between a state and an out-of-state potential taxpayer where the state has the constitutional right to impose a tax.”2 One might think of nexus as the switch that turns on the light, but in this case, it turns on the taxes, or at least work relating to taxes. Nexus discussions have been a focus of tax research and policy for many years. A survey of Fortune 1,000 companies almost 30 years ago, in 1996, said that “interpretation of the term ‘nexus,’ is the most important state and local tax issue facing Fortune 1000 companies.”3 Nexus standards often vary from one taxing jurisdiction to another; for example, when the topic is state income tax reporting and payment. Our tax responsibilities turn on the rules of that state, which are often significantly different from the rules elsewhere. Nexus can vary with the type of tax; for example, sales tax reporting versus income tax reporting responsibilities.4 Nexus for income tax purposes will not necessarily focus just on income or the level of income. For example, the location of business inventory could also be a factor. Tax professionals will recognize nexus as a term most commonly associated with sales and use tax and state income tax issues, but we will see that the concept also plays an important role in discussions of the research and development credit and many other areas. The importance of nexus discussions was greatly enhanced by the Supreme Court’s decision in Wayfair.5 In the six years since that decision, states have developed many new laws, rulings, and other guidance. Our study of nexus will be brief, yet it may also seem surprisingly broad in scope. It affects us in many ways, whether large or small. Wayfair is of major importance, yet it is also just a brushstroke on our increasingly complex canvas of connections between tax laws and taxpayers. People innately expect some connection between themselves and the taxes they pay. Let’s say Melvin walks into his small shoe repair shop in San Diego.6 Melvin finds tax bills from a South American country and a state other than California. He’s been told it is best to write when it comes to dealing with such matters, so rather than call, he writes both asking, “Why are you taxing me? I don’t have anything to do with you.” Weeks pass, and he gets written responses saying, “Why not? Why can’t we tax you?” Melvin writes back, “Because there’s no connection; you need some connection with me or mine to tax me. There is no nexus!” Our (hopefully) preposterous narrative suggests that most of us, whether we do tax research or hammer away at the soles of shoes, have an expectation of some connection, some nexus, that ties us to the tax bills that come our way. We didn’t address here whether Melvin was a former resident of the state that sent him a tax bill, but we will later note that there are indications of California continuing to tax former residents. What’s the connection between the taxpayer and the tax bill? That’s our focus, and while nexus is most often associated with state and local taxation, the reader may be surprised at the number and variety of connections that purport to tie taxpayers to particular taxes. We may be surprised at the tenacity of the nexus concept — how it does, in a sense, move around. For example, nexus can arise with the individual’s estate, and while the tax literature may not describe it this way, there is a sense in which the individual’s death ends nexus and the individual income tax. One of our areas of focus is when nexus goes away. We will find generally that it can be tenacious.

1. Nexus and Entity Choice

Selecting the type of entity for a business or multiple businesses can be an important consideration generally, as we discussed in an earlier article: Our focus includes a more detailed look at the C corporation, but we also discuss ownership by the individual (the sole proprietorship), the S corporation, and the partnership. A C corporation is one that hasn’t elected S corporation status for a particular year. It is possible for a corporation to have a history that includes C corporation status for some periods and S corporation status for other periods. A single individual cannot be a partnership, although it is possible for spouses to operate as a partnership. It is possible for a single individual to operate a business as a C corporation or S corporation. The limited liability company, the LLC, can be disregarded as an entity if owned by an individual. An LLC with multiple members is generally taxed as a partnership. It is possible for an LLC to be taxed as a corporation. Many of the details of how to achieve a particular tax entity result may be gleaned from IRS Form 8832 and its instructions.7 In general, a taxing jurisdiction’s definition of nexus may not have different rules for different types of entities, but it can be an important factor in the analysis, particularly when there are variations in ownership. Factors that tend to trigger nexus in the case of the individual may not apply to an entity. For example, as we discuss below, General Motors walked into a big San Francisco tax bill by introducing a product there. For an individual, however, attendance at a place of worship can be a nexus factor, which obviously isn’t applicable to GM. Understanding the ownership of the business can be an important first step in analyzing nexus. Planning for a change in ownership can also be a factor, but related-party rules must be part of the analysis. This discussion will, at times, focus on general principles. The concept of nexus is relevant in all 50 states and in federal contexts. Even states with no income or sales tax will have areas of concern with nexus. Our focus, however, will often emphasize the California rules.

1. Nexus Explodes
2. Wayfair

Some point to increased need in the taxing jurisdictions, including pressures created by COVID-19, to explain expanding nexus. There are likely a multitude of reasons, but the major one came with the Supreme Court’s expansion of the reach of state and local taxation in Wayfair. South Dakota opened the door to expanded taxes by eliminating physical presence as a nexus requirement, but it prevailed by only one vote in a 5-4 decision.8 There was connection with the state, but the transactions occurred without the presence of the sellers. Since opening this door to increased taxation, states and retailers alike have been asking if there will be similar pro-tax collector decisions.9 The South Dakota statute at issue in the decision had an expansive “either/or” approach that defined nexus as “gross revenue from sales delivered into the state exceeding $100,000 or engaging in at least 200 separate transactions involving items delivered into the state.”10 The Supreme Court’s reasoning included a theme of letting Congress monitor fairness to businesses.11 The Court found undue burdens were not present because the statute was not retroactive and required considerable business in the state. Also noted was that South Dakota had adopted the Streamlined Sales and Use Tax Agreement.12

2. Quinn

Wayfair is fairly characterized as pro-state taxation. On January 16 the U.S. Supreme Court denied certiorari in Quinn,13 another pro-state taxation action (though not a decision) that let stand a ruling by the Washington Supreme Court sanctioning a capital gains tax. The tax can reach gains that are entirely out of state. There are federal limitation issues in Washington’s statute, so it was apparently necessary to conclude that the capital gains tax was not a tax on capital gains, which would make it an impermissible tax on property subject to state limitations. Rather the court had to classify it as a permissible excise tax, and this had to classify the tax as one based on the transaction — the sale or exchange — not the income itself. The key language in the Washington statute is the transaction being a voluntary sale or exchange.14 The tax reaches only “residents,” which gets into classifications we consider as being issues of nexus. The heading for the statute at issue in Quinn is “Capital Gains Tax.” Most tax practitioners would consider a capital gains tax an income tax. Federal taxation of these gains is found in the IRC section titled “Income Taxes,” not in “Miscellaneous Excise Taxes.” A dissenting opinion in Quinn argued (understandably) that the capital gains tax was an income tax. Justice Sheryl Gordon McCloud looked to the nature of the tax, “not its legislative label.”15 If one agrees that a capital gains tax is an income tax (or a property tax), can it simultaneously be classified as an excise tax on the privilege of selling? Can a tax simultaneously have multiple classifications — be a tax on a privilege and a tax on income? Even if one believes in the potential for multiple tax classifications, it appears that the Quinn majority  needed to achieve (and did achieve) a classification that had to disregard the actual nature of the tax. The connection (or nexus) between gains and income had to be erased to achieve a permissible classification of the tax because the nature of the proposition was either/or, not both. The petition for writ of certiorari argued against taxation even if the tax is classified as an excise tax, arguments that include nexus and whether there is “substantial connection” between Washington and the out-of-state sales just because of residency. The petition also argued that the tax violated the federal constitutional limitation on burdening interstate commerce.16 The statute apparently doesn’t reach short-term capital gains, which is unusual. These gains are usually considered the “most taxable” in that they get no rate break. The petition also argued that capital gains taxes are taxes on the income, rather than taxes on a resident’s decision to engage in the transaction.17 The residency issue was not emphasized in the petition, though we consider it an issue of nexus. Residency looks to have triggered taxability under this state’s rules once you succeed in calling a capital gains tax an excise tax, rather than an income tax.

1. Sales or Use Tax
2. Economic Nexus and Sales or Use Tax

The theme for this section is “get out your research tools.” Among the states that have sales tax, which includes the District of Columbia, the tax bases “have never been harmonized; each state has virtually unrestrained sovereignty to choose its own tax base. Unsurprisingly, huge variations exist among the states regarding what is included or excluded from the tax base. To make matters worse, fifteen states also allow some variation between their state and local sales tax bases.”18 As of 2024 all states with a sales tax (which is all but a handful) have enacted some variation of the economic nexus concept in Wayfair, which focuses on the remote seller having a volume of sales or number of transactions into the state, or a combination of these two touchstone criteria. The term “economic nexus” arose in a sales tax context, but the concept has spread. Post-Wayfair, “nearly all states that impose a sales tax have also adopted marketplace facilitator legislation, under which remote businesses that facilitate transactions on online platforms, often between unrelated purchasers and sellers, are required to register, collect, and remit sales taxes on these transactions.”19 The importance of this topic, and the increased effect on remote sellers, may be indicated by collections of tax from remote sales going from about $3.2 billion in 2018 (the year of Wayfair) to about $23.3 billion in 2021.20 The state enactments are generally not uniform regarding thresholds and effective dates. For example, some have only a dollar criteria whereas others have a combination of dollar and transaction thresholds. The American Institute of CPAs has noted transaction-measurement issues such as whether multiple transactions may arise from one invoice and how to handle installment payments.21 A marketplace facilitator may sell its own goods and facilitate sales by others.22 Amazon is one example of a marketplace facilitator. Liability disputes can arise between the remote seller and marketplace facilitator.23 Some businesses reported to the Government Accountability Office that “frequent changes to the state and local tax requirements or limited information in some state publications (including guidance and forms) contributed to business research costs.”24 The compliance complexities in this new environment are such that some states offer “amnesty and voluntary disclosure programs.”25 The GAO concluded that “the question remains” whether this new environment, while generating increased tax revenues for states and localities, is consistent with “equity, economic efficiency; and a combination of simplicity, transparency, and administrability.”26 Among the complexities arising from increasing technology is “click-through” nexus, which can arise when a purchaser clicks through from your website to another site, which eventually yields a commission from, for example, Amazon. State statutes are sometimes ambiguous or silent regarding whether sales on a collecting marketplace translate into economic nexus for sales tax purposes.27 This article generally divides sales tax nexus into physical nexus, economic nexus, and affiliate nexus; the latter discussion includes affiliations like Amazon. Further, several states have used these standards to subject remote businesses to the state’s income tax.28 Being in business isn’t necessarily a requirement for incurring sales tax responsibilities and needing a permit. For example, Texas has an occasional sales tax exemption. If a person satisfies either of two rules, there is no sales tax collection requirement. One of the rules allows sales of up to two taxable items during any 12-month period. The state’s example is a family sells a piano, then the kid’s bike, with the result being no sales tax. But when the family sells the lawn mower, it owes sales tax on this third item, unless it qualifies under another exemption. This exemption generally exempts up to $3,000 in sales in a year. The Texas guidance stresses that the acquisition must have been for personal use and that a person is “considered engaged in business” for this purpose if they fail to qualify under either the two-sale rule or the $3,000 rule.29 The acquisition for personal use criteria may be problematic when personal property is used in part for business. Registering to pay sales tax can sometimes involve a fee. Location details should be considered in one’s research, including considerations of multiple ship-to and ship-from locations. Nexus rules have also been used to expand unnecessary reporting of resale transactions wherein there is no sales tax. Another interpretative issue that can arise is counting transactions when the businesses sell through their own website and sell through unrelated marketplaces.

The following factors add to the complexity:

• Sales tax is sometimes administered at the state level with local jurisdiction add-ons to arrive at actual rates affecting taxpayers (and businesses that remit the sales tax), but there are also instances of local sales tax administration, known as “home rule jurisdictions.”
• Remote sellers can encounter varying tax rates, whereas jurisdictions may have a uniform rate with the state, which then allocates portions to local jurisdictions.
• The proliferation of indirect taxes and fees such as lodging and accommodation taxes, which can affect those industries.
• In some jurisdictions, the tax base can include services or digital products instead of just tangible personal property. In some jurisdictions, those making sales through a marketplace facilitator may encounter these difficulties:
• Product definitions and interpretations regarding exemptions may vary.
• Companies might sell into multiple jurisdictions with differing filing and withholding requirements.
• Remote sellers sometimes qualify for a relatively simple state compliance system, but then a factual change may cause them to lose access to this procedure and instead require the seller to deal with both the state and local jurisdictions.
• The speed of legislative changes and added enforcement efforts have created compliance difficulties even for those businesses making utmost efforts.
• Remote sellers may encounter multiple audits in one state; that is, an audit by the state and local taxing jurisdictions within the state, a complexity which has resulted in companies fighting back with lawsuits.

Even the GAO has acknowledged that “businesses face substantial compliance costs and uncertainty navigating these requirements” and that when Wayfair removed the need for a physical presence in the state, such as a store or warehouse, the states responded in a manner “resulting in a complex patchwork of requirements with wide variation.”30 The GAO further noted: “Currently, if a remote seller sells into all 45 states that have enacted sales tax economic nexus requirements and the District of Columbia, it could be subject to audits by each and by localities in some, and, as applicable, appellate processes in each jurisdiction.”31 This includes “nexus notices” coming from the taxing authorities.32 The GAO concludes that there is “substantial uncertainty” as to what extent sales taxation is legally permissible for states and localities given the constitutional protection; that is, states are not to discriminate against or impose an undue burden on interstate commerce. This is balanced, however, against the power that states and localities have to levy tax. And while Congress can step in to regulate interstate commerce, it has yet to provide major legislation in this complex area.

1. California Sales and Use Tax Scope

The California tax applies to sales of tangible personal property, defined in the code as personal property that can be “seen, weighed, measured, felt, or touched, or which is in any other manner perceptible to the senses.”33 California explains its statute using some of these examples. As one might expect, there is some wrestling with the personal property versus realty distinction.34

• Sales of sand and gravel to a highway contractor was personal property as taken from a pit. This is an example of realty becoming personal property as it is extracted.35 One can also see personal property becoming realty, for example, nails becoming part of a house. There usually wouldn’t be a sales tax on the nails after they become part of the realty that is sold, but sales of nails to construct a house may incur tax.
• Equipment attached to realty remained personal property “with rights to removal, replacement and consumption.”36
• Film negatives and master recordings used for training purposes were tangible personal property.37
• The exemption from state and local taxes for lottery tickets applied only to sales to the public, but sales of printed lottery tickets to the California Lottery Commission were taxable. Here we see close reading of the statute to conclude that paper containing the lottery rights was tangible personal property.38
• Coal used in electricity production was not exempt on the grounds that it was purchased for resale because it wasn’t incorporated into a final product but rather was used as a catalyst in the manufacturing process.39 The tangible personal property classification also comes up in connection with California’s franchise (income) tax.40 There is no statutory or regulatory definition of tangible personal property. Black’s Law Dictionary defines the term as “personal property that can be seen, weighed, measured, felt or touched or is in any other way perceptible to the senses.” For assets such as computer software, the distinction between tangible and intangible property can become blurred.41 The key California statute addressing sales of tangible property is Cal. Rev. & Tax. Code section 25135. The following administrative rulings illustrate the importance of gaining an understanding of the taxpayer’s activities and how its sales are structured and reported.In Appeal of Babcock and Wilcox Co.,42 the taxpayer fabricated steam generation systems in a different state and assembled them in California at the purchaser’s location. The transaction involved many facets, such as drafting, engineering, testing, and assembly, but the California State Board of Equalization rejected assignment to where the greater portion of the income producing activities were performed, concluding the focus should be in-state tangible personal property.43When a taxpayer that assembled seat parts in California for a Texas company attempted to use the destination rule to assign the revenue outside California, the BOE disagreed. The taxpayer was held to have California income from the sales of services, not tangible personal property.44 Another example in which a taxpayer was unsuccessful involved an attempt to “treat a portion of the sales price of its products as royalties assignable to the state where the income producing activity was performed.”45 The BOE concluded that there was no separate sale of an intangible and taxed the entire sale as tangible personal property. These disputes, though not within the sales and use tax portions of the rule, did not prevent the asset from being tangible personal property. The service versus asset sale distinction could have sales tax implications, though not the focus of these cases. One generally needs to read broadly in researching nexus issues, realizing that case distinctions may affect the various types of tax. Major transactions generally can have significant sales tax implications. When the goal is exit planning or otherwise selling one’s business, the sales agreement’s allocations can have significant sales tax implications. To the extent the proceeds relate to tangible personal property, they are generally subject to California sales tax. Allocation also arises in the sales tax arena in questions such as whether delivery charges are part of the sales price for tangible personal property versus payment for services. For example, a computer company billing for its services might become subject to sales tax as the final seller if it bills separately for cards and forms. California regulations state: “Generally data processing firms are consumers of all tangible personal property, including cards and forms, which they use in providing nontaxable services unless a separate charge is made to customers for the materials, in which case tax applies to the charge made for the materials.”46 A computer company sending a customer tangible personal property that it has “produced, fabricated, or printed to the special order of the customer” is generally subject to sales tax. “However, if the contract is for the service of researching and developing original information for a customer, tax does not apply to the charges for the service. The tangible personal property used to transmit the original information is merely incidental to the service.”47 This regulation has a separate discussion distinguishing pickup and delivery charges, which seems to say that such charges aren’t subject to sales tax when the context is basically one of services (processing of customer furnished information). However, it then says that sales tax may apply to pickup charges when there is a sale of tangible personal property. There are special regulations dealing with transportation charges.48 The rules are complex and contain many fine distinctions. Keep in mind that this discussion is just California’s analysis.

1. California Sales or Use Tax Particulars

The Tax Foundation has warned that California is especially difficult to navigate, writing: “The California base is woefully narrow, riddled with exemptions and excluding swaths of personal consumption.”49 There appears to be no one-stop shop for guidance on the sales and use tax. Rather, there is a multitude of guidance, which may focus on topics such as rates and examples of taxable purchases.50 The sales tax rate in the state can range from 7.5 to 10.25 percent. Payments may need to go to different collection locations, and it may not be possible to pay California and let the state distribute the revenue.51 Any tax over the 7.5 percent rate may reflect a local sales tax or involve district taxes.52 Sales tax is generally collected by the California retailer, or tax collecting may be the responsibility of a remote seller. Barring sales tax collection, the buyer may encounter use tax responsibility. Retailers engaged in business in California are required to register with and file with the California Department of Tax and Fee Administration (DTFA). The DTFA has enforcement offices focused on sales tax outside the state, namely in New York City, Chicago, and Houston.53 Appeals and disputes involving sales and use tax are subject to their own procedures regarding resolution and time frame. These include discussions with staff in the DTFA’s business tax and fee division, the DTFA’s appeals board, and then the Office of Tax Appeals.54 A retailer would figure a sales tax rate using the retail location. The California sales tax is normally collected at the point of sale. Cal. Rev. & Tax. Code section 6066 generally states that in a particular jurisdiction, the seller’s permit will look to where the retailer is located, and this will determine the rate. For a major purchase with significant sales tax, the buyer may want to consider a retailer in a lower-rate jurisdiction. The distinctions and particulars seem endless. California even has a special sales and use tax exemption for “space flight property.”55

1. Sales Tax — Real Estate

From a planning standpoint, one of the important considerations is to avoid unnecessarily paying sales tax on services because services and tangible personal property are billed together rather than separately. It can be true that a state’s law will mandate including services in the sales tax base in some cases. For example, Nebraska’s rules state that if a retailer sells tangible personal property and installs it, the retailer must include installation charges in the tax base even if separately computed and invoiced. However, contractors who install and apply building materials and fixtures to real estate encounter their own set of rules.56 So one must also look for any special industry rules. California’s guidance for sales and use tax for contractors explains that how the state’s “sales and use tax law applies to construction contracts depends on the type of contract, how contractors purchase materials, fixtures, machinery and equipment, and how they install such items under contracts to improve real property.” It adds that the “law considers construction contractors to be consumers of materials they use and retailers of fixtures they install.”57 It defines materials to be property that loses its identity to become part of the realty, such as bricks, plaster, lumber, windows, and paint. Fixtures, however, don’t lose their identity when installed. Examples of fixtures include air conditioning units, prefabricated cabinets, furnaces, and signs. Contractors are essentially considered resellers of some items, so sales tax would not normally be paid. In other instances, they are considered consumers who pay tax on their materials. There may be narrow exemptions. For example, there are rules focused on “certain purchases for the construction of certain military and veteran medical facilities.” Even then, however, the exemption for these materials and supplies is only extant through 2024.58 The DTFA provides detailed examples for different types of contractors and products, such as asphalt, flooring, and landscaping.59 Sales tax is a significant component in the cost of most constructed realty in California.60 In general, when the completed building is resold, the nails, lumber, and other components have lost their identity as personal property and have transitioned into the category of realty, the sale of which is generally exempt from sales tax. Getting down to the miniscule, California considers a fire hose to be property but the rack holding it realty. The state’s list of what qualifies as realty includes intercom systems, carpet, and pads if “tacked down”; rugs are personal property. Also, “the sale of a furnished apartment house involves the sale of tangible personal property subject to sales tax.”61 Transfers of realty in California may be subject to a documentary transfer tax. Leases of personal property may be exempt from California sales tax, but there are exceptions.62 It is also true that some states, including California, have taxes aimed at kinds of services.63 But it is quite common to find the general focus of the state’s sales tax being on sales of tangible personal property as is the case in California. As is common, California taxes restaurant food while exempting groceries; purchases with food stamps; many medicines; and professional services, such as doctors, lawyers, and CPAs. Texas taxes sales of tangible personal property but only specified services.64 Texas also provides detailed rules on the topic of identifying personal property in its real estate industry generally. It distinguishes lump sum contracts that treat the homebuilder’s bill as exempt to the client, with the homebuilder owing tax on purchases of equipment, incorporated materials, consumable materials, and taxable services, though purchases of real estate services are exempt. Under a “separated contract,” the homebuilder is basically treated as a reseller who collects sales tax within the contract price as to incorporated materials, whereas the homebuilder pays tax on items such as equipment, consumable materials, and taxable services.65 Even when a state’s sales tax base includes services, it is common for the state to exclude real estate services and commissions. As for manufacturers, Texas “exempts tangible personal property that becomes an ingredient or component of an item manufactured for sale, as well as taxable services performed on a manufactured product to make it more marketable.”66

1. California Sales or Use Tax Examples

Retailers located outside California, including foreign sellers, making sales of tangible personal property for delivery in California are generally required to collect California use tax when sales by the retailer and related parties exceed $500,000. The federal income tax rules defining related parties are incorporated here.67 Having a physical presence — defined as maintaining inventory, offices, representatives, installers, assemblers, or order takers in California — also triggers these responsibilities.68 California also has a series of guides for particular industries, including for beer brewers and distributors, caterers, destination management companies, florists, fulfillment centers, gas stations, liquor stores, event planners, grocery stores, mobile phone vendors, rental companies, winemakers, and distributors. Below is a discussion of some California-specific rules.

1. Internet Nexus

The out-of-state retailer is engaged in business in the state and is required to register to collect use tax in a structure involving circumstances indicative of nexus. The retailer’s parent operated retail stores in the state, but the out-of-state subsidiary sold tangible personal property in California through internet websites advertising gift cards. Signs in the parent company’s stores told customers they could buy gift cards online through the out-of-state retailer’s web address. The in-state parent was seen as conducting activities in-state on behalf of the out-of-state subsidiary.69

2. Advertising Agency

An advertising agency that buys and bills clients for tangible personal property can trigger unnecessary sales tax if it isn’t careful in its pay-then-rebill practices. Estimates can trigger sales tax problems.70

3. Agricultural Business

There is no sales tax for sellers of feed relating to food animals, nonfood animals that are to be sold in the business, breeding animals, and their offspring.71 Hay growers fall into this category if they produce hay only for sale to beef cattle feedlots or dairies or sell only through a farmer-owned cooperative. Alfalfa purchases are exempt from sales tax if the purchase is food for food animals, in which case an exemption certificate from the buyer is required. Sales of food animals are not subject to sales tax whereas sales of breeding stock are taxed, as are sales of horses. Sales tax on feed generally turns on whether the feed is sold for nonfood animals and “feed includes grain, hay, seed, kibble and similar products.”72 There are rules on when an exemption certificate is required if the farmer is to avoid sales tax on exempt purchases. Detailed rules apply regarding when medicines and drugs for farm animals are exempt. Pet store owners are exempt from sales tax on feed for animals to be sold in the business. The tax applies to feed for personal pets, even if the pet belongs to the store owner. In California, sales tax applies to the retail sale of nonfood animals, which includes cats, dogs, and horses, as well as “animal serum and red cells” because the latter “are not considered a form of animal life used for human consumption.” Since the sales tax reaches only some property, it appears that the California regulations are telling us that tangible personal property includes red blood cells.73 Do the California regulations imply that humans with red blood cells have within us tangible personal property that is potentially subject to sales tax? We aren’t going to research further than to note that there is a California tax exemption dealing generally with sales of human blood and body parts.74 When dispensed for a human or an animal and prescribed by a “licensed practitioner of the healing arts,” a drug or medicine may be exempt as a healthcare supply.75 The healthcare supplies provision also states that sales of hospital beds are exempt. It adds that this includes beds that are specially designed and have special features and that the term includes the mattress but not bed linens. There are special sales tax exemptions for retailers supplying those involved in farming, ranching, and gardening for “seeds, fertilizer, and plants or plant stock.” Special beneficial rules can apply to the sale of liquefied petroleum gas when the use relates to producing or harvesting agricultural or horticultural products or when there’s a home not connected to gas pipes or mains. While the sale of farm machinery and equipment is generally subject to sales tax, a partial exemption can apply when the sale is to a qualified person, the use relates to producing and harvesting agricultural products, and the asset meets the definition of farm equipment and machinery. A livestock building can qualify for partial exemption as “farm equipment” if designed and used exclusively for breeding and raising livestock. Egg production and milk production can also qualify for the exemption. Horticultural buildings, such as a greenhouse used for raising and packing tomatoes, may qualify for partial sales tax exemption. But the partial sales tax exemption is lost if the same building is used to sell the tomatoes. Nexus questions can have tiers, such as a sales tax question turning not only on the asset sold but where it is sold.76

4. Veterinarians

In general, vets are retailers regarding some products, and sales tax exemption applies to items for resale, just as the wholesaler is generally exempt on items to be resold to a retailer. Items the vet will consume in the business are ordinarily taxable, but drug or feed exemptions may apply. The rules are so detailed that they contemplate that the vet may be partially exempt from a 5 percent component of the tax on some items sold to a rancher. This can necessitate the vet, when not helping the animals, spending time getting “a specific partial exemption certificate.”77

5. Manufacturing and R&D

A reduced sales and use tax rate can apply to qualifying purchases. Among the requirements are that the tangible personal property be used more than 50 percent of the time in manufacturing or processing tangible personal property, electrical power generation, or R&D. Qualified tangible personal property can include machinery and equipment and related equipment and devices but not tools and supplies.78

6. Motor Vehicle Dealers

Dealers generally fall into the category of a retailer that makes three or more sales of tangible personal property in a 12-month period. Whether the buyer’s use is personal or business is not distinguished. In general, a true broker gets offers from potential buyers and conveys those offers to potential sellers, and these activities are not subject to tax, whereas a retailer would have power to transfer title to the vehicle. A broker may collect use tax as a convenience to a customer. A vehicle to be delivered out of state would not generally be subject to sales tax. Used motor vehicle dealers are generally required to collect sales tax and remit directly to the Department of Motor Vehicles or in some cases to the DTFA. There is a separate booklet for auto repair garages and service stations.

1. California Nexus — Sales Tax of the Remote Seller

California’s economic nexus rule for out-of-state sellers is more than $500,000 in sales of tangible personal property in the current or prior tax year. Given that many states have thresholds as low as $100,000, California’s rule is relatively generous. California’s law addresses the retailer but uses a total sales touchstone, whereas other states sometimes define the threshold in terms of only retail sales.79 California’s rule limits economic nexus for the sales tax to tangible personal property. However, California includes sales made through marketplace facilitators in measuring economic nexus and does not consider electronically downloaded software as tangible personal property for this purpose. In measuring the $500,000, California looks to the retailer and all persons related to the retailer, as defined in IRC section 267(b). Related-party work here can require analysis. “Related” may relate to family members as well as entity ownership, including partnerships, trusts, and corporations, whether C or S corporations. The key language for determining the total is “total combined sales of tangible personal property for delivery in this state.”

III. The State Income Tax Nexus Overview

1. General

There is federal legislation limiting the ability of states and localities to tax income when the taxpayer’s activities in the state are limited to soliciting orders. But interacting with customers through the company’s website has become problematic because the Multistate Tax Commission understood this to be unprotected activity.80

1. Residency as a Nexus Issue

The definition of residency can be complex. When California determines you are a resident of the state, this basically entitles it to tax you on your in-state and worldwide income. California’s rates on individuals reach as high as 13.3 percent. Effective in 2024, the rate on high-wage earners can be 14.4 percent given the recent elimination of the wage cap on the state’s 1.1 percent payroll tax for state disability insurance. California’s tax rules reach income earned in the state from day one. A former resident visiting the state and earning some income for services in the state would have to report this income. There is no threshold type of rule. The computation of income earned in California might be computed on a pro rata, day-count approach.81The part-year resident pays California tax on worldwide income while a resident and California-source income while a nonresident. The details of computation can include steps such as splitting your S corporation’s flow-through income between periods of your residency and nonresidency.82 Different taxing jurisdictions will have their own residency definition. This can include definitions at the state level for purposes of the state’s income tax. “Nexus” as a term is commonly associated with sourcing questions, distinguishing when, for example, an out-of-state corporation becomes taxable in California on a type of income. However, such classifications as we discuss here — resident versus nonresident distinctions — seem essentially nexus in nature in that within the details of the definitions concerning residency, the tax law writers articulate particular factors that connect the taxpayer to the tax. Residency questions can play a role in federal tax matters. This can involve federal tax rules as they reach (or don’t reach) the income of noncitizens depending on whether they are U.S. residents.83 Also, some penalties related to section 6751(b) may require written approval of a supervisor. We refer to the 2023 Tax Court case, Kraske, which focused on when supervisory approval was required.84 The case was appealable to the Ninth Circuit because the taxpayer was a California resident. The state has a list of considerations in resolving whether a taxpayer is a California resident — where you live, vote, worship, golf, and so forth. But we note that it was the taxpayer’s residency that appears to have determined the outcome of this federal penalty case.85 Federal rules may look at residency from the standpoint of whether you live somewhere in the United States (as a resident or foreign national), or whether you live in a state, and that the federal rules stand alongside a mixture of rules for determining residency at the state and local level. There is the common thread of trying to find the connection, the nexus, that brings tax rules to the taxpayer’s doorstep. We believe residency questions, which can present any number of complexities, are basically one of the subsets of nexus.

1. Nexus Issues and the Estate Tax Collector

Even estate and gift taxes can have issues that are essentially nexus in nature. There are complexities such as an IRS statement that the “determination of whether an individual is a nonresident noncitizen for U.S. estate and gift tax purposes is different than the determination of whether an individual is a nonresident alien for U.S. federal income tax purposes.”86 Researching these issues is less of an issue in California, but it is not uncommon to encounter state inheritance taxes or transfer taxes.

1. A Closer Look at California’s Nexus Rules,

Including Residency

California’s tax on corporations is a flat 8.84 percent. Corporations can also incur California’s alternative minimum tax. States have different approaches to taxing corporations. Some have progressive corporate tax rates while others have flat rates. Some have a gross receipts tax in lieu of a corporate income tax, and some states have both a gross receipts tax and a corporate income tax.87 A California corporation is deemed to be doing business in California and pays tax on its income to the state. A corporation formed in another state but doing business in the state will file (and register) there. California’s primary definition focuses on “actively engaging in any transaction for the purpose of financial or pecuniary gain or profit.”88 The statute’s title is “Doing Business,” but the statute itself doesn’t include that phrase. The mere receipt of dividends and interest and the distribution of this income to shareholders is not deemed doing business that triggers California income tax, but generally, the definition is broad and far reaching. An individual being classified as a resident is basically the nexus that triggers California’s ability to tax worldwide income. If the state considers you a resident and you are traveling in outer space (see discussion below) or working to mine the moon, your income earned while in outer space is in all probability taxable in California. So, to say California can tax your “worldwide” income if you are a resident might be an understatement. In general, flow-through income to a resident will incur California tax. For example, subchapter S corporation flow-through income to an individual residing in California will be taxable even if entirely from a corporation with no nexus in California. The nexus question can, of course, have an effect in a corporate context. California is one of the few states taxing subchapter S corporations, imposing a 1.5 percent corporate level tax on California-source income, plus a minimum franchise tax.89 California basically defines an individual as a resident when present in California for other than a temporary purpose, or one is domiciled in California and away for a temporary or transitory purpose. The definition of resident is somewhat nebulous, but California’s list of considerations emphasize time spent in and out of state; location of family; principal residence; state on your driver’s license; state where your car is registered; state of your professional license; where you’re registered to vote; location of bank accounts; origination point of your financial transaction; location of doctors, dentists, accountants, and attorneys; social ties, such as location of place of worship, professional associations, country clubs; location of realty and investments; and permanence of work assignments in California.90 If you live out of state, stay out of state, and your only nexus with California is owning realty there, mere ownership of its realty wouldn’t make you a California resident. Leasing and rental relationships outside your home jurisdiction should also be part of nexus research, although mere ownership of realty in California should not per se convert you into a resident. An out-of-state corporation owning and renting California realty would report this income. California’s discussion of its residency guidelines includes some that focus on day counts when out of California for employment-related reasons. Phrases like “employment-related” in residency discussions would seem to make even employee versus contractor status a nexus-related subset of research. If someone is rendering services in a state, that person’s status as an employee rather than a contractor can have implications in determining whether the employer has nexus. Employee status suggests more control and may be more likely to raise nexus issues, although employee-contractor determinations are not necessarily conclusive as to matters pertaining to employer nexus. “Even if your business is located in one state but you have employees or independent contractors in another, this could create nexus with the latter state.”91 In general, the taxpayer’s relationship with contractors should be part of the tax planner’s research regarding nexus issues. When employees are not in the home state, their presence elsewhere can create not only nexus issues regarding the state’s income tax, but it can also raise exposure to that state’s unemployment insurance tax, disability tax (or insurance), and workers’ compensation tax. State income tax withholding regarding employees can be affected by such matters as reciprocity agreements between states, which can allow employees to pay tax only in their state of residency.92 Working too many hours on a California vacation can theoretically be a residency issue because being on vacation in California helps establish nonresidency.93 A nonresident can realize gains on appreciation attributable to periods of former residency and avoid tax on the realization of gain for California reporting purposes, even if all or part of this gain relates to appreciation that arose during periods when the individual was a resident. Nonresidents are taxed on gains on California realty; residents are taxed on the sale of realty in another state, another country. The exact time of change in status, shifting from a nonresident to resident, or former resident to a nonresident, can be critically important in determining taxability under California’s rules.

1. Nexus Can Mean Penalties, Interest, and

Paying the Tax Collector’s Costs

As former California resident Gilbert Hyatt learned, the scope of nexus and the exact timing as to determining residency or nonresidency can extend beyond taxes to require the taxpayer to also pay the expenses of the tax collector. The history of the legal saga discussed here defies quick summarization, but we’ll hit the highlights. In the beginning, Hyatt, a longtime California resident, made millions on a computer-related technology patent. Hyatt apparently filed the first general patent on the microprocessor, a patent that was later invalidated, albeit he may have retained other claims.94 Hyatt claimed Nevada residency in 1991 and 1992. In 1991 he sold his house in California, then took these out-of-state steps suggestive of Nevada residency: rented an apartment, registered to vote, obtained insurance, opened a bank account, and acquired a driver’s license.95 California audited Hyatt beginning in 1993, concluding that he didn’t move to Nevada until April 1992 and that he owed over $10 million in California taxes, interest, and penalties. California declined to find him a nonresident for any part of 1991 even though, by the end of that year, he had sold his California house and taken the steps to establish Nevada residency. California apparently did a lot of work on this case, in a manner that drew criticism. In a 2019 U.S. Supreme Court decision addressing Hyatt’s rights to sue California over its conduct, Justice Clarence Thomas wrote for the Court that the taxpayer “unfortunately will suffer the loss of two decades of litigation expenses and a final judgment against the Board for its egregious conduct.” Nexus is a concept normally associated with taxpayers, not tax collectors, but regardless of the terminology, we note that the Supreme Court effectively agreed to erase a connection that could tie the taxpayer to the tax collector’s pocketbook, even if the collector’s conduct is egregious. If one thinks about the costs of recordkeeping in these cases, nexus issues can reach copy machine charges in the hundreds of thousands of dollars. In a 2023 case update, we read that Hyatt had won a quarter of a billion judgment against the California Franchise Tax Board, which eventually yielded him nothing but more legal fees related to matters such as whether he had to reimburse the FTB’s copying charges.96 The case brought by Hyatt against the FTB involved constitutional issues and whether the FTB was liable for several alleged torts. The costs were disputed. The Nevada Supreme Court issued an order last year in favor of the FTB for approximately $1 million, reversing about $787,000 and remanding about $467,000.97 This was some improvement for Hyatt. In 2022 the Nevada district court had awarded the FTB its full cost request of $2.26 million, which included costs stretching back to the late 1990s.98 The FTB sought cost recovery under a Nevada statute.99 The details of the FTB costs included travel and lodging costs of $225,431,100 $242,255 for expert witness fees, $63,008 for videotaping, and $651,628 for copying, most of which was in-house. We would argue that nexus and taxes, particularly in our recent history, tend to spread out, expand, and escalate rather quickly, to the point that it is even difficult to keep track of the taxes, penalties, and fees. In Hyatt, the FTB won about $1 million in 2023 in just costs and may be awarded more on remand. The taxpayer ended up being liable in 2023 for the tax collector’s costs, some of which went back to the 1990s, all because in 1991 and 1992 he claimed to move residency from California to Nevada just before realizing a lot of income. The FTB apparently even agreed that the taxpayer ceased to be a California resident by April 1992. We note that the issues that trigger connection ties to taxation can be complex — even, seemingly, close calls — and involve not only taxes but interest, penalties, and sometimes, even the costs of the tax collector. The FTB has a publication (Pub. 1024) and website page that lists more than 75 separate penalty provisions (many of which have federal counterparts).101 Hyatt’s case raises any number of issues for the tax planner. For example, operating as a C corporation raises many issues, including basic math of an entity-level tax and the potential for double taxation.102 Assignment of income between the shareholder and the corporation can be an issue, one that basically looks to find connection to either the entity or the individual, which is essentially a question of nexus. Steps to confirm whether a corporation owns an asset before a sale or licensing could be scrutinized by the tax authorities. If we assume Hyatt had formed a corporation and established ownership of any patent rights in the corporation, would a C corporation, had it been organized out of state, have had an easier time proving nonresidency status regarding the income? For example, the long list of considerations in resolving whether an individual is a California resident includes questions that presumably wouldn’t arise in a corporate context, such as where you go to worship. Would Hyatt have fared better had he operated as a C corporation? Our focus is not so much one of resolving the issue but rather to suggest that the tax planner’s range of research questions can include entity questions within what is essentially nexus research. What if Hyatt had formed an out-of-state corporation and elected S status? Having a history as a C corporation can have the effect of triggering entity-level tax during the first five years of being an S corporation.103

1. Can Income Tax Nexus Reach Gain That

Predates Connection to the Taxing Authority?

Our example will be in the context of a particular flow-through entity, the S corporation, and will presume a California connection. The state tells nonresidents they are taxable on the sale of California realty. In general, we will assume a California S corporation has a large gain on the sale of California realty. What if a nonresident buys outstanding shares after the sale? Can the long arm of nexus reach gains that predate ownership? Let’s say there are two 50 percent shareholders, both California residents taxable in California on their worldwide income, one of whom sells half of her 50 percent to a nonresident at midyear. The federal rules count days and generally prorate when ownership changes so that the federal rule would basically allocate the whole-year’s income and its components to the flow-through shareholders using, roughly:

• 50 percent (non-selling shareholder holds 50 percent all year);
• 37.5 percent (50 percent shareholder for half of the year and 25 percent shareholder for half of the year); and
• 12.5 percent (25 percent for half of the year).

But the federal rules have two exceptions to the whole year/prorated approach, one of which is an election needing all the shareholders to agree. This rule would allow cut-off accounting at midyear, then allocating the first half year’s income 50/50, and then allocating the second half year’s income 50/25/25.The general rule under IRC section 1366 is a pro rata rule that doesn’t distinguish when income was earned during the year, but is that lack of distinction necessarily fair in a state tax context? Does the whole-year reporting concept characterize a California realty sale as California income even when, after proration among shareholders, the proration relates to gain that predates the nonresident’s buy-in? Our circumstances qualify for an election, given reg. section 1.1368-1(g)(2), that would split the year into two periods (which would require two entity returns) if all shareholders elect and there is a 30-day period within which there is a disposition of 20 percent or more of the corporation’s stock.104 Our look at this election would be over if we didn’t find this level of stock disposition within a 30-day period. The 20 percent rule focuses on stock outstanding, not stock held by any shareholder. But given qualification and if the election is made, we’d find the new shareholder’s share of the S corporation’s income measured only by corporate income in the latter portion of the year, which didn’t include any sale of California realty. So, does that mean we can conclude the new shareholder has no California gain to report on the sale of California realty? That’s not to say the out-of-state shareholder wouldn’t have California income on say business income earned during the new shareholder’s period of ownership. The next question is whether California’s rules are identical and whether California automatically follows the federal election. Can one make the election under the state’s rules but not the federal rules? In general, the rule on splitting the subchapter S corporation’s year into two periods is of little effect if corporate income is earned evenly throughout the year. The election affects the measure of a shareholder’s share of gain but minimally if income is earned evenly throughout the year. But that is just the beginning of the tax planner’s analysis. Our main points here are not to resolve these issues but suggest to the tax planner the need to research federal and state conformity. A federal election can have important state tax consequences even if the election is easily dismissed as entailing extra work and having minimal federal consequence. Taxpayers and tax planners need to address these issues as early as possible. For example, the new shareholder may want to consider requiring an election under reg. section 1.1368-1(g)(2) by all shareholders as part of the agreement for buying stock if there is a potential advantage. In a closely held context, it is not uncommon for all shareholders to be involved in the legal and tax issues of a stock sale.

1. Nexus and the Passthrough Entity Election

California also has a passthrough entity tax election for tax years beginning after December 31, 2020, and before January 1, 2026. This election generates tax at the entity level but a credit at the shareholder level. The election, in California, does not require all shareholders to be included. The credit is nonrefundable but subject to carryover for five years. This election applies to passthrough entities generally, including partnerships. The election can convert the tax paid to the state into a business expense, toward the goal of sidestepping the $10,000 limit on itemized deductions of property taxes plus sales or income taxes paid to the state.105 Nexus can be affected by elections — the issue here being the characterization of tax as an individual tax (itemized deduction) or entity-level tax (business deduction).

1. Small Nexus Can Mean a Big Tax

A relatively small amount of nexus can be used to reach large amounts of income. General Motors claims its connections to San Francisco were limited in terms of employees and sales, yet the presence of the self-driving unit in the city was used by the city to reach GM’s worldwide income. GM’s San Francisco tax bill over a seven-year period averaged over $15 million per year ($108 million total), which was apparently many multiples of its gross revenue in the city.106 Reading such accounts, it seems fair to say that at times, nexus can (or can try) to create situations that are downright confiscatory.

1. Nexus Developments and Grantor Trusts

Given a California resident is taxed on worldwide income, is it possible to circumvent that rule to some extent by shifting income to an out-of-state entity, in this case a trust that is recognized as an entity for income tax but not transfer tax purposes? Under the old law, it was apparently possible to achieve a “disconnect” regarding California taxes by shifting taxable income to an out-of-state trust, whereas now this income will be treated as California income. California now taxes undistributed out-of-state income within the out-of-state entity by taxing it to the California resident. It achieved this though a statute. Gov. Gavin Newsom (D) signed S.B. 131 into law on July 10, 2023, with its provision targeting California’s income tax treatment of incomplete gift non-grantor trusts. Before this law, California income tax was triggered only if the trust had California-source income, a fiduciary residing in the state, or a non-contingent California resident beneficiary.107 Basically, nexus wasn’t found under the old law when the entity was recognized, but California changed the law to tax the resident on out-of-state income. Entity questions can be important in the analysis of nexus.

1. Nexus Has International Implications

Noncitizens generally become taxable on their worldwide income for U.S. income tax purposes when they become resident aliens. And the IRS guide says: A resident alien’s income is generally subject to tax in the same manner as a U.S. citizen. If you are a resident alien, you must report all interest, dividends, wages, or other compensation for services, income from rental property or royalties, and other types of income on your U.S. tax return. You must report these amounts from sources within and outside the United States.108 A key issue regarding taxation of nonresidents is the question of effectively connected income, which is essentially a nexus question. Nexus usually looks for the “connection” that brings in the tax collector. So, one’s nexus research may have to include such terms as “effectively connected.”109

1. Nexus and Heaven as a Tax Shelter

Nexus and taxable ties that bind can end. Nexus can arise with the individual’s estate, and while the theological or tax literature may not describe it in this fashion, there is a sense in which the individual’s death ends nexus and achieves a disconnect between the taxpayer and the tax collector.110 In state tax questions, nexus and residency questions do arise, and there is the possibility of a former resident ending or limiting the state income tax collector’s authority by moving. But residency questions and nexus questions do seem to go away in the case of the individual’s death. However, nexus can potentially rise up again in the pursuit of tax collection against the individual’s estate or successor owners.

1. California Nexus if You’re Wealthy
2. California’s Proposed Tax on the Wealthy

A California wealth tax on the mega wealthy has been repeatedly proposed but never enacted. The third version was proposed in January 2023 and dropped in committee a year later. The sponsor plans to keep reintroducing the bill, which focuses on residents but could reach former residents who have not resided in the state for four years. A nonresident with some history of nexus is distinguished here from a nonresident with no history of nexus, which raises any number of questions. The argument is that former residency is sufficient nexus for the tax collector to potentially reach, for a time, the nonresident’s worldwide assets.111

1. The Los Angeles Stamp Tax on High-Priced Homes

Effective April 1, 2023, Los Angeles began imposing a progressive (two-tier) stamp tax on the sale of residential realty with a beginning threshold of $5 million. The sale of a home in Los Angeles County for $20 million would incur a documentary stamp tax of over $1 million in addition to other real estate transfer taxes and recording fees. The nexus discussion concerning realty is minimal when the focus of the tax is the realty’s physical location, but one could encounter issues regarding the scope of the tax. There is prospect of repeal of this tax in the November election.112

1. Nexus and the Federal Income Tax
2. Nexus and R&D

We previously noted that R&D can be an issue in sales tax discussions. We note below that it comes up as an exception to a proposed space travel tax. In our nexus discussion below, the taxing authority’s incentive is to find a lack of nexus between expenditures and qualifying activities, more often the tax collector is seeking to find nexus that justifies taxation. The IRS audit technique guide on R&D contains a nexus discussion that focuses on the taxpayer establishing the required connection between expenditures related to R&D and qualified research activities. A “business component” is a product, process, computer software, technique, formula, or invention used in a trade or business.113The taxpayer’s struggles with the auditor in these cases often focus on whether there were tests, comparisons of alternatives in a technological, scientific, engineering, or software context. Qualifying expenditures that can increase the R&D credit are largely wages, supplies, and contract costs, and the IRS auditors are increasingly pressing to show a detailed “nexus” between these expenditures and particular tests, even to the point of pressing the taxpayer to show the date an employee worked on a test. There is no requirement that R&D costs be captured under an approach or accounting method; however, qualified research expenses must be identified by business component. There must be established “the required nexus between [qualified research expenses] and qualified research activities” and representations are often

found wanting because they are not “supported by measurable corroborative records.”114 Insufficient nexus has also been found regarding voluntary separation payments and qualified research expenditures under the R&D rules.115

1. Nexus and Tax Administration

The heading for section 7212 is “Attempts to interfere with administration of internal revenue laws.” It deals with topics such as attempts to “intimidate or impede” government workers about their business of collecting taxes. In any event, the concept of “nexus” does come up in the interpretation of this law in the Supreme Court’s discussion in Marinello.116 The Court interpreted section 7212 as requiring nexus between the defendant’s conduct and a particular administrative proceeding. “That nexus requires a relationship in time, causation or logic with the proceeding.”117 In the Eleventh Circuit’s decision in Graham, the court found nexus with a particular administrative proceeding in the context of liens.118 The taxpayer delivered sham financial instruments in the purported payment of his taxes.119

1. Nexus and Section 162

To be deductible under section 162(a), an expense must be directly connected with, or pertain to, the taxpayer’s trade or business.120 The issue is beyond our scope, but there has historically been a required nexus between the taxpayer and home to sustain a travel deduction, given the statutory language of needing to be away from home. It is possible to travel so much that one can’t deduct travel expenses for lack of a home.121 Again, even in section 162, we see an emphasis on connection, which is essentially a search for nexus.

1. Nexus and the Museum Gift Store

Nexus discussions arise in the context of whether an exempt’s activities are tax exempt or unrelated to its exempt purpose. “A nexus between the items sold in a museum gift shop and the accomplishment of the museum’s exempt purposes must be established before sales of items can be considered substantially related within the meaning of section 513(a).” The IRS discusses concepts such as a lack of nexus when a folk-art museum sold scientific books.122 So, while the nexus term is most often associated with state and local tax issues, it arises in many different contexts in which a person is asking about the connection needed to reach a particular tax result. The term is relatively common in tax literature. There are distinctions between the types of connection needed to arrive at a tax conclusion. Whether one can move nexus arguments from one area of the tax law to justify a conclusion in another area of the tax law is obviously an issue for consideration in one’s tax research. We encourage the tax researcher to think broadly and read expansively when the issue is basically one of connection or nexus.

1. Nexus May Show Up Anywhere
2. Nexus and International Tax Issues

The OECD, an international organization headquartered in Paris, whose members include the United States, discusses “nexus” in a manner surprisingly like discussions revolving around Wayfair. The OECD discussions focus more on larger multinationals but also provide blueprints for change that recognize “that in an increasingly digital age, taxing rights can no longer be exclusively determined by reference to physical presence.”123 One reference to nexus as related to the OECD states: Pillar One establishes new nexus and profit allocation rules for large multinational enterprises that meet certain revenue and profitability thresholds. In addition, the Pillar broadens countries’ ability to tax activity occurring within its borders regardless of a company’s physical presence or market jurisdiction.124

1. Nexus and Outer Space

Space travel as a business is growing, and there has been at least one federal proposal to tax space travel.125 This has been described as an excise tax on “space travel,” but it is a tax imposed by a country, so there may need to be some nexus by launching from within the United States. Thinking of nexus from the perspective of Wayfair, the state was at least “there,” that is, it was the shipment destination, making it sufficient to establish nexus. Does one find nexus in outer space? Rep. Earl Blumenauer, D-Ore., proposed taxation in different tiers as a per-passenger tax “like that for commercial aviation.” The two-tier arrangement would impose more tax the higher you go. If nexus focuses on departure from the United States, why does the tax go up with increasing distance from the point of nexus? Will there be nexus in the international taxation section of the library or the treaty section? Will the tax law section of libraries have an “other galaxy” section someday? There are some discussions that contemplate visiting spaceships staying at a locale, which may raise hotel-type tax proposals. There are discussions of mining the moon, but who gets to tax that when (presumably) nobody owns the moon? Nexus for tax purposes is not always easy to find. Blumenauer’s proposal does not appear to include nexus discussions. Justification for the tax includes connection with sundry problems, including “black soot-producing kerosene.”126 The literature, however, does include proposals for “taxing mining in outer space,” whose goals would include reducing the threat of “space colonies and extra-terrestrials claiming asset-based benefits.”127 The number of tax articles focused on outer space is surprising, although perhaps less so as one studies the seemingly endless pursuit by tax law writers and tax collectors to find nexus and some reason to tax an activity or income.

VII. Conclusion

Any study of nexus shows the proliferation of taxes generally. The practicalities of nexus have become so complex and multifaceted that the issues require more research by issue, tax, and jurisdiction, as taxes proliferate in the post-Wayfair environment. If you are a tax protester, you’ve got your work cut out for you. In the past, tax protestors had fewer taxes to protest. But for modern-day tax protestors, the most difficult question is, “Where do I start?” Yet our point is not protests but rather the more mundane issues of scope and relationships to consider in one’s research. The study of nexus can help the tax planner or business owner better organize planning because of the multitude of taxes and jurisdictions to consider. The type of connection or nexus one finds can create tax contingencies, tax administration efforts, and more research for the tax professional focused on planning or compliance.

1. But Not Everything Is Taxable —

Not Yet Anyway

We’d like to close with these thoughts about the limitations of nexus, the connection that ties us and our clients to the tax collector. All young kids are cute; this stands confirmed, no exceptions, per a recent mall-walk point of study. This is also true of most of our pets. Yet being around young kids and pets is still tax free, so far as the authors have been able to determine. In recent research of multistate sales, use, income, and other taxes, whether direct or indirect, about all we didn’t see was a tax on being around young kids and pets and being at home with your feet up. Did it ever occur to the reader that the biggest tax shelters of this world might be elementary school teaching, being a dog groomer, or just being at home with your feet up? If your evening with your feet up includes a bit of tea, try not to think of Boston harbor . . . and taxes. Enjoy your tea and petting your new puppy, even if that part of your evening is, well, taxable. Take some pleasure in the thought that putting your feet up is still tax free. And if your thoughts turn heavenly, surely heaven is tax free. We hope our closing thoughts don’t give any new ideas to the taxwriters of the world.128

1 “Nexus,” Oxford English Dictionary (2004).

2 Arizona Department of Revenue, “Nexus Program for Corporate Income Tax” (undated). See also Arizona DOR, “Nexus Program for Individual Income Tax” (undated).

3 KPMG Survey, “‘Nexus’ Definition Critical for Corporations, Says Peat Marwick,” Tax Notes Today, Apr. 3, 1996.

4 See the dated but useful discussion in Diana Dibello and Sylvia Dion, “Navigating Nexus,” Journal of Accountancy, Nov. 1, 2010.

5 South Dakota v. Wayfair, 585 U.S. 162 (2018).

6 One of the authors had an ancestor in colonial days who made wooden molds for cobblers, but their family got out of the trade. Hence, the example.

7 Robert L. Rojas and J. Michael Pusey, “Incorporating Your Business — A Planning Opportunity and a Puzzle,” Rojas & Associates (Jan. 18, 2020).

8 The Supreme Court annually grants certiorari in fewer than 150 of perhaps 7,500 petitions. It granted certiorari in Wayfair on January 12, 2018, heard the case on April 17, then issued its decision on June 21, a pattern of dates that suggests the Court’s perceived importance of the decision. The close vote suggests the difficulties and complexities involved.

9 American Institute of CPAs, “South Dakota v. Wayfair” (undated).

10 AICPA, Written Statement of the American Institute of CPAs Submitted to the U.S. Senate Committee on Finance Hearing, “Examining the Impact of South Dakota v. Wayfair on Small Businesses and Remote Sales” (July 14, 2022).

11 Although the Supreme Court said that Congress has authority to legislate in the SALT arena, six years after Wayfair, we’ve seen no significant federal legislation in response.

12 AICPA, supra note 10.

13 Quinn v. Washington Department of Revenue, 526 P.3d 1 (Wash. 2023), cert. denied, No. 23-171 (Jan. 16, 2024).

14 Wash. Rev. Code section 82.87.010, Findings of Intent.

15 Quinn, 526 P.3d 1, 32 (McCloud, J., dissenting).

16 Kalvis Golde, “Washington Residents Challenge State’s Effort to Tax Long-Term Capital Gains,” SCOTUSblog, Oct. 7, 2023.

17 Petition for Writ of Certiorari, Quinn v. Washington, No. 23-171 (U.S. Aug. 21, 2023).

18 Karl A. Frieden and Douglas L. Lindholm, “A Global Perspective on U.S. State Sales Tax Systems as a Revenue Source: Inefficient, Ineffective, and Obsolete,” State Tax Research Institute, at 34 (Nov. 2021).

19 AICPA, supra note 10.

20 Government Accountability Office, “Remote Sales Tax: Federal Legislation Could Resolve Some Uncertainties and Improve Overall System,” GAO 23-105359, at 19 (Nov. 14, 2022).

21 AICPA, supra note 10.

22 GAO, supra note 20.

23 Id. at 27.

24 Id. at 28.

25 Id. at 29.

26 Id. at 31.

27 “What Is Nexus? [Definition + Examples],” Brotman Law (undated).

28 Id.

29 Texas Comptroller of Public Accounts, “Garage Sales and Occasional Sales” (Sept. 2020). See also California’s discussion of garage sales, which includes such statements as “if you have more than two garage sales within a 12-month period, you are required to hold a seller’s permit.” California Department of Tax and Fee Administration, “Temporary Sellers” (undated).

30 GAO, supra note 20.

31 Id. at 26.

32 Id. at 27.

33 Cal. Rev. & Tax. Code section 6106.

34 Id. See also Searles Valley Minerals Operations Inc. v. State Board of Equalization, 160 Cal. App. 4th 514 (Cal. Ct. App. 2008.)

35 Santa Clara Sand and Gravel Co. v. State Board of Equalization, 225 Cal. App. 2d. 676 (Cal. Ct. App. 1964).

36 Standard Oil Co. of California v. State Board of Equalization, 232 Cal. App. 2d 91 (Cal. Ct. App. 1965).

37 Simplicity Pattern Co. v. State Board of Equalization, 615 P.2d 555 (Cal. 1980).

38 City of Gilroy v. State Board of Equalization, 212 Cal. App. 3d, 589 (Cal. Ct. App. 1989).

39 Searles Valley Minerals Operations Inc. v. State Board of Equalization, 160 Cal. App. 4th 514 (Cal. Ct. App. 2008.)

40 Cal. Rev. & Tax. Code section 7512.1.

41 See Franchise Tax Board, “Multistate Audit Technique Manual” section 7152 for a discussion of this issue.

42 78-SBE-001 (Jan. 11, 1978).

43 See FTB, supra note 41, section 7512.1.

44 Appeal of Mark IV Metal Products Inc., 82-SBE-181 (Aug. 17, 1982). See also FTB, supra note 41, section 7512.1.

45 Appeal of Dart Container Co. of California, 92-SBE-021 (July 30, 1992). See also FTB, supra note 41, section 7512.1.

46 Cal. Code Regs. tit. 18, section 1502(c)(8).

47 Cal. Code Regs. tit. 18, section 1502(c)(3).

48 Cal. Code Regs. tit. 18, section 1502(h).

49 Jared Walczak, “State Sales Tax Breadth and Reliance, Fiscal Year 2021,” Tax Foundation, May 5, 2022.

50 See California DTFA, All Publications (undated).

51 For research generally, see California DTFA, Forms and Publications (undated). See generally the rates by geographic location. California DTFA, California City & County Sales & Use Tax Rates (eff. Jan. 1, 2024). See also California DTFA, Detailed Description of the Sales & Use Tax Rate (undated).

52 See generally California DTFA, Laws, Regulations and Annotations.

53 California DTFA, Office Locations & Addresses.

54 See California DTFA, “Appeals Procedures, Sales and Use Taxes and Special Taxes and Fees” (Mar. 2020); see also California FTB, Appeal a Decision (updated Jan. 3, 2024).

55 Cal. Rev. & Tax. Code section 6380. See also the discussion Nexus and Outer Space, infra.

56 See Nebraska DOR, “Construction Contractor Fact Sheet,” and “Information Guide: Nebraska Sales and Use Tax Guide on Installation Labor” (Feb. 2024); and Nebraska Department of Labor, “Important Information for Contractors Performing Construction Services in Nebraska.”

57 California DTFA, Industry Topics for Construction Contractors (undated).

58 Id.

59 California DTFA, Specific Jobs and Construction Contractors (undated). See also California DTFA “Construction and Building Contractors” (Apr. 2022); Cal. Code Regs. tit. 18, section 1521; and California DTA, “Audit Manual, Chapter 12, Construction Contractors” (May 2017). See generally Tax Lawyers Group, “CDTFA-California Department of Fee and Tax Administration Sales Tax Issues for Contractors.”

60 Texas comptroller, Real Property Repair and Remodeling (Mar. 2007).

61California DTFA, Sales and Use Tax Annotations section 150.0260.

62 Cal. Rev. & Tax. Code sections 1660.1661; see California DTFA, “Leasing Tangible Personal Property” (Apr. 2022).

63 “Some labor services and associated costs are subject to sales tax if they are involved in the creation and manufacturing of new tangible personal property.” California Tax Service Center, What Is Taxable?

64 Cory Halliburton, “Texas Nonprofits and Sales Tax on Admissions,” Freeman Law.

65 Texas comptroller, Taxes, Homebuilders and Real Property Services (Mar. 2001).

66 Texas comptroller, Taxes, Manufacturing Exemptions (Mar. 2021). The discussion includes such details as specifying that the Texas hammer used in fabricating a product for sale is taxable.

67 IRC section 267.

68 California DTFA, Use Tax Collection Requirements Based on Sales into California Due to the Wayfair Decision (undated).

69 California DTFA, Sales and Use Tax Annotations 220.0125, “Engaged in Business.”

70 California DTFA, Sales and Use Tax Annotations, 100.0016, “Advertising Agency Acting as Agent” (Apr. 22, 2003).

71 California DTFA, Industry Topics for Agricultural Industry (undated).

72 Id.

73 California DTFA, Sales and Use Tax Annotations, Annotation 110.0000, “Animal Life and Feed” (Nov. 13, 1995).

74 California DTFA, Sales and Use Tax Annotations, Annotation 495.0051, “Blood and Tissue Banks” (June 18, 2010).

75 Tex. Tax Code section 151.313.

76 See California DTFA, “Agricultural Industry” (Oct. 2022).

77 Id.

78 See California DTFA, “Manufacturing and Research & Development Exemption Tax Guide” (undated).

79 GAO, supra note 20 (citing Cal. Rev. & Tax. Code section 6203(c)(4)(A)).

80 See Kent DeBruin and Scott D. Smith, “Consequences of the MTC’s Revised Interpretation of P.L. 86-272,” The Tax Adviser, AICPA (May 2023); Chuck Jones, “States’ Reactions to MTC’s Application of P.L. 86-272 to Internet Sales,” The Tax Adviser, AICPA (Dec. 2022).

81 See FTB, Part-Year Resident and Nonresident (updated Jan. 4, 2024).

82 See FTB, Pub. 1100 (Rev. 05/2020), “Taxation of Nonresidents and Individuals Who Change Residency.”

83 IRS, Residency Starting and Ending Dates (updated June 28, 2023).

84 Kraske v. Commissioner, 161 T.C. No. 7 (2023).

85 Stephen Olsen, “Tax Court Follows Ninth Circuit Despite Golsen Rule Nuance,” Tax Notes Federal, Jan. 22, 2024, p. 687.

86 IRS Pub. 519 (2022), “U.S. Tax Guides for Aliens,” at 3.

87 Janelle Fritts, “State Corporate Income Tax Rates and Brackets for 2023,” Tax Foundation, Jan. 24, 2023; Katherine Loughead, “State Corporate Income Tax Rates and Brackets for 2024,” Tax Foundation, Jan. 23, 2024.

88 Cal. Rev. & Tax. Code section 23101.

89 See Stephen Fishman, S Corp Tax Treatment in California — Guide for Freelancers, collective.com; FTB, S Corporations — Business Type (updated Jan. 29, 2024).

90 FTB, Pub. 1031, “2023 Guidelines for Determining Resident Status,” at 5.

91 Brotman, supra note 27. Brotman discusses sales tax in terms of “physical nexus,” “economic nexus,” and “affiliate nexus.”

92 Nellie Akalp, “When Do You Have Nexus in a State?” Corpnet.com (updated Jan. 12, 2024).

93 FTB, Pub. 1031, “2023 Guidelines for Determining Resident Status,” at 5.

94 Jeremy M. Norman, “Gilbert Hyatt Files the First General Patent on the Microprocessor; It Is Later Invalidated,” Historyofinformation.com (Dec. 1970); Rani Mehta, “Meet Gil Hyatt, the Inventor Who’s Spent $7m Fighting the USPTO,” managingip.com (Nov. 1, 2021).

95 Franchise Tax Board of California v. Hyatt, 587 U.S___ (2019).

96 Gilbert P. Hyatt v. Franchise Tax Board of California, No. 84707 (Nev. July 5, 2023).

97 Bradley R. Marsh et al., California Lawyers Association 2023 State and Local Tax Annual Meeting Roundup, Greenberg Traurig (Aug. 8, 2023).

98 Hyatt v. Franchise Tax Board of the State of California, No. 84707 (Nev. July 5, 2023).

99 See also IRC section 430; IRM Part 35, ch. 10, section 1; Cal. Rev. & Tax. Code section 19717; FTB, “California Taxpayers’ Bill of Rights,” FTB 4058CEN (rev. Dec. 2017).

100 Regarding the matter of paying for the auditor’s gas, which was presumably among the travel expenses in 2022, California gas prices included a federal and state excise tax, a tax aimed at lowering greenhouse gas emissions, a tax for the state’s low-carbon fuels program, a fee for underground gas storage, and state and local sales taxes. “The sales tax rate is applied to the price of gasoline after the federal and state excise taxes have been added.” California DTFA, Tax Guide for Gas Station Operators (undated).

101 FTB, Pub. 1024, Penalty Reference Chart (rev. Oct. 2012).

102 See Rojas and Pusey, supra note 7. This article appeared in the May 2020 issue of Practical Tax Strategies.

103 IRC section 1374.

104 See also the definition of pro rata share in Treas. reg. section 1.1377-1.

105 See California FTB, Passthrough Entity (PTE) Elective Tax (rev. Mar. 18, 2024). The $10,000 limit is scheduled to expire after 2025.

106 Malathi Nayak, “GM Slams San Francisco in Lawsuit over $108 Million Tax Bill,” Transport Topics, Jan. 2024.

107 “United States: 2023 Year-End Estate Planning Advisory,” katten.com (Nov. 20, 2023).

108 IRS Pub. 519, “U.S. Tax Guide for Aliens,” at 15 (2023).

109 See also Ajit Kuman Singh, Exploring the Nexus Doctrine in International Tax Law (2021); Nathalie Nguyen, “Foreign Tax Credit Proposed Jurisdictional Nexus Requirement,” Bloomberg Tax, Sept. 2, 2021; Huaning Li, “The Nexus Standard and its Implications for International Tax Competition and Soft Law,” Osgoode Hall Law School, York University, Aug. 11, 2020 (PhD dissertation); and Stjepan Gadzo, Nexus Requirements for Taxation of Non-Residents’ Business Income (2018).

110 Presuming the reader believes in heaven and that the taxpayer is in heaven, it does seem clear that the tax collector — in so far as representing the state’s interest — is not getting to heaven to conduct an audit. And the individual in heaven is for sure not coming back to the tax collector’s office to pay taxes. We do not suggest that tax collectors can’t get to heaven (Luke 19). There are scriptural suggestions of “heavenly transport” but no suggestion of their being used to come to Earth to pay taxes (Ezekiel 1). We’ll not discuss — the issue is well beyond our scope — whether there is a tax collector’s office in the other place.

111 See BNY Wealth Management, “New State Wealth Taxes in the Cards for 2023? Key 2023 Proposals by State” (undated).

112 See Alexander G. Davis and Roger Bond Choquette, “Los Angeles Faces Potential Repeal of ‘Mansion Tax,’” Mayer Brown, Feb. 22, 2024.

113 IRC section 41(d)(2)(B).

114 IRS, Research Credit Claims Audit Techniques Guide (RCCATGG): Credit for Increasing Research Activities Section 41.

115 See Office of the Chief Counsel, Release 20131102F (Mar. 15, 2013).

116 Marinello v. United States, 584 U.S.___ (2018).

117 U.S. Department of Justice Criminal Tax Manual, “26 U.S.C. section 7212(a) ‘Omnibus Clause.’”

118 United States v. Graham, 981 F.3d 1254 (11th Cir. 2020). Note that the provision at issue in this case appears to show no amendments or other changes in the statutory language since its enactment in 1954, which is unusual.

119 “Eleventh Circuit Finds Nexus, Affirms Tax Obstruction Conviction,” Tax Notes Today Federal, Dec. 4, 2020.

120 Regs. section 1.162-1(a); Kornhauser v. United States, 276 U.S. 145, 153 (1928) (characterizing the required nexus as a “direct” or “proximate” connection); and ILM 202053010 (Sept. 16, 2020).

121IRC section 162(a)(2); and IRS Pub. 463, “Travel, Gift, and Car Expenses,” at 4.

122 LTR 201429029 (Apr. 24, 2014).

123 OECD, “Tax Challenges Arising from Digitalisation — Report on Pillar One Blueprint” (Oct. 14, 2020).

124 See “Understanding Digital Services Taxes & the OECD (Organisation for Economic Co-operation and Development),” Bloomberg Tax, Jan. 4, 2023. See also Samuel Pollock, “International: Setting Aside International Nexus,” Baker McKenzie (Feb. 15, 2024).

125 U.S. Rep. Earl Blumenauer, “Blumenauer Announces New Space Tax Proposal” (July 20, 2021).

126 For a discussion of Blumenauer’s proposal and a distinct orbital tax, see “Space Law: Taxation,” Slaughter and May (Dec. 22, 2023); see also Timothy G. Nelson and James Anderson, “Can Space Activities Be Taxed?” Financier Worldwide Magazine, Nov. 2019.

127 Pavel Semerad, “Asteroid Mining Tax as a Tool to Keep Peace in Outer Space, Space Policy,” sciencedirect.com (Aug. 2023).

128 The information contained in this article is general in nature and is not legal, tax, or financial advice. For information regarding your particular situation, contact an attorney or a tax or financial adviser. The information in this newsletter is provided with the understanding that it does not render legal, accounting, tax, or financial advice. In specific cases, clients should consult their legal, accounting, tax, or financial adviser. This article is not intended to give advice or to represent our firm as being qualified to give advice in all areas of professional services. Exit Planning is a discipline that typically requires the collaboration of multiple professional advisers. To the extent that our firm does not have the expertise required on a particular matter, we will always work closely with you to help you gain access to the resources and professional advice that you need.

Robert L. Rojas and J. Michael Pusey are with Rojas & Associates CPAs in California. In this report, Rojas and Pusey offer a comprehensive examination of nexus, its consequences, and the future of nexus disputes. Copyright 2024 Robert L. Rojas and J. Michael Pusey. All rights reserved.