Web-based service businesses should watch out and get ready. State taxing authorities are coming after you. Recent state court opinions and changes in state tax policies have now placed web-based service providers squarely in the target sights of state taxing agencies for state gross receipts and income/franchise taxes. These states are looking to force these service businesses to allocate income or gross revenues to these states and pay state taxes simply based on their customers' location. While not yet wide-spread, imposing gross revenue or franchise/income taxes merely based upon the economic presence of the service provider in the state is gaining popularity among the states. This could subject an unsuspecting web-based service provider to a substantial state tax liability.

Here's What's Happening

A growing number of states have decided to tax sellers of services based on the benefit or receipt location (e.g. residence or address) of their customers, rather than where the service is being performed. These states then look at whether the service provider solicits such sales, as well as the dollar amount or volume of sales to determine if sufficient economic contacts with the state exist to impose its tax laws on the seller. Take for example a web-based advertising service that performs all of its services and has all of its employees, offices, and servers in the State of Florida, but who has online customers in a number of states including Minnesota. These Minnesota customers electronically purchase the advertising services via the Internet. The seller has no physical contact with Minnesota nor any agents or representatives who regularly travel to Minnesota. It performs its services by placing advertising for a customer on various websites. It actively advertises for customers over the Internet, as well as regularly sends e-mails to its customers in Minnesota. The company has over 100 customers in Minnesota.

Under Minnesota law, this advertising business is subject to Minnesota franchise/income tax. By regularly dealing with customers in Minnesota and having over 100 customers, Minnesota will take the position that this advertising service has sufficient presence, i.e., "economic nexus," with Minnesota and must apportion some of its income and pay franchise/income tax on such income to Minnesota.

Disturbingly, this concept of "economic nexus" creating tax liability is becoming more widespread. In addition to Minnesota, other states such as West Virginia, Ohio, New Jersey, Massachusetts, Iowa, Maine, Michigan, North Carolina, and South Carolina have adopted one form or another of this economic nexus theory to expand their tax reach. But what exactly is "economic nexus?" And can states legally do this?

Defining Economic Nexus

"Economic nexus" does not really have a specific widespread definition or uniform understanding. A recent Tax Alert from the Maine Revenue Service says, "Economic nexus is a short-hand term for the principle that a taxpayer's purposefully directed business activity in a State (other than solicitation of sales activity protected by P.L. 86-272) may be sufficient to subject the taxpayer to income tax in that State regardless of the level-or absence-of physical presence in that State." [Maine Tax Alert, Vol. 18, No.2 (February 2008).] An example of how this works is Michigan's Department of Treasury's declaration that simply maintaining an Internet site outside of Michigan from which a Michigan ' customer can make a purchase will be deemed active solicitation in Michigan, and if sales exceed $350,000 a year, the seller will have nexus with Michigan and be subject to Michigan Business Tax [RAB 2007-6]. However, even though this expansive view of economic presence is becoming more common, other views of "economic nexus" required a bit more meat. In New Jersey and South Carolina for instance, economic nexus hinged more on whether some intangible rights of the seller were being used in the state by an affiliate to generate income, rather than focusing on the interstate solicitation or contacts of a business with state residents. [Lanco v. Director, Division of Taxation, 879 A 2d 1234 (N.]. Super. Ct. App. Div. 2005); Geoffrey, Inc. v. S.C. Tax Commission, 437 S.E. 2d 13 (S.c. 1993)].

Nevertheless, a recent decision of the West Virginia Supreme Court in MBNA America Bank supports the broader view of economic nexus, stating that a service provider only needs significant economic presence in the state to have income tax nexus. [Tax Comm'r of the State of West Virginia v. MBNA America Bank, NA., 640 S.E. 2d 226 (W Va. 2006); See also MBNAAmerica Bank NA. v. Indiana Department of Revenue, Indiana Tax Court (Oct. 20, 2008) (Court followed wv. decision)]. Under this far reaching "economic nexus" concept, the active interstate solicitation of customers in West Virginia, solely through the mail and by telephone, along with the large amount of gross receipts attributable to such customers, was sufficient to make MBNA subject to tax. Obviously, this more expanded concept of economic nexus is what should be of great concern to web-based service providers. As noted earlier, by latching onto this decision, and others like it, state taxing authorities in a number of states are now looking at such service providers for potential tax revenues.

Whether economic nexus exists either as applied in its more substantive form of requiring some intangible property/affiliate presence or its expanded exploitation of the market concept, it should be noted that the United States Supreme Court has yet to decide its constitutionality. But so far, most state courts are generally siding against businesses and in favor of increased tax revenues.

Not All Is Lost

All the news is not bad, however, since a majority of states still apportion their income or gross revenue taxes based on where the service is performed. Thus, even if economic nexus actually exists to subject the service provider to one of these state's tax jurisdiction, there may be nothing to apportion to that state if all of the provider's services were performed outside the state. Yet, as the economic nexus bandwagon continues, more and more states will likely change their laws (like Maine in 2007 and Michigan in 2008) so as to tax out-of-state service providers when their customers receive the benefit of their services in such states.

As state taxing authorities now flex their muscles and push the concept of economic nexus to the extremes, web-based service providers should start worrying about how to reduce their tax exposure through proper planning and action, before it's too late.

Stanley R. Kaminski, JD., CPA concentrates his practice in the areas of state and local taxation, including sales/use tax, franchise tax and multistate corporate and individual income tax issues. Mr. Kaminski's practice also encompasses abandoned property/escheat issues. Mr. Kaminski has also written numerous articles and chapters on state and local taxation for the Research Institute of America, Council on State Taxation, the Illinois Institute for Continuing Legal Education, State Tax Notes, Tax Management, Inc., and Matthew Bendel: He was the author of the Research Institute of America's Illinois Tax Handbook. Mr. Kaminski is also a frequent lecturer and guest speaker for organizations such as the Chicago Tax Club, the National Business Institute, and the Council on State Taxation. Moreovel; he is a regular lecturer at the Council on State Taxation's "Advanced Sales Tax" School.

Reprinted with permission of the National Association of Tax Professionals