Economic Nexus

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What Is Economic Nexus?

Economic nexus is a concept that relates to a business's obligation whereby out-of-state sellers are liable to collect and remit sales tax in U.S. states under certain conditions. Various factors, including sales revenue, transactions, and the extent of economic activity within the state, determine this obligation. Each state establishes its thresholds and laws for economic nexus, which can vary significantly.

While there may be some complexity in navigating these regulations, state governments generally provide structured guidelines for businesses to follow. The rise of online companies has introduced additional complexity to sales tax regulations, prompting states to adapt their laws to capture sales tax revenue from online transactions.

What Is Economic Nexus?

Economic nexus can be defined as a connection between the state and a business with a customer base in the state's jurisdiction. When the business generates sales revenue from the state, they are expected to pay sales tax to the state government.
Most states specify thresholds based on the sales revenue or transaction volume, exceeding which businesses (both physical and online) should pay sales tax.
Its laws and thresholds differ from state to state, which is a source of confusion for sellers operating in multiple states.

Economic Nexus Explained

Economic nexus is the crucial link between businesses and state governments, forming the foundation for sales tax collection, which is particularly significant as many businesses operate across multiple states. This nexus establishes the framework that holds businesses accountable for generating sales. When a business surpasses a specific threshold in sales revenue or transaction volume, it triggers the obligation to remit sales tax.

While most states require businesses engaged in sales within their jurisdiction to register for future monitoring, this measure holds particular importance to online firms facing tracking challenges. However, it is worth noting that despite the complexities of its laws, they signify a commitment to fair taxation and revenue collection. Although variations exist among states, this diversity allows adaptability in addressing different business models and situations.

Out-of-state businesses should approach this regulatory landscape with diligence, recognizing the importance of compliance. While it may involve paperwork and calculations, it ultimately contributes to a fairer tax system. By adhering to these regulations, businesses can avoid legal repercussions and demonstrate their commitment to responsible tax practices, ensuring a positive and constructive relationship with state governments.

For businesses engaged in sales across various states, several crucial considerations must be kept in mind when filing sales tax returns:

Some states offer exemptions for specific products, such as digital goods, which can aid sellers in managing costs effectively.
The frequency of evaluation periods for sales tax obligations varies from state to state, with some states conducting yearly evaluations while others performing quarterly assessments.

Examples

The hypothetical and real-life examples below will help understand the concept better.

Example #1

Mitch is an online book retailer from Utah. He has customers from Oregon, Arizona, California, and Nevada. His sales revenue and the number of transactions by the state for 2022 are given below. Let us see how Mitch proceeds with the nexus:

State	Oregon	Arizona	California	Nevada
Sales Revenue	$150,000	$90,000	$500,000	$80,000
Number of Transactions	1800	900	5000	600

Oregon does not have a sales tax nexus. So, Mitch does not have to pay any sales tax.
In Arizona, the sales revenue threshold is $100,000. Since Mitch does not exceed the threshold, he does not have to remit taxes. But he has to register with the state.
California has a threshold of $500,000 in sales revenue. Mitch meets this threshold, making him liable to pay sales tax.
The threshold in Nevada is $100,000 in sales revenue or 200 transactions. While Mitch has not met the sales revenue threshold, he has exceeded the transactions threshold, which again makes him liable to remit sales tax in Nevada.

Example #2

In a significant development, South Dakota has taken steps to eliminate its 200-transaction threshold for economic nexus, effective from July 1, 2023. Previously, the state required businesses to meet two criteria: $100,000 in gross sales revenue and 200 transactions to establish economic nexus. This change is expected to benefit sellers with high transaction volume but may not reach substantial sales revenue.

South Dakota's decision follows a growing trend among states reevaluating and removing transaction thresholds. Other states that have already eliminated these thresholds include North Dakota, California, Massachusetts, Colorado, Iowa, Washington, Maine, and Wisconsin. This shift towards simplifying criteria offers relief to businesses operating across state lines, aligning with calls for greater uniformity and consistency in sales tax regulations.

Example #3

Every state has been implementing economic nexus requirements for remote out-of-state sellers. These requirements oblige such sellers to register, collect, and remit sales tax once they cross a specific sales or transaction threshold within a state. To understand the diversity in these economic nexus rules across states, let us take a closer look at a few examples of economic nexus by state:

Alabama: Effective October 1, 2018, Alabama requires remote sellers to register once their sales exceed $250,000 in the previous calendar year. This threshold applies to retail sales.
Alaska: Alaska follows the Remote Seller Sales Tax Code & Common Definitions, where the threshold is set at $100,000 or 200 transactions from the previous calendar year.
Arizona: In Arizona, the threshold varied over the years, starting at $200,000 in 2019, decreasing to $150,000 in 2020, and ultimately settling at $100,000 in 2021 and beyond, based on the previous or current calendar year's gross sales.

These examples illustrate the differences in economic nexus thresholds among states for businesses operating in multiple jurisdictions.

Physical Nexus vs Economic Nexus

Let us compare the Economic and Physical Nexus regarding their implications for sales tax obligations and their impact on businesses.

Basis	Economic Nexus	Physical Nexus
Definition	Sales tax obligations due to economic activity, regardless of physical presence.	Due to its physical presence, it has sales tax obligations, including brick-and-mortar stores, warehouses, employees, etc.
Identification	It can be challenging to identify and track online businesses' economic activities.	Easily identifiable as states can track businesses with a physical presence.
Applicability to E-commerce	It holds online businesses responsible for sales tax based on economic presence.	Did not require online businesses to remit sales tax solely based on physical presence.
Challenges	Registration, documentation, and tax collection for online sellers can be complex.	E-commerce growth made tracking online sales difficult under physical nexus.
Affiliate Nexus	Affiliation with agents or affiliates may trigger economic nexus obligations.	Affiliate nexus may apply if a seller uses affiliates or agents in another state.

Frequently Asked Questions (FAQs)

1. What is the economic nexus in California?

In California, economic nexus refers to the obligation of out-of-state sellers to collect and remit sales tax when their annual sales in the state exceed $500,000. This threshold is based on gross sales of tangible personal property and includes both in-state and remote sales.

2. Does economic nexus apply to income tax?

No, economic nexus primarily applies to sales tax rather than income tax. It determines when a business must collect and remit sales tax based on its sales activity in a particular state. Income tax, on the other hand, depends on a business's net income and may have separate thresholds and regulations.

3. Does economic nexus reset every year?

Economic nexus thresholds generally do not reset annually. Once a business surpasses the specified sales or transaction threshold in a state, it must collect and remit sales tax for the remainder of that calendar year and often in subsequent years unless there are changes in the state's tax laws.