Summary. Multistate tax exposure accumulates invisibly. A company hires a remote employee, stores inventory in a fulfillment warehouse, or crosses a sales threshold in a state it has never visited, and acquires filing obligations nobody noticed until an audit or a diligence request surfaces them. The framework has three moving parts: nexus, which decides whether a state may tax at all; apportionment, which decides how much of the company's income that state may reach; and the reporting method, which decides whose income is counted. Each has shifted substantially in the last decade — economic nexus for sales tax after Wayfair, a narrowing interpretation of the federal protection for solicitation-only activity, and a broad move toward single sales factor apportionment with market-based sourcing. This article explains each part and the practical work of finding and fixing exposure.

State tax exposure is the liability most commonly discovered by someone else. A buyer's diligence team asks for state filings and receives a list with four states on it for a company selling into forty. An auditor from a state the company has never visited sends a nexus questionnaire. A CFO preparing for a financing has to book a reserve for a liability nobody knew existed.

The structural reason is that state tax obligations attach through conduct that has no tax purpose and generates no notification. Nobody sends a letter when a company crosses a threshold. A remote hire, a trade show, a warehouse contract, or an ordinary sales year in a growing market can create a filing obligation, and the statute of limitations never starts on an unfiled return. A company that had nexus and did not file in 2016 remains exposed in 2026.

This article works through the framework in the order the analysis has to be done.

Nexus: may the state tax at all

Two constitutional constraints, plus a federal statute.

The Due Process Clause

Requires minimum contacts and that the tax bear a rational relationship to values connected with the taxing state. In practice, the due process standard is easily satisfied by purposeful availment and rarely decides modern cases.

The Commerce Clause

Complete Auto Transit, Inc. v. Brady, 430 U.S. 274 (1977), supplies the four-part test that still governs: the tax must be applied to an activity with a substantial nexus with the taxing state, be fairly apportioned, not discriminate against interstate commerce, and be fairly related to services provided by the state.

For decades, Quill Corp. v. North Dakota, 504 U.S. 298 (1992), and National Bellas Hess, Inc. v. Department of Revenue, 386 U.S. 753 (1967), read substantial nexus for sales and use tax to require physical presence.

South Dakota v. Wayfair, Inc., 585 U.S. 162 (2018), overruled both. The Court held that physical presence is not required and that South Dakota's threshold — two hundred thousand dollars in sales or two hundred separate transactions into the state annually — established substantial nexus. The Court noted approvingly that the statute applied prospectively only, that South Dakota was a member of the Streamlined Sales and Use Tax Agreement, and that small sellers were protected by the threshold.

Every state with a sales tax adopted an economic nexus standard within roughly two years. Thresholds vary — many at one hundred thousand dollars of sales, some higher, some retaining a transaction-count alternative and many having repealed it — and the measurement period and the definition of includible sales differ.

Income tax nexus

Most states asserted economic nexus for income tax purposes well before Wayfair. Geoffrey, Inc. v. South Carolina Tax Commission, 437 S.E.2d 13 (S.C. 1993), upheld income tax on an intangible holding company with no physical presence, licensing trademarks into the state.

Many states now use factor presence standards derived from the Multistate Tax Commission model: nexus exists where a company exceeds a stated threshold of property, payroll, or sales in the state — commonly fifty thousand, fifty thousand, and five hundred thousand dollars respectively, or twenty-five percent of total.

Public Law 86-272

The single most important federal limitation, and the one whose scope is currently contested.

15 U.S.C. §§ 381–384 prohibits a state from imposing a net income tax on a business whose only activity in the state is the solicitation of orders for sales of tangible personal property, where the orders are sent outside the state for approval and filled from outside the state.

The limits of the protection matter as much as its content:

  • Tangible personal property only. Services, software delivered as a service, licensing, and leasing are all outside it.
  • Net income taxes only. It does not protect against sales tax, gross receipts taxes such as Ohio's CAT or Washington's B&O, franchise taxes measured other than by net income, or the Texas margin tax.
  • Solicitation only. Wisconsin Department of Revenue v. William Wrigley, Jr., Co., 505 U.S. 214 (1992), held that the protection covers solicitation and activities entirely ancillary to it, but not activities serving an independent business function — there, replacing stale gum, supplying display racks, and storing inventory. The Court also recognized a de minimis exception.

The internet activities question. The Multistate Tax Commission revised its statement on P.L. 86-272 in 2021 to take the position that a business engages in unprotected in-state activity when it interacts with customers through its website in ways beyond presenting static text and photographs — including post-sale chat assistance, placing cookies that gather information for non-solicitation purposes, offering extended warranties, and remote repair of downloaded software. Several states adopted this position by regulation.

The position has been challenged. California courts have invalidated its adoption through a Technical Advice Memorandum on procedural grounds, and litigation continues in New York and elsewhere. The practical guidance is that the protection is narrower than it was and its boundaries are unsettled; a company relying on P.L. 86-272 should document exactly what its website and personnel do in each state and should not assume the analysis is stable.

The activities that create nexus in practice

  • Employees or independent contractors working in the state, including a single remote employee. This is now the most common source of unexpected nexus.
  • Inventory in the state, including inventory held by a third-party fulfillment provider — a substantial exposure for marketplace sellers, since the marketplace moves inventory without seller involvement.
  • Property, owned or leased, including servers in some states.
  • Trade shows, subject to state-specific safe harbors.
  • Deliveries in company vehicles, which defeats P.L. 86-272 protection.
  • Affiliate and click-through relationships, under pre-Wayfair statutes that remain on the books.
  • Economic thresholds, crossed without any physical contact.
  • Registration to do business with the secretary of state, which many states treat as creating or evidencing nexus for franchise tax purposes.

Apportionment: how much may the state reach

Once nexus exists, the state may tax only the portion of income fairly attributable to it. The mechanism is a formula.

From three factors to one

The traditional Uniform Division of Income for Tax Purposes Act formula, UDITPA § 9, averaged three equally weighted factors: property, payroll, and sales, each expressed as the ratio of the in-state amount to the everywhere amount.

The overwhelming trend has been toward the single sales factor, which most states now use for most taxpayers. The policy motivation is transparent — property and payroll factors penalize a company for locating facilities and employees in the state, while a sales factor taxes based on where the customers are, which for most states means taxing out-of-state producers.

The consequence for a multistate business is that the sales factor is nearly the whole game, and the sourcing rules that determine where a sale occurs are correspondingly critical.

Sourcing sales

Tangible personal property is generally sourced to the destination — where the goods are delivered or shipped to the purchaser. UDITPA § 16.

Throwback and throwout. UDITPA § 16(b) provides that a sale is thrown back to the origin state if the taxpayer is not taxable in the destination state. This exists to prevent "nowhere income" — receipts assigned to a state that cannot tax them. Many states have repealed throwback; some use a throwout rule instead, removing such sales from the denominator. The interaction with P.L. 86-272 is important: a company protected in the destination state is not "taxable" there, so its sales may be thrown back to a state where it has full exposure.

Services and intangibles are the harder question, and states have moved decisively.

  • The traditional rule, UDITPA § 17, sourced receipts by cost of performance — to the state where the greater proportion of the income-producing activity was performed, based on costs.
  • The modern rule is market-based sourcing: receipts are sourced to where the customer receives the benefit of the service, or where the intangible is used. A large majority of states have adopted it.

Market-based sourcing sounds simple and is not. For a service delivered to a corporate customer with operations in twenty states, determining where the benefit is received requires either a look-through to the customer's own operations or a cascading set of proxies — billing address, order location, commercial domicile — that different states order differently. For software and digital services the question of where a user "receives the benefit" is genuinely indeterminate, and states reach inconsistent answers that produce both double taxation and nowhere income.

Alternative apportionment

Both taxpayer and state may petition for an alternative method where the statutory formula does not fairly represent the taxpayer's activity in the state, UDITPA § 18. The burden is high, and courts require a showing that the standard formula produces a grossly distorted result. Container Corp. of America v. Franchise Tax Board, 463 U.S. 159 (1983), articulates the constitutional standard: the taxpayer must prove by clear and cogent evidence that the income attributed to the state is out of all appropriate proportion to the business transacted there.

Business and nonbusiness income

Only business income is apportioned. Nonbusiness income is allocated in full to a single state, generally the state of commercial domicile for intangibles or the situs for real property.

UDITPA § 1(a) defines business income using two tests that most states apply in the alternative:

  • The transactional test: income arising from transactions and activity in the regular course of the taxpayer's trade or business.
  • The functional test: income from property whose acquisition, management, and disposition constitute integral parts of the taxpayer's regular business operations.

The distinction matters most on a sale of a business or a major asset, where a large gain is either apportioned across the states or allocated entirely to one. The functional test generally makes gain on operating assets business income. Allied-Signal, Inc. v. Director, Division of Taxation, 504 U.S. 768 (1992), holds that a state may tax gain from an investment in a non-unitary business only if the investment served an operational rather than an investment function.

Combined reporting and the unitary business principle

The problem

A corporate group can shift income among affiliates. The classic structure places trademarks in a Delaware holding company and pays it royalties from operating affiliates, deducting in high-tax states and accumulating income where it is not taxed — the Geoffrey structure.

Separate versus combined

Separate-entity states tax each corporation on its own income, with addback statutes and transfer pricing adjustments as the defenses against shifting. Many separate-entity states now have related-party addback provisions disallowing deductions for intangible and interest expenses paid to affiliates, subject to exceptions where the recipient was subject to tax.

Combined reporting states treat the members of a unitary business as a single taxpayer, combining income and apportionment factors, then applying the state's formula to the combined result. Intercompany transactions are eliminated. This makes the Geoffrey structure ineffective.

Roughly half the states with corporate income taxes require combined reporting, and the number has grown.

The unitary business principle

The constitutional foundation. A state may tax an apportioned share of the income of a unitary business conducted partly within its borders, even where the income arises from activity elsewhere.

The Supreme Court's cases identify the hallmarks: functional integration, centralization of management, and economies of scale. Mobil Oil Corp. v. Commissioner of Taxes, 445 U.S. 425 (1980); Container Corp., above. The absence of a unitary relationship means the state may not reach the affiliate's income at all — ASARCO Inc. v. Idaho State Tax Commission, 458 U.S. 307 (1982), and F.W. Woolworth Co. v. Taxation & Revenue Department, 458 U.S. 354 (1982), both found no unitary relationship with passive investments.

Water's edge

A combined report could in principle reach worldwide income. Most combined reporting states permit or require a water's edge election, limiting the combined group to U.S. entities plus specified foreign affiliates — those with substantial U.S. activity, those in listed tax haven jurisdictions in some states, and entities with significant Subpart F or GILTI income depending on the state.

Barclays Bank PLC v. Franchise Tax Board, 512 U.S. 298 (1994), upheld worldwide combined reporting against Commerce Clause and foreign affairs challenges, so the water's edge limitation is a legislative choice rather than a constitutional requirement.

The election is typically binding for a period of years and revocable only with consent, so it should be modeled before it is made.

Sales and use tax

A separate system with separate rules, and for most growing companies the larger near-term exposure.

Sales tax is imposed on the retail sale of tangible personal property and enumerated services. The seller collects it as agent for the state; the legal incidence varies but the practical effect is that a seller who fails to collect owes the tax from its own funds.

Use tax is the complement, owed by the purchaser on taxable property used in the state where sales tax was not paid.

The mechanics that generate liability:

Taxability determinations. Services are taxable in some states and not others. Software is the perennial problem: prewritten software delivered on tangible media is nearly always taxable; downloaded software usually is; software as a service is taxable in a substantial and growing minority of states; and custom software is often exempt. Digital goods, data processing, information services, and advertising services all have inconsistent treatment.

Exemption certificates. A seller that does not collect on an exempt sale must hold a valid certificate. In an audit, missing or defective certificates convert exempt sales into taxable ones, and this is the single largest source of sales tax assessments. Certificates must be collected at the time of sale, validated, kept current, and retained.

Marketplace facilitator laws. Every sales tax state now requires marketplaces to collect and remit on behalf of third-party sellers. This removed a great deal of seller exposure prospectively — but not retroactively, and not for a seller's direct-channel sales.

Local taxes. Home rule jurisdictions in several states administer their own sales taxes with separate registration, rates, and bases. Colorado, Louisiana, and Alabama are the recurring examples.

Sourcing. Destination-based in most states, origin-based in a few, with complex rules for services, digital goods, and mixed transactions.

Successor liability. Nearly every state imposes liability on the purchaser of a business for the seller's unpaid sales tax, with a bulk sale notification procedure and a tax clearance certificate as the protection. This is a standard diligence item and a standard indemnity.

Responsible person liability. Officers, directors, and employees with control over tax funds can be held personally liable for unremitted trust fund taxes. Personal liability generally survives bankruptcy and dissolution of the entity.

Other state-level taxes

Gross receipts taxes. Ohio's CAT, Washington's B&O, Oregon's CAT, Nevada's Commerce Tax, and Texas's margin tax. These are not net income taxes, so P.L. 86-272 does not apply and deductions are limited or unavailable. A company with thin margins can owe substantial gross receipts tax while losing money.

Franchise and net worth taxes, measured by capital, net worth, or authorized shares. Delaware's franchise tax, Texas's margin tax, and similar impositions in a number of states.

Pass-through entity taxes. Following the 2017 federal cap on the individual deduction for state and local taxes at 26 U.S.C. § 164(b)(6), most states with an income tax enacted an elective entity-level tax on pass-throughs, paired with a credit or exclusion for the owners. Notice 2020-75 blessed the structure at the federal level. The elections are annual, the mechanics differ substantially by state, and the interaction with resident credits for taxes paid to other states is a recurring source of error.

Withholding and composite returns for nonresident owners of pass-through entities.

Employment taxes and unemployment insurance in every state where an employee works — the obligation that most often accompanies a remote hire and is most often overlooked.

Finding and fixing exposure

The nexus study

The standard engagement. Inventory, by state and by year:

  • Employees and contractors, including remote workers and their start dates.
  • Property owned or leased, including inventory at third-party facilities and cloud infrastructure where relevant.
  • Sales by state and by year, separated by tangible property, services, and digital products, and by channel.
  • Travel by employees — salespeople, technicians, installers, and executives — and its purpose.
  • Registrations with secretaries of state.
  • Affiliate relationships and intercompany transactions.

Map that against each state's nexus standards and each year's thresholds, and produce a matrix showing where filings were required and were not made.

Quantify

Estimate tax, interest, and penalties by state and year. Note that for sales tax the exposure is the gross tax that should have been collected, not a margin on it, which is why sales tax exposure so often exceeds income tax exposure by an order of magnitude for a company with modest profitability.

Under ASC 450, material exposures require accrual or disclosure, and a diligence team will ask.

Remediate

Voluntary disclosure agreements are the primary tool. A taxpayer approaches the state anonymously, usually through counsel or a representative, and negotiates: a limited look-back period — commonly three or four years rather than unlimited — waiver of penalties, and prospective compliance. The taxpayer generally must not have been contacted by the state first, which is why waiting until a nexus questionnaire arrives forecloses the option.

Amnesty programs appear periodically and can offer better terms.

Prospective registration alone is a mistake where material historical exposure exists. Registering signals nexus and invites the state to ask how long it existed.

Managed audits and prospective-only agreements are available in some states.

Then build the process

Automate sales tax determination and filing. Set thresholds and monitor them monthly. Require tax review before hiring in a new state. Collect and validate exemption certificates at onboarding. Track employee travel days. And revisit the analysis whenever the business changes channel, product mix, or footprint — which is to say, continually.

Primary authority

A worked exposure analysis

A software company, nine years old, headquartered in Colorado, selling a subscription platform to business customers nationwide. Revenue has grown from two million to thirty-eight million. Twelve employees work remotely across seven states. No state filings outside Colorado.

Step one: the facts by year. Pull the sales ledger by customer billing address by year. Pull the HR record of every employee's work location and start date. Pull the AWS regions, the trade show calendar, and the list of contractors.

The picture that emerges is typical: sales crossed one hundred thousand dollars in eleven states in 2021, nineteen states in 2023, and twenty-six states today. The first remote hire outside Colorado was in 2019.

Step two: income tax nexus. The remote employees create physical presence nexus in seven states from their respective hire dates. P.L. 86-272 is unavailable — the company sells a subscription service, not tangible personal property. Factor-presence thresholds are exceeded in a further dozen states on sales alone.

Income tax exposure is real but modest, because the company was unprofitable until 2023. Where a state uses single sales factor apportionment, the apportioned share of a small profit is small.

Step three: sales tax. This is the exposure.

Subscription software is taxable in a substantial number of states — the treatment of SaaS varies, and the company must determine taxability state by state and, in home rule jurisdictions, locality by locality. In states where it is taxable, the company was required to collect from the date it crossed the economic nexus threshold.

The liability is the tax that should have been collected, plus interest and penalties. On thirty-eight million dollars of revenue, with perhaps forty percent sourced to states taxing SaaS at an average combined rate near seven percent, the annual exposure runs past one million dollars — against a company whose entire pre-tax profit is smaller than that.

The mitigant is exemption certificates. Many of the company's customers are resellers or otherwise exempt, and where a valid certificate can be obtained now for a historical period, the liability disappears. This retroactive certificate collection campaign is unglamorous and is usually the single highest-value remediation step available.

Step four: employment obligations. Withholding, unemployment insurance, and in some states paid leave contributions in each of the seven employee states, from each hire date. Separately assessed and separately penalized.

Step five: remediate. Voluntary disclosure agreements in the states with material exposure, negotiated anonymously, with three- or four-year look-backs and penalty waiver. Register prospectively in the remainder. Implement automated tax determination. Begin the certificate campaign immediately, because response rates decay with time.

The lesson for the board. None of this was created by a decision anyone identified as a tax decision. It was created by hiring good people who lived elsewhere and by selling successfully into new markets.

Handling a state audit

State audits differ from federal audits in ways that reward preparation.

The nexus questionnaire. Most audits begin here — a short form asking about employees, property, deliveries, travel, and sales in the state. It looks administrative and is not. Answers are used to establish nexus for all open years, and because no return was filed, there is no statute of limitations to bound the exposure.

Do not complete one without counsel. Do not guess. Do not volunteer information beyond what is asked. And recognize that receiving one generally forecloses the voluntary disclosure option for that state, which means the decision about whether to come forward should be made before questionnaires start arriving, not after.

Scope and sampling. Sales tax audits are conducted on samples — a statistical sample or a block sample of periods — with an error rate extrapolated across the audit period. The sampling agreement is negotiable and consequential: an unrepresentative sample period containing an unusual transaction can be extrapolated into a very large assessment. Review the sample selection before agreeing to it.

The exemption certificate campaign. In a sales tax audit, missing certificates are the largest single assessment category, and most states permit the taxpayer to obtain certificates from customers during the audit. Start this on day one; it takes months and response rates fall as time passes.

Managed audits. Several states offer a self-audit under agency supervision in exchange for penalty waiver and sometimes interest relief. Worth considering where the taxpayer has good records and internal capacity.

Assessment and protest. An assessment triggers a short protest deadline — often thirty to sixty days — and missing it usually forfeits administrative review. Most states then offer an informal conference, a formal administrative hearing before an appeals division or independent tax tribunal, and judicial review.

Pay-to-play. A number of states require payment of the assessment before judicial review, or the posting of a bond. This changes the strategy substantially: the administrative levels may be the only forum realistically available, and they deserve the full effort rather than being treated as a way station.

Settlement. Most state assessments settle. Offers in compromise, closing agreements, and negotiated resolutions on the merits are widely available, and the agency's willingness to settle typically improves after a well-prepared protest demonstrates a genuine legal dispute rather than a records problem.

Interest is rarely waivable. Penalties usually are, on a reasonable cause showing supported by evidence of a good-faith effort to comply.

Individual residency, and why it belongs here

Business owners bring their own state tax problem, and it is frequently larger than the company's.

Two ways to be a resident. Nearly every state taxes as a resident either someone domiciled in the state or a statutory resident — typically someone who maintains a permanent place of abode in the state and spends more than 183 days there. A person can be a statutory resident of one state and domiciled in another, and be taxed as a resident by both.

Domicile is intent plus presence, and it is sticky. A domicile continues until a new one is established, which requires physical presence in the new location plus intent to remain indefinitely. Auditors examine the classic factors: where the largest and most valuable home is, where the family lives, where business activity is centered, where items of sentimental value are kept, and where the person is registered to vote and licensed to drive.

Day counting is real and it is audited. High-tax states run sophisticated residency audits using cell phone records, E-ZPass data, credit card transactions, and building access logs. Any part of a day in the state generally counts as a day. Contemporaneous records matter far more than reconstructed calendars.

The credit for taxes paid to other states prevents most double taxation, but not all. Comptroller of the Treasury v. Wynne, 575 U.S. 542 (2015), applied the internal consistency test to strike Maryland's failure to grant a credit against its county-level tax, and residency disputes still produce genuine double taxation where two states each assert resident status.

The sale of a business is when this matters most. A founder contemplating a nine-figure exit who relocates to a no-income-tax state will be examined closely. Timing is critical: gain recognized before the change of domicile is taxed by the old state, and several states assert source-based taxation of gain on an interest in an entity doing business there regardless of residency. A move made shortly before a closing, without a genuine change in life, is the fact pattern residency auditors are looking for.

Practical counsel. Change domicile decisively or not at all — sell or lease the old home, move the family, change the registrations, and document the day count from day one. And decide before the letter of intent, not after.

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This article is provided for general informational purposes and does not constitute legal or tax advice. State tax law changes constantly: nexus thresholds, sourcing rules, combined reporting requirements, pass-through entity tax elections, and the treatment of software and digital services all differ by state and are frequently amended. The scope of Public Law 86-272 protection for internet activities is actively contested and unsettled. Confirm current rules in each state before relying on any position, and consult qualified state and local tax counsel before making a voluntary disclosure.