Advances in technology have made it feasible for small to midsize businesses to carry on national and even international operations from a remote location. Not surprisingly, these remote businesses typically rely on a wide variety of independent contractors and other third-party service providers to perform services for out-of-state customers. Although the use of independent contractors may be helpful or even necessary from an operational standpoint, it may bring about unwanted nexus issues. A business that uses an independent contractor in a state may create a sales and use tax collection/reporting responsibility in that state.
Although this article will focus on sales and use tax nexus, the key underlying question is whether a business that uses an independent contractor or third-party service provider in a state establishes a physical presence in that state. If the independent contractor establishes a physical presence, then there will likely be nexus or a reporting obligation for both sales/use and income taxes (as well as possible franchise, gross receipts and other taxes). Note that income tax nexus analysis must also consider the implications of P.L. 86-272, which is not specifically addressed in this article.
Most businesses are aware that a physical presence in a state through either property or employees will create nexus in that state for sales and use tax purposes. Some businesses, however, may be unaware that the use of independent contractors may also establish a physical presence and consequently create a sales and use tax reporting responsibility. The expanded use of third-party service providers, coupled with the increased scrutiny from state tax agencies, mean that these nexus issues are usually not discovered until an inopportune time, such as receiving a notice from a state or during the due diligence process for a potential transaction.
Any analysis of whether the use of independent contractors will create a taxable presence in a state for sales and use tax purposes begins with the United States Supreme Court’s holdings in Scripto, Inc. v. Carson [362 U.S. 207 (1960)] and Tyler Pipe Industries, Inc. v. Washington Department of Revenue [483 U.S. 232 (1987)].
In Scripto, the Court examined whether the Florida marketing activities of ten independent sales representatives created sales/use tax nexus for an out-of-state manufacturer. The Court refused to make a distinction between employees and independent contractors for purposes of determining nexus as it was “a fine distinction without constitutional significance.” The Court was concerned that “to permit such formal ‘contractual shifts’ to make a constitutional difference would open the gates to a stampede of tax avoidance.” Ultimately, the Court's focus was whether the sales representatives’ activity in Florida created and maintained a commercial market for Scripto’s goods. Because the presence of the sales representatives was continuous, the Court held that Scripto had nexus for Florida sales and use tax.
Similarly, in Tyler Pipe, the Court held that the activities of a single independent contractor residing in Washington were sufficient to create constitutional Business and Occupation tax nexus for an out-of-state manufacturer. Once again, the Court held that the “crucial factor” was “whether the activities performed in this state on behalf of the taxpayer are significantly associated with the taxpayer’s ability to establish and maintain a market in this state for the sales.”
Note that, in both cases, the Court rejected making any distinction between employees and independent contractors for purposes of determining sales/use tax nexus. The Court, however, did not go as far as holding that the mere existence of an in-state independent contractor was sufficient to create nexus. Rather, the true determinative factor will be whether the activities performed by the independent contractor are significantly associated with the taxpayer's ability to establish and maintain a market in the state.
Third-Party Service Providers
Although the independent contractors in Scripto and Tyler Pipe were sales representatives, the same standard espoused by the Court will also be applied to determine whether the use of independent contractors in other contexts will create nexus for sales and use tax purposes.
Warranty, Repair or Installation Services
Common activities that remote businesses often outsource to independent contractors are warranty, repair and installation services. There has been substantial litigation on this issue particularly in the context of warranty and repair services performed with respect to computers, hardware, and related equipment. In an attempt to establish uniformity on this issue, the Multistate Tax Commission (MTC) issued Nexus Program Bulletin No. 95-1, which took the position that in-state warranty repair services through third party repair services providers will create constitutional nexus under Scripto and Tyler Pipe for the imposition of a use tax collection responsibility for all sales made to customers in that state. Generally, most states have followed the MTC’s lead and will impose sales and use tax nexus on a taxpayer for the presence of an independent contractor performing warranty, repair and installation services in a state on behalf of a taxpayer.
However, there are some notable exceptions. In California, for example, a taxpayer will not be deemed to have sales and use tax nexus solely because of its use of a representative or independent contractor in California for purposes of performing warranty or repair services with respect to tangible personal property sold by the retailer. To take advantage of this exception, however, the ultimate ownership of the representative or independent contractor cannot be substantially similar to that of the retailer (Cal. Code Regs. 18 § 1684(a)).
Remote businesses often use third-party fulfillment houses, such as Fulfillment by Amazon, to handle the seller’s warehousing, shipping and, occasionally, customer service needs. In addition to evaluating whether this establishes and maintains a market in the state for the sales, a business needs to determine the impact if the remote seller is storing the inventory in the state. Unsurprisingly, the use of in-state fulfillment houses will likely create sales and use tax nexus for a remote seller in most states (see our previous article, “Using Fulfillment by Amazon: State and Local Tax Issues at Stake.”
A few states, however, have affirmatively decided not to impose sales and use tax nexus on remote sellers who utilize in-state fulfillment houses. Both Connecticut and New York have enacted statutes providing that an out-of-state retailer’s use of an unaffiliated fulfillment house in the state will not create nexus if the retailer is not otherwise engaged in business in the state (N.Y. Tax Law § 1101(b)(8); Conn. Gen. Stat. § 12-407(a)(15)(C)).
Out-of-state businesses often engage independent contractors to perform consulting and other professional services. Like other independent contractors, those providing consulting and other professional services will create sales and use tax nexus in a state for an out-of-state taxpayer if the activities performed by the independent contractor help establish and maintain a market in the state for the sales. Typically, independent contractors performing consulting and other professional services are not considered to create and maintain a market for sales. In the current environment of diminished tax base and aggressive state tax agencies, however, out-of-state businesses should be mindful of where it hires independent contractors to perform consulting and other professional services.
We have just scratched the surface on the sales and use tax nexus issues that can arise from the use of independent contractors. These issues are often complex due to the wide variety of services that independent contractors can perform. Businesses, especially those with a limited nexus footprint from property and employees, should be mindful of where and how they employ independent contractors and whether the activities performed by the independent contractors establish and maintain a market in the state. Independent contractors hired to perform services relating to the sales or operational functions are more likely to create sales and use tax nexus than those performing purely professional services. Businesses should be cognizant of the nuances among states, however, as there are some subtle differences which can lead to potential filing obligations.
Businesses often have difficulty keeping up with the activities of their employees that may create potential nexus exposure. Doing so for independent contractors is even more difficult. We recommend taxpayers conduct frequent reviews of their state and local tax compliance responsibilities, factoring in the use of independent contractors and whether such use helps create and maintain a market in a particular state. Finding potential nexus exposure before a state taxing agency conducts an audit can save a taxpayer significant dollars. Once these issues are discovered, companies should consider working with state and local tax professionals to mitigate the amount of exposure by participating in voluntary disclosure programs or working out other tax settlements with the state.
For more information concerning the state sales tax consequences of hiring independent contractors, you may contact us here.
Tarra Curran is Managing Director and leader of the State and Local Tax Practice in New England. She can be reached at email@example.com or 401.626.3240.
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