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December 5, 2012
Is Trailing Nexus Constitutional?

Full Text Published by Tax Analysts®

by Jennifer Carr

Jennifer Carr is a legal editor of State Tax Notes.

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Trailing nexus is a method used by some states under which businesses that cease the activities that created nexus with the state continue to have a tax obligation after those activities have ended. States apply trailing nexus mostly to sales and use tax, but it also appears in income tax law. Although it seems reasonable for states to use trailing nexus for income taxes because of case law that generally authorizes a more flexible economic nexus approach for those taxes, trailing nexus is contrary to the bright-line physical presence nexus rule for sales and use tax. There have been no appellate cases resolving the question, but taxpayers appear to have a good basis for challenging trailing nexus, particularly as it's applied to sales and use taxes.

A typical fact pattern implicating trailing nexus for sales and use taxes would be an out-of-state company that conducts mail order business and has a related storefront business, and it closes its retail locations and ceases to have a physical presence in the state. Under Quill v. North Dakota, the company would no longer have nexus and would not be required to collect and remit sales tax on its sales to customers in the state. However, if the state has a trailing nexus provision, the company must continue collecting and remitting sales tax for the duration of the nexus period.

Fewer than 10 states have some type of trailing nexus provision. The most widely known is Washington, where nexus continues for the state's business and occupation tax (B&O) one year after a taxpayer stops the business activity that created the nexus.1 The state's trailing nexus is four years for sales and use tax purposes.2 Minnesota's sales tax has a trailing nexus for "the following 11 calendar months."3 In California, trailing nexus for sales and use tax is generally the quarter in which the taxpayer ceases nexus-creating activities plus an additional quarter. However, the law says that "depending on the facts and circumstances specific to each retailer, the period of trailing nexus may be shorter or longer than the general 'quarter-plus-a-quarter' approach."4 The Texas sales tax has a trailing nexus period of 12 months.5

Sales and Use Taxes

Although states use trailing nexus for both sales and income taxes, the analysis of whether the method is constitutional would be different for sales and income taxes. Some practitioners and taxpayers continue to argue that the Quill physical presence standard applies to income taxes as well as sales taxes, and that the U.S. Supreme Court has not resolved the issue. However, in light of cases such as Lanco Inc. v. Division of Taxation, KFC Corp. v. Department of Revenue, and Tax Commissioner v. MBNA America Bank, several states have concluded that the physical presence standard does not apply to income taxes and that some sort of economic presence is sufficient for meeting the income tax substantial nexus requirement. A trailing nexus analysis should include separate analyses for different taxes because the nexus requirements for them are different.6

In Quill, the U.S. Supreme Court held that commerce clause substantial nexus for sales tax requires physical presence in the state. The Court also explained the differences between due process nexus and commerce clause nexus. Due process, it wrote, "centrally concerns the fundamental fairness of governmental activity." That analysis requires a court to ask "whether an individual's connections with a state are substantial enough to legitimate the state's exercise of power over him." Commerce clause nexus, on the other hand, is "informed not so much by concerns about fairness for the individual defendant as by structural concerns about the effects of state regulation on the national economy." The Court, citing its prior decision in Bellas Hess, concluded that a bright-line physical presence test for commerce clause nexus was appropriate.7 As a result, a mail order company that ships products into a state could not be required to collect and remit sales and use tax from its customers.

Applying that standard to sales and use tax trailing nexus provisions raises serious questions about their constitutionality. Unlike the due process clause analysis, which is informed by notions of fairness, the commerce clause nexus requirement for sales and use taxes is a bright-line physical presence standard. State courts have applied Quill in that manner.8 Once the physical presence has ended, the nexus must end as well. The New York State Department of Taxation and Finance reached that conclusion in an advisory opinion issued in 2002.9 In that opinion, the petitioner was a mail order company with customers in New York. The company had in the past sent representatives to New York to trade shows and to meet customers, but it had discontinued all New York visits. All solicitation was through catalogs and promotional materials mailed directly to customers. The department's advisory opinion concluded that once the petitioner no longer had representatives in the state, it was not required to be registered or to collect tax there. Given the bright-line physical presence standard for sales tax, that appears to be the most reasonable conclusion.

Income Taxes

There is generally more wiggle room for states on the income tax nexus question. The standard for determining commerce clause nexus for income and other taxes is the four-part Complete Auto test,10 under which a tax will survive a commerce clause challenge if it (1) is applied to an activity with substantial nexus with the taxing state, (2) is fairly apportioned, (3) does not discriminate against interstate commerce, and (4) is fairly related to the services provided by the state. The most frequently litigated portion of the test is the substantial nexus prong. Unlike the sales tax bright-line physical presence test, the test for income taxes is malleable. For instance, in MBNA, the West Virginia Supreme Court of Appeals held that a credit card company with no physical presence in the state had substantial nexus with West Virginia for business franchise and corporate income tax purposes by virtue of its direct, continuous, and systematic engagement with West Virginia residents in credit card solicitation. In reaching that conclusion, the court held that the physical presence test of Quill applied only to sales and use taxes.

In KFC, the Iowa Supreme Court held that an out-of-state franchiser could be required to pay tax on the income received from its Iowa franchisees. The court held that the physical presence test of Quill applies only to sales and use taxes and that "by licensing franchises within Iowa, KFC has received the benefit of an orderly society within the state and, as a result, is subject to the payment of income taxes that otherwise meet the requirements of the dormant commerce clause." And in Lanco, the New Jersey Supreme Court affirmed, with little comment, an appellate division decision holding that the state could constitutionally tax a foreign corporation with no physical presence in the state that derived income from a licensing agreement with a corporation conducting retail business in New Jersey.

The question then is how this case law carries over into the trailing nexus concept. What if a taxpayer with nexus were to do something specific in a state on day one that created new business, leave the state on day five, and generate income from the sale of tangible personal property based on its day one activities on day six? Would it be unconstitutional for a state to tie the income to the nexus? What if the income were generated on day 400? Or what if the taxpayer could clearly show that the income had no connection whatsoever to the now-ended nexus-creating activities? Unlike the sales and use tax bright-line standard, the income tax case law appears to provide some leeway for continued nexus under those circumstances.

Speaking at the California Tax Bar and Tax Policy Conference held November 1-3, Jeffrey L. McGuire, deputy director of the California State Board of Equalization's Sales and Use Tax Department, analogized trailing nexus to the wake created from a boat. Even though the boat is gone, he said, the effects continue because a taxpayer can continue to reap the economic benefits from its nexus-creating activities. Given the above-mentioned economic presence case law, it seems reasonable to view nexus in that manner. However, it also seems that there must be some connection between the income and the nexus-creating activities and that the period must be much shorter than yearlong trailing nexus periods used in some states. Also, if states are using the boat-wake analogy to justify trailing nexus, it may be necessary for taxpayers to be able to rebut a presumption of a connection between the income and the nexus-creating activities.

At least one state has rejected the notion of trailing nexus regarding income tax as well as sales tax. In a 1999 letter ruling, the Tennessee Department of Revenue concluded that a taxpayer that closed its retail store and sales division but continued to have mail order sales in the state had nexus after its physical presence in the state ended. The department wrote that even though the taxpayer was likely doing business under the state's statutory provisions, it fell within the protections of P.L. 86-272 because the company's only remaining activity in Tennessee was the solicitation of sales of tangible personal property. As a result, the DOR wrote, "there would be insufficient nexus to require the taxpayer to remit franchise, excise taxes."


Trailing nexus is not an especially significant issue because most states don't appear to use it. However, it provides an interesting means for considering differences in nexus between sales and income taxes as well as a basis for considering the purpose of nexus and its function in state taxation. States that use trailing nexus are skirting the boundaries of constitutionality, particularly regarding sales and use taxes, because it is difficult to reconcile the method with the bright-line physical presence standard. However, given the more flexible nexus case law for income taxes, trailing nexus is more defensible regarding those taxes as long as the period is reasonable and there is a tie between the income and the original nexus activities.


1 RCW 82.04.220.

2 WAC 458-20-193(7)(c).

3 See Revenue Notice 00-10.

4 California Board of Equalization Annotation 220.0275.

5 Texas Admin. Code section 3.286(b)(2).

6 Lanco Inc. v. Director, Division of Taxation, 908 A.2d 176, 177 (N.J. 2006) (For the opinion, see Doc 2006-21177 or 2006 STT 199-22); KFC Corp. v. Dep't of Revenue, 792 N.W.2d 308, 322 (Iowa 2010) (For the opinion, see Doc 2011-23 or 2011 STT 2-10); Tax Commissioner v. MBNA America Bank, 640 S.E. 2d 226 (W.Va. 2006). (For the opinion, see Doc 2006-23668 or 2006 STT 228-18.)

7 National Bellas Hess v. Department of Revenue, 386 U.S. 753 (1967).

8 See Travelscape LLC v. Dep't of Revenue, 705 S.E.2d 28 (S.C. 2011): "Commerce Clause nexus for sales and use tax purposes requires some physical presence within the taxing jurisdiction." (For the opinion, see Doc 2011-1152 or 2011 STT 131-17); Lamtec Corp. v. Dept of Revenue, 215 P.3d 968 (Wash. App. 2009): "In Quill, the U.S. Supreme Court determined that, in the context of sales and use taxes, an entity must be physically present in the taxing jurisdiction to establish the constitutional requisite substantial nexus." (For the opinion, see Doc 2009-17692 or 2009 STT 149-30.)

9 TSB-A-02(19)S, June 26, 2002.

10 Complete Auto Transit v. Brady, 430 U.S. 274 (1977).


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