Are you thinking about joining the growing number of small and midsize companies using independent contractors or third-party providers to service out-of-state customers? While this may be a good move operationally, it can trigger nexus liabilities. That’s the legal responsibility to collect sales taxes in states where the services are performed.
Although this column 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 so, 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).
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 hungry for revenue, 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 U.S. Supreme Court’s holdings in Scripto Inc. v. Carson and Tyler Pipe Industries Inc. v. Washington Department of Revenue.
In Scripto, the court examined whether the Florida marketing activities of 10 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.
The conclusion of this column will appear next week, covering sales and use tax nexus for warranty, repair and installation services.
Tarra Curran is a managing director at CBIZ Tofias.
