As state laws keep evolving and new regulations come into play, maintaining compliance is becoming harder than ever for businesses. One of the most important terms for companies to understand is the concept of “nexus.”
Although the term sounds complex, it simply refers to the physical — or economic — connection a business has to a particular state. That, in turn, impacts whether or not companies are required to collect sales tax on transactions that occur in that state.
In this post, we’ll be exploring the concept of physical nexus. We’ll be breaking down exactly what physical nexus means, why it’s crucial for avoiding regulatory penalties, and how companies can stay on top of their sales tax responsibilities.
What is physical nexus?
Saying that a business has physical nexus in a given location is simply another way of saying that it has a physical presence there. It could be a brick-and-mortar store, offices, or even remote employees.
If you have physical nexus in a particular state, you’re legally required to collect tax on sales made to customers residing there, and remit it to the appropriate tax authorities. In essence, you can think of physical nexus as a tangible presence that links your company to a state, establishing tax obligations. Basically, it’s a way for tax authorities to ensure that retailers operating in a particular location fulfill their obligations to the local economy.
Physical nexus was affirmed as a legal concept in 1992 due to the U.S. Supreme Court case Quill Corp v. North Dakota. Despite being headquartered in Illinois, Quill Corporation — an office supply company — was required to collect use tax on products sold to customers in North Dakota.
The court sided with Quill Corporation, ruling that a state could not compel a business to collect sales tax unless it had a tangible physical connection to the area. The most common examples of activities that create physical nexus include:
- Leasing or owning property in a particular state, including warehouses, storefronts, or offices.
- The presence of employees (full time, part time, or contractors) will automatically trigger physical nexus.
- The storage of sales inventory, even through a third party such as Fulfillment by Amazon.
- In-person services or selling, even if it’s just agents visiting a state to attend trade shows.
Now that we’ve covered the definition of physical nexus and what creates physical nexus in a particular state, let’s look at why the concept is so important for retailers, e-commerce stores, and other sellers of goods and services.
Why does physical nexus matter for businesses?
If your business has physical nexus in a state, you’re legally obligated to collect sales tax on transactions occurring in that state, and to remit it to the proper authorities. This is the case whether you’re selling goods or services out of a brick-and-mortar store, online as an e-commerce seller, SaaS subscriptions, or a combination of the three.
Understanding physical nexus is vital for today’s companies for a range of reasons. For one thing, it directly ties into regulatory compliance. On top of that, if you’re planning to expand your operation, you need to know the financial impact that will have on your company before you make any concrete changes. The only way to effectively gauge that is by taking physical nexus into account.
Let’s walk through some of the major risks that businesses run by failing to collect and remit sales tax in a state where they have physical nexus.
1. You’ll be liable for financial fees and penalties.
If you have physical nexus in a state but fail to collect and remit sales tax, you’ve violated that state’s tax laws. As a result, you’ll be required to pay fees and penalties to that state’s tax authority, the size of which will depend on the amount of unpaid tax you owe.
The exceptions are Alaska, Delaware, Montana, New Hampshire, and Oregon, as these states do not charge sales tax — although some local Alaskan governments might. It’s important to note that there are also penalties for waiting too long to register for sales tax once you have physical nexus.
2. You could be subject to audits and scrutiny.
Failing to comply with sales tax laws dramatically increases your company’s odds of being audited by state tax authorities.
3. You’ll have to pay taxes retroactively, likely with interest.
If you’re found to be in non-compliance with state tax laws, you’ll be required to pay any back taxes you owe. This will most likely include interest, which will begin accruing from the date that your tax return was due, and will keep accruing until the tax is paid.
4. You run the risk of reputational harm and even legal action.
Failing to comply with sales tax laws can do lasting reputational damage to your company, limiting your future revenue. You could even find yourself on the receiving end of a state lawsuit to collect unpaid taxes.
Determining if your business has physical nexus
Businesses need to be confident in assessing whether they have physical nexus in a given location. Otherwise, you could be accruing interest and penalties on unpaid sales tax without even being aware of it.
To avoid that, ask the following questions to see whether you have nexus.
Where do you have physical operations?
Local operations or a physical presence of any kind — including stores, offices, warehouses, or employees — will trigger physical nexus in any state that charges sales tax.
Do you store inventory in third-party warehouses?
Even if you store inventory in a warehouse owned by a third party, your business will still have physical nexus in that state. Given the rising popularity of third-party warehouse services like Fulfillment by Amazon, this is a very important point.
Do you have employees or independent contractors in other states?
If the answer to either of those questions is yes, you likely have physical nexus in those states.
Here’s a quick example of how it works. Say your company operates an e-commerce store out of California. You also store inventory in a third-party warehouse in Nevada, and you employ sales reps who travel to Idaho to see clients. Even though you don’t have a brick-and-mortar location in any of these states, you would have physical nexus in all three of them.
Keep in mind that states sometimes define physical nexus differently, so it’s important to use the right resources to assess where you have nexus.
Some of the best ways of doing so include:
- State Department of Revenue websites, which explain nexus and sales tax requirements for different locations.
- A nexus study, performed by a licensed tax professional, which will help you determine your sales tax obligations.
- Tax software that can automatically monitor where you have nexus based on your business activities.
Now that you know more about physical nexus, let’s take a quick look at how it compares to economic nexus.
Physical nexus vs. economic nexus
Until relatively recently, physical nexus was the main qualifier of whether a business had to register for sales tax in a particular state. That all changed in 2018, with the South Dakota v. Wayfair ruling, which allowed states to require sales tax based on companies’ economic presence in a state.
A business has economic nexus in a state once it hits a certain threshold of annual transaction volumes or total yearly revenue. While each state sets its own specific thresholds, the most common are $100,000 in annual sales or 200 transactions over the course of a year.
This makes things considerably trickier for businesses. Not only can you trigger physical nexus through physical operations in a state, but you can also trigger economic nexus by doing enough business in a given location.
Since companies can have physical nexus without economic nexus and vice versa, it’s essential to understand when and where you’ve triggered each type. Otherwise, you could get hit with sizable fines and penalties seemingly out of the blue.
Steps to stay compliant with physical nexus laws
Staying compliant with physical nexus laws can be a complex and time-consuming process. But following these steps can bring peace of mind that your business is meeting its sales tax obligations.
- Register for sales tax: Sales tax registration is an agreement with a state’s tax authorities to collect and remit sales tax on transactions in that state. You can do this manually or use a tool like Numeral, which can register for sales tax on your behalf, saving you time and hassle.
- Review business activities: Once you’re registered, you’ll need to regularly review your business operations to assess whether you’ve triggered physical nexus in any other states.
- Use tax automation software: Sales tax software like Numeral can automatically charge customers the correct sales tax amount on every transaction across 11,000 jurisdictions and even remit your taxes to the proper authorities.
The laws governing sales tax get updated frequently, so it’s important for businesses to consult with licensed tax professionals who have experience navigating regulatory compliance. This is especially true for companies that operate in multiple states or sell on e-commerce platforms like Amazon.
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States with and without physical nexus requirements
Put sales tax on autopilot
Triggering physical nexus without being aware of it can cost your business thousands of dollars in fines, penalties, and back taxes. That’s why it’s crucial to carefully monitor your business activities to assess any ramifications they might have on your sales tax responsibilities.
With Numeral’s advanced sales tax automation, you can streamline the collection and remittance of sales tax in every state where your business has a physical presence.
