Economic nexus

What Is Economic Nexus?

Economic nexus defines the connection between a business and a state that is sufficient to require the business to collect and remit sales tax, despite not having a physical presence within that state. This concept falls under the broader category of Taxation, specifically concerning sales and use tax obligations for remote sellers. It expands the traditional understanding of nexus beyond a physical footprint, acknowledging the significant economic activity that can occur through e-commerce and other digital sales channels. For a business to establish economic nexus in a state, it generally must meet certain thresholds, typically based on the volume of sales or the number of transactions into that state within a specified period. Once economic nexus is established, the business becomes legally obligated to collect sales tax from customers in that jurisdiction and remit it to the state's tax authority.

History and Origin

The concept of economic nexus significantly altered the landscape of state sales tax collection. Prior to 2018, the prevailing legal standard for sales tax nexus was the "physical presence" rule, established by the U.S. Supreme Court cases National Bellas Hess v. Department of Revenue of Illinois (1967) and Quill Corp. v. North Dakota (1992). These rulings dictated that a state could only compel a business to collect its sales tax if the business had a tangible physical presence in that state, such as an office, warehouse, or employees. However, with the rapid growth of e-commerce, many states argued that this rule prevented them from collecting substantial revenue from online sales, creating an unfair advantage for out-of-state sellers and a disadvantage for in-state brick-and-mortar businesses.²⁶

This changed dramatically with the landmark U.S. Supreme Court decision in South Dakota v. Wayfair, Inc. on June 21, 2018. The Court, in a 5-4 ruling, overturned the physical presence rule, recognizing that "the Internet's prevalence and power have changed the dynamics of the national economy."²⁵ This decision effectively allowed states to require businesses with no physical presence to collect and remit sales tax if they meet certain economic activity thresholds within the state. South Dakota's law, which served as the test case, required remote sellers to collect sales tax if they had over $100,000 in gross revenue or 200 or more separate transactions in the state annually.²⁴ Following the Wayfair decision, nearly all states that impose a sales tax quickly enacted their own economic nexus laws, leading to a complex patchwork of varying thresholds and rules across the country.²³ The Tax Foundation provides a detailed overview of how states have adopted economic nexus.²²

Key Takeaways

• Economic nexus is a legal standard requiring businesses to collect sales tax based on their economic activity in a state, rather than solely on their physical presence.
• The U.S. Supreme Court's 2018 decision in South Dakota v. Wayfair, Inc. overturned the long-standing physical presence rule, paving the way for states to enact economic nexus laws.
• Most states that levy sales tax have adopted economic nexus thresholds, typically based on sales gross receipts (e.g., $100,000 or $500,000) or transaction volume (e.g., 200 transactions) within a given period.
• Compliance with economic nexus laws can be complex due to the varying thresholds and rules across different state tax jurisdictions.
• Failing to comply with economic nexus requirements can result in significant penalties, including uncollected taxes, interest, and fines.

Interpreting the Economic Nexus

Interpreting economic nexus primarily involves understanding the specific thresholds and rules set by each state. There is no universal federal standard; rather, each state with a sales tax has established its own criteria for what constitutes sufficient economic activity to create nexus. Businesses must monitor their sales volume and transaction count in every state where they sell goods or services.

The key aspects to interpret include:

• Dollar Threshold: Most states set a minimum dollar amount of sales into the state, such as $100,000 or $500,000. For instance, California's economic nexus threshold is $500,000 in sales of tangible personal property in the current or prior calendar year.²¹
• Transaction Threshold: Some states also include a minimum number of transactions (e.g., 200 sales) as an alternative or additional trigger for economic nexus. However, many states, including South Dakota, have begun removing their transaction thresholds due to the disproportionate burden they can place on businesses with many small sales.²⁰,¹⁹
• Counting Sales: Businesses need to clarify which types of sales count towards the threshold. This can include all sales, only taxable sales, or exclude sales made through a marketplace facilitator if the facilitator is responsible for collecting the tax.¹⁸,¹⁷
• Lookback Period: States specify the period for which sales activity is measured, often the current calendar year or the preceding 12 months.

Businesses are expected to continuously track their sales activity. Once the economic nexus threshold is met, the obligation to register and begin collecting sales tax typically commences immediately or after a short grace period.¹⁶ This requires robust tax compliance systems and careful attention to evolving state regulations.

Hypothetical Example

Consider "GadgetHub," an online retailer based in Oregon (a state with no sales tax) that sells consumer electronics nationwide. Prior to the Wayfair decision, GadgetHub would only collect sales tax if it had a physical presence in a customer's state, such as a warehouse or employee.

After the Wayfair ruling, let's say California implemented an economic nexus law with a threshold of $500,000 in sales into the state in the current or prior calendar year.¹⁵

Here's how economic nexus would apply to GadgetHub:

1. Year 1: GadgetHub sells $300,000 worth of electronics to customers in California. Since this is below the $500,000 threshold, GadgetHub does not establish economic nexus in California and is not required to collect California sales tax.
2. Year 2: GadgetHub experiences significant growth in California. By August of Year 2, its sales to California customers reach $600,000. At this point, GadgetHub has crossed California's economic nexus threshold.
3. Action Required: Upon crossing the threshold, GadgetHub immediately establishes economic nexus. It must then register with the California Department of Tax and Fee Administration (CDTFA) for a California seller's permit.¹⁴ Once registered, GadgetHub is legally obligated to begin collecting California sales tax on all taxable sales shipped to customers in California.

This example illustrates how a business with no physical presence can still incur significant tax liability based purely on its economic activity within a state.

Practical Applications

Economic nexus has profound practical applications, particularly for businesses engaged in interstate commerce and the digital economy. Its primary impact is on sales and use tax obligations. Remote sellers, including online retailers, software-as-a-service (SaaS) providers, and other businesses that sell across state lines, must now actively monitor their sales volume and transaction count in every state where they have customers.¹³

Key practical applications include:

• Sales Tax Collection: Businesses are required to register for sales tax permits in states where they meet economic nexus thresholds and collect sales tax from customers in those states. This is a significant shift from the pre-Wayfair era, where many online sales were untaxed by the destination state.
• Software and Automation: Due to the complexity of varying state thresholds, tax rates, and rules regarding exemptions, many businesses utilize automated sales tax software to track nexus, calculate taxes, and manage remittances.¹²
• Marketplace Facilitator Laws: In conjunction with economic nexus, many states have also enacted marketplace facilitator laws. These laws shift the sales tax collection responsibility from individual sellers to the marketplace (e.g., Amazon, Etsy) if the sale occurs through their platform.¹¹
• Business Planning and Expansion: Companies must now factor economic nexus into their business planning, especially when expanding into new markets. Understanding potential tax obligations influences pricing strategies, logistical decisions, and overall financial projections. The California Department of Tax and Fee Administration (CDTFA) provides specific guidance for businesses regarding the Wayfair decision.¹⁰

Limitations and Criticisms

While economic nexus aims to level the playing field between online and brick-and-mortar retailers and recover lost state tax revenue, it presents several limitations and has faced criticism, particularly from small and medium-sized businesses.

Major limitations and criticisms include:

• Compliance Burden: The primary critique is the significant tax compliance burden placed on businesses, especially smaller ones. Each state has unique thresholds and rules, creating a complex patchwork of requirements. Businesses must track sales into potentially dozens of different states, register in each, and then correctly calculate, collect, and remit taxes based on varying product taxability and local rates.⁹ The compliance costs can sometimes outweigh the actual tax collected, disproportionately affecting small businesses.⁸
• Varying Thresholds: The lack of uniformity in economic nexus thresholds across states adds to the complexity. While many states use a $100,000 sales threshold, others set it higher (e.g., $500,000 in California and Texas), and some still include transaction count thresholds, which can be triggered by a high volume of small-dollar sales.⁷
• Remote Workforces: The expansion of nexus to economic activity also extends to remote workforces. A single remote employee can inadvertently create nexus for a business in a new state, triggering additional income, payroll, and sales tax obligations, further complicating tax liability for businesses with distributed teams.⁶
• "Use Tax" Burden: While sales tax is collected by the seller, use tax is owed by the buyer on purchases where sales tax was not collected. Before Wayfair, buyers were technically responsible for remitting use tax on out-of-state purchases, though compliance was low. Economic nexus shifts this burden to sellers, but the complexities of multistate taxation can still lead to situations where neither sales nor use tax is correctly collected and remitted.

The Journal of Accountancy highlights these challenges, noting that new sales tax nexus standards are creating a larger compliance footprint for U.S. companies.⁵

Economic Nexus vs. Physical Nexus

The distinction between economic nexus and physical presence (often referred to as "physical nexus") is fundamental in understanding sales tax obligations.

The confusion between the two often arises because, historically, physical presence was the sole determinant for sales tax obligations. The Wayfair decision expanded the definition of nexus to include economic activity, meaning a business can now have sales tax nexus in a state due to either a physical presence or by meeting economic thresholds. Importantly, if a business has a physical presence, it generally has sales tax obligations from day one, without needing to meet any economic threshold.⁴

FAQs

What is the primary purpose of economic nexus laws?

The primary purpose of economic nexus laws is to allow states to collect sales tax from out-of-state businesses that have a significant volume of sales within their borders, even if those businesses lack a traditional physical presence in the state. This aims to ensure fair competition between local businesses and remote sellers and to generate revenue for state services.

How do I know if my business has economic nexus in a particular state?

To determine if your business has economic nexus in a state, you must monitor your sales activity—both total sales value and, in some states, the number of transactions—into that state. Each state sets its own specific thresholds. You should consult each state's department of revenue or a tax compliance professional to understand the exact requirements.

Do all sales, including tax-exempt sales, count towards the economic nexus threshold?

This depends on the state. Some states count all sales, including those that are ultimately tax-exempt (like certain wholesale sales or sales to tax-exempt organizations), towards the economic nexus threshold. Other states may only count taxable sales of tangible personal property. It's crucial to check each state's specific guidelines regarding what counts toward their threshold.

##³# What happens if my business meets the economic nexus threshold but doesn't collect sales tax?

If your business meets an economic nexus threshold and fails to register and collect sales tax, it could face significant consequences. These typically include being liable for the uncollected sales tax, along with penalties and interest. This can result in a substantial tax liability for the business, as it will likely have to pay these amounts out of its own funds.

##²# Does economic nexus affect other types of taxes besides sales tax?

While economic nexus most famously applies to sales tax due to the Wayfair decision, the concept of a sufficient connection to a state for tax purposes can extend to other taxes, such as income tax or gross receipts tax. Some states had economic nexus provisions for certain other taxes even before Wayfair. The legal landscape for nexus, in general, continues to evolve beyond just sales tax.¹