ASC 740 Provision for Income Taxes requires taxpayers to determine, more likely than not, if their in-state activity results in an income tax liability. This issue has become increasingly sensitive since 2018, when the United States Supreme Court (the Court) rendered its decision in South Dakota v. Wayfair, Inc., embracing and endorsing economic activity as a nexus threshold (i.e., standard for tax jurisdiction) for sales tax. Previously, a physical presence within a state was the nexus threshold. Now tax practitioners need to address the issue: can a state impose its income tax on a taxpayer whose only connection to the state is economic activity?

The simple answer is no. A state cannot impose an income tax on a taxpayer based solely on economic activity because Wayfair did not address income tax. But does the Court's silence indicate a different limitation? The U.S. Constitution limits the states' ability to impose taxes. Two of the most relevant provisions are the Due Process and Commerce clauses. If tax practitioners take a deep look at Wayfair, the Due Process requirements, and the Commerce Clause requirements, they will find that Wayfair left a number of unresolved issues with respect to state income tax.

Those issues must be fully explored as part of the ASC 740 process. ASC 740 governs how companies recognize the effects of income taxes on their financial statements under U.S. GAAP. As part of this process, every tax provision prepared under the guidelines of ASC 740 must analyze if a taxpayer's in-state activity, more likely than not, gives rise to a state income tax liability to conclude whether a taxpayer's economic activity results in a state income tax liability.

This article will discuss the Due Process Clause and Commerce Clause and how both could result in a state lacking the authority to impose an income tax on a taxpayer, notwithstanding the taxpayer's economic connection to the state.

Due Process

The Due Process Clause of the U.S. Constitution embodies the notion of notice and fair warning. A Due Process analysis should answer the question of whether a taxpayer's activity in the taxing jurisdiction is sufficient to put the taxpayer on notice that such jurisdiction may impose a tax. To satisfy a Due Process inquiry, the Court has held that there must be "some definitive link, some minimal connection, between the state and the person, property, or transaction it seeks to tax." The existence of minimum contacts requires some act by which a taxpayer "purposefully avails itself of the privilege of conducting activities within the state thus invoking the benefits and protections of its laws."

To establish the minimum contacts needed to satisfy the Due Process requirement, the Court has ruled that a taxpayer must knowingly sell products or services to businesses or residents in a state on a regular, consistent, or systematic basis. However, what if a taxpayer generated revenue from a state but did not knowingly sell products or services to in-state residents and businesses? In a recent decision by the Commonwealth Court of Pennsylvania, Online Merchants Guild v. Department of Revenue, No. 179 M.D. 2021, September 9, 2022 (Online Merchants Guild), the court determined that a taxpayer that sells products through the Fulfillment by Amazon (FBA) program, was not subject to Pennsylvania's income tax jurisdiction because it did not satisfy the minimum contact requirements of the Due Process clause, notwithstanding its inventory was stored in Pennsylvania and its products were sold to Pennsylvania residents. In that case, as is typical of Amazon FBA participants, 1) goods are shipped to Amazon warehouses, 2) Amazon moves the taxpayer's inventory amongst its warehouses without the knowledge of the taxpayer, 3) products are sold through Amazon's website, 4) Amazon collects the sales proceeds from the customers and 5) Amazon does not disclose the customer to the taxpayer. Under these circumstances the court stated, "we are hard pressed to envision how, in these circumstances, an FBA Merchant has placed its merchandise in the stream of commerce with an expectation that it would be purchased in the Commonwealth, or has availed itself of the Commonwealth's protections, opportunity, and services."

Following the logic of Online Merchants Guild, if a taxpayer generates revenue from a state without purposefully directing its business activity to in-state individuals and businesses, there may not be an adequate connection to the state to satisfy Due Process requirements, and consequently the state may not be able to exert income tax jurisdiction over the taxpayer. One may wonder how a taxpayer may generate revenue from a state without intention or action to do so beyond an Amazon relationship. Consider a contract manufacturer that drop ships merchandise to a state at the request of the contractor. Did the manufacturer purposefully avail itself to the state to which the item is shipped merely because a third party directed the shipment into such state? Consider an investment advisor that provides advice to an investment fund located in a single state that has investors in various states. Certain states may source the fees from the investment advice in proportion to the investors in the fund. Merely based upon this indirect connection to the state, should the investment advisor reasonably expect that they may be subject to income tax in all states where the investors are located? These questions should be considered when accounting for income tax under ASC 740.

Commerce Clause: The Fourth Prong of Complete Auto

Years of case law has evolved to outline what states can do without unduly burdening interstate commerce under the dormant Commerce Clause. The leading case is the 1977 U.S. Supreme Court case Complete Auto Transit v. Brady (Complete Auto), which established a four-prong test to assess the validity of a state taxing provision. The four prongs are: 1) there must be substantial nexus between the taxpayer and the state assessing the tax, 2) the tax must be fairly apportioned, 3) the tax must be non-discriminatory, and 4) the tax must be fairly related to the benefits the taxpayer received from the purported taxing authority (the Fourth Prong). All four requirements must be met for a state's income tax to be sustained. Under this analysis and years of adjudication, a taxpayer and the income stream to be taxed must have substantial ties to the taxing state.

Our focus is on the Fourth Prong and its limitations upon the imposition of an income tax. One may view the Fourth Prong as aligned with physical presence, which ensures that only companies that use state facilities and services in the course of doing business in a state can be taxed by the state. The Fourth Prong has received little attention from the Court historically. Unfortunately, the only time the Court addressed the Fourth Prong was in a 1981 case (Commonwealth Edison Co. v. Montana, and the Court minimized its importance. In Commonwealth Edison, the Court focused on the level of contacts justifying the tax to satisfy the Fourth Prong, not whether the amount of tax was out of proportion to the services and benefits the taxpayer received from the state. The Court declined to engage in a quantitative analysis to determine if a state income tax is fairly related to the benefits the taxpayer received from the state. In lieu of drawing a bright or even blurry line, the Court deferred to Congress to set a standard for whether and when the benefits from the taxing state align with the tax imposed.

A proper analysis of the Fourth Prong should require a quantitative analysis. At least one court has taken up that task, albeit in a use tax case. In Burke & Sons Oil Co., v. Director of Revenue, State of Missouri, a 1988 case in which the Missouri Court of Appeals placed the actual state protections and services under a microscope. The court performed a detailed analytical and mathematical analysis and concluded that Burke & Sons delivering products in its own trucks to one single customer in Missouri 93 times over a 61-month period with no other contact was not sufficient activity to satisfy the Fourth Prong of Complete Auto. The court estimated that the cost of Burke & Sons using the Missouri roads was $2,880, whereas the tax assessment was $125,000. The court found such tax did not fairly relate to the services provided by the state.

The Missouri court's opinion highlights the tension between the dormant Commerce Clause and the affirmative exercise of congressional authority to regulate commerce among the states. The courts are not blind to this issue. One reason the Court opted to consider Wayfair was Congress's failure to address a nexus standard for sales tax. Is it possible the Court may now realize it can no longer rely on Congress to ensure that states do not burden interstate commerce by imposing income taxes that are out of all reasonable proportion to the services that the state provides to taxpayers (i.e., the Fourth Prong)? Given another chance to consider the Fourth Prong is it possible the Court may now support a deeper quantitative analysis to satisfy the Fourth Prong and set sufficient standards for future analysis? A deeper analysis may support the requirement of a sufficient physical presence in the state because without a physical presence, it seems unlikely a state could provide protections that justify the tax in the first instance.

Following the logic of Burke & Sons, if the amount of income tax is not in line with demonstrable protections afforded by the state, the tax may not be sustainable because it fails the Fourth Prong. Further, if a taxpayer generates income from a state with no physical presence, the application of an income tax is questionable under the Fourth Prong unless the state can demonstrate how protections can be provided to a company with no presence in the state.

The Takeaway

Every tax provision prepared under the guidelines of ASC 740 must analyze if a taxpayer's in-state activity, more likely than not, gives rise to a state income tax liability. While this analysis must consider whether the economic nexus standard set forth in Wayfair applies, it should not stop there. Until a tax practitioner's analysis fully considers the Due Process and Commerce Clause requirements, and issues left unresolved by Wayfair, it cannot properly conclude on the applicability of a state income tax to a taxpayer's facts. When all factors are considered, it is possible that an income tax liability will not be sustained if the taxpayer's only connection to a state is economic activity. Contact an Andersen advisor to learn how this analysis may apply to the state income taxes imposed on your company.