Where you have to file once the work crosses a state line

Nexus is not one question

The single most common error in this area, in articles and in practice, is treating nexus as one thing. It is not. A state can have the right to tax your income, to require you to collect its sales tax, and to require payroll registration and withholding, and those three tests are different. You can easily have one without the others.

South Dakota v. Wayfair is the case everyone cites. It was a sales tax case. It settled that a state may require sales tax collection without physical presence, and it is routinely quoted as though it decided income tax nexus, which it did not. Reasoning from Wayfair to an income tax filing obligation is the standard mistake in this genre, and it produces confident answers that are wrong in both directions: filing where you need not, and not filing where you must.

What creates an obligation

Rather than a threshold table that is out of date the moment a legislature moves, the durable version is the list of facts that get tested, state by state, against that state’s own rules:

• People. Where employees and contractors physically work, including from home, and for how long.
• Property. Where equipment, inventory, and leased space sit. Inventory held in someone else’s warehouse still sits somewhere.
• Payroll. Wages paid for work performed in the state, which drives registration and withholding independently of income tax.
• Receipts. Sales into the state, which for many states is now an economic test rather than a physical one.
• Registrations. Qualifying to do business, holding a professional license in the state, or registering for one tax, each of which a state may read as presence for another.

Public Law 86-272, and where it stops

There is a federal protection, and it is narrower than its reputation. Public Law 86-272 bars a state from imposing a net income tax where the only in-state activity is soliciting orders for tangible personal property, with the orders approved and shipped from outside the state.

Read that qualifier carefully, because it is the whole of it. The protection covers tangible goods. It does not cover services, and it does not cover intangibles. A professional practice selling services across state lines is outside this protection entirely, which surprises people who have heard the statute cited as a general shield.

Whether ordinary internet activity costs a business that protection is genuinely unsettled, and unsettled in the least convenient way. A multistate body issued a revised interpretation taking an expansive view of what defeats the protection, a number of states adopted that reading, and taxpayers challenged it. Those challenges have not produced one answer: courts have landed differently in different states, and some of what has been decided turns on a particular taxpayer’s facts rather than on whether the rule itself is good.

So this is not a question waiting on one decision to settle it. The same conduct can be protected in one state and not in the next. That is an argument for taking a position deliberately and writing down the reasoning at the time, rather than assuming an answer travels across state lines.

Sourcing: whose income is it

Establishing that a state may tax you is only the first half. The second is how much, which is a sourcing question, and states do not answer it the same way.

For services the two broad approaches are cost of performance, which looks to where the work was done, and market-based sourcing, which looks to where the customer received the benefit. The same engagement, billed identically, can be sourced to different states depending on which rule applies. When two states apply different rules to the same dollar, the same income can be claimed by both, and the mechanism that is supposed to relieve that does not always relieve it completely.

The owner’s return follows the entity’s

For an S corporation or a partnership the exposure does not stop at the entity. Income sourced to a state generally flows to the owners as income of that state, which can create nonresident filing obligations for people who have never set foot in it.

Several mechanisms exist to manage that, and which one is right is a real decision rather than a default: composite or group returns filed by the entity, nonresident withholding remitted on an owner’s behalf, and entity-level elections that shift the tax to the business.

Those elections are worth being precise about, because the risk is not where it is usually assumed to be. Whether the federal deduction survives an entity-level election was fought over for years and is no longer the live question. What does keep moving is each state’s own version: whether it offers an election at all, who actually benefits from one, and the deadlines and prepayment rules attached to it, which are unforgiving and have been rewritten more than once. An election that was right last year can be wrong this year because a legislature moved, not because anything about the business changed. It gets checked against the state’s current rules at filing, every year.

Residency, and the credit that is supposed to fix it

An individual is generally taxed by a residence state on everything, and by other states on what is sourced to them. The relief is a credit for taxes paid to other states, and it is where multi-state individual returns most often go wrong in the taxpayer’s disfavor: claimed in the wrong state, limited in ways that surprise, or missed entirely.

Residency itself is not a matter of where the mail goes. A move made halfway is the expensive version, where the old state still considers you resident and the new one already does. Days, domicile, and what was actually given up all matter, and they are established with records kept at the time.

What this looks like as an engagement

The work is a determination, not an opinion: which states, on what basis, for which years, and what it costs to fix. Where an obligation has already been missed, most states have a voluntary route that limits how far back they look and abates some of the penalty, and those programs generally close once the state contacts you first. That ordering is the reason to deal with a known exposure in the year you notice it.