The State Taxing Authorities May Be Coming to Find You
In 2018, the U.S. Supreme Court issued its decision in South Dakota v. Wayfair. This was a lawsuit against an online retailer about the collection of sales tax on internet orders, but the implications of the case go far beyond sales tax and may quickly start impacting community banks.
Economic Nexus
Economic nexus refers to the requirement that an entity pay tax on income derived in a state even if they have no physical locations there or employees who work or travel there. Before the Wayfair case, many questioned the constitutionality of states taxing out-of-state businesses. After Wayfair, it is clear that a physical presence isn’t necessary and states are rushing to respond with many states expected to expand their economic nexus rules during 2019 and 2020.
For community banks, the economic nexus rules can cover many routine transactions such as making a loan to a customer secured by real estate across state lines. Interest derived from a loan on a customer’s vacation home or business property out of state could be subject to economic nexus rules in the state where the property is located. Fee income from customers who live out of state is another possible source.
Bright Line Standards
Some states have established bright line tests that do not require businesses to pay tax in their state until the gross revenue earned in a state hits a certain threshold. The most common threshold today is $500,000 of gross revenue but some states have lower thresholds.
Other states have taken a bolder approach and asserted that any revenue, even a single dollar of interest income, earned in the state is subject to the tax.
States and Cities with Economic Nexus Standards
State and local tax laws are evolving quickly. But below are a list of some of the locations that currently have economic nexus standards.
- Alabama
- California
- San Francisco
- Colorado
- Connecticut
- Indiana
- Kentucky
- Michigan
- Minnesota
- New York State
- Ohio
- Oregon
- Philadelphia
- Tennessee
- Virginia
- Washington
- Wisconsin
From our experience, Virginia, Wisconsin, and Minnesota are some of the most aggressive states in the country when it comes to enforcing these economic nexus standards. All three states assert that doing any level business in the state subjects the corporation to tax.
Managing State Tax Risk
After Wayfair, Wells Fargo Bank accrued a $481 million reserve on its quarterly financial statements related to state income tax nexus issues. Large financial institutions are often some of the first companies targeted by states for income tax collection. And as states continue to move forward, we believe there is increased risk of community banks also being targeted. States are getting smarter at detecting out of state lenders and in at least one case we believe they may be matching local mortgage filings to income tax filing records.
The decision about whether or not to file in a given jurisdiction where you may have economic nexus comes down to risk management, but banks should be actively evaluating their risk and making an informed decision about whether or not they file. The first step is determining the population of potential states by reviewing a list of loans secured by out of state property as well as other potential revenue sources. Next you should quantify the total potential tax liability including penalties and interest.
For banks with audited financial statements, choosing not to file in a state where you have economic nexus may be considered an uncertain tax position that would have to be disclosed for financial statements purposes depending on the level of materiality. For S Corporations, determining the potential impact on your shareholder group of additional tax filings is another key consideration.
Next Steps
Today, many community banks only file in their home state. Over time, we believe that many banks may end up filing across much of the country.
CLA is here to help you evaluate your risk and make a plan to tackle the challenges of economic nexus. Please contact us.
Amanda Garnett is a principal in the financial institutions practice of CliftonLarsonAllen (CLA) from Peoria, Illinois. She currently leads the firm’s Midwest financial institution tax team and serves institutions ranging in size from $15 million to $3.5 billion in total assets. In addition to tax compliance, Amanda assists clients in the areas of tax consulting, mergers and acquisitions, and regulatory reporting. She also routinely teaches courses for banking associations across the country.
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