Nexus vs. Residency: Your Guide to Error-Free State Reporting - www.sovos.com
←
→
Page content transcription
If your browser does not render page correctly, please read the page content below
Nexus vs. Residency: Your Guide to Error-Free State Reporting www.sovos.com
Contents
02 Overview 05 Withholding
03 C
ompany nexus or recipient state 06 The confusion about nexus
of residence?
07 W
hy states require information
03 Nexus defined reporting for residents
03 Nexus and sales and use tax 09 Challenges & best practices
04 Nexus and residency-based reporting 14 About Sovos
When it comes to state tax information reporting, companies typically fall into one
of two categories. Either they are conducting direct state reporting solely based on
the company’s nexus, or they are reporting based on residency.
In this whitepaper, Sovos explores:
• Nexus vs. residency
• Why the nexus myth is faulty
• Why states require tax information reporting for residents
• How information reporting is used to enforce income tax compliance
• The key organizational challenges of complying with state tax information reporting requirements
• Proven strategies to overcome those challenges
1
Overview
Tax information reporting to the states is required for U.S. companies when it pays income to that
states’ resident(s), and that includes 1099 reporting. Depending on the state’s specific requirements,
information must be filed either directly to the state or via the IRS’s Combined Federal State Filing
(CF/SF) program.
Banks and financial institutions offering interest and dividend earning products or retirement and
annuity planning services have significant state reporting obligations. Insurers offering life and annuity
products have significant obligations in terms of tax withholding and reporting obligations at the
state level - especially payments related to Form 1099-R. Property and casualty and health insurers
are responsible as well because non-employee compensation payments, which will be reported on
the new Form 1099-NEC as of 2020 are required at the state level. And Affordable Care Act (ACA)
Forms 1095-B and C are required to be reported at the state level as well. Lastly,gig economy payers
and payment processors who file Form 1099-K must report at the state level following much lower
thresholds than are required by the IRS.
Many filers of Forms 1099 believe that tax information reporting to the states is only required when
the company has nexus, which has long been associated with state & local tax (SALT) and some
corporate income tax reporting obligations. But 1099 and W-2 tax withholding and reporting to the
states follow a different nexus ruleset.
Like its SALT counterparts, 1099 tax information reporting requirements vary across every state. Each
state has different rules for when a recipient must receive reporting, what is required to be reported
and how to report it. This level of complexity has forced many companies to adopt expensive manual
processes in an effort to comply. Some companies roll the dice and avoid reporting altogether a risky
strategy given the steep monetary and potential criminal penalties that the states have instituted
for intentional disregard of reporting. While ignoring state reporting obligations has worked for some
companies, it will not protect them from audits and penalties in the future. Technology systems used by
states to collect tax information have gone digital allowing them to easily detect noncompliances. Will
your current state tax information reporting process stand up to this new level of scrutiny?
2
Company nexus or recipient
state of residence?
Takeaways for this section:
Historically, nexus was defined as a company’s obligation to collect and pay sales
and use taxes based on the company’s physical presence.
State tax information reporting obligations require a similar approach to the
Supreme Court’s Wayfair ruling.
Most states require reporting based on where their recipients reside rather than a
company’s physical presence.
Residency-based taxation occurs when residents of a state or country are taxed on
income earned worldwide and non-residents are taxed on income they earn in a
local jurisdiction.
Nexus defined
By definition, nexus means a connection or series of connections linking two or more things. Tax nexus
occurs when a business has a tax presence in a certain state and each state has different definitions for
what constitutes tax nexus.
Tax nexus is widely associated with the U.S. sales and use tax framework. When a company has sales tax
nexus in a state, it has an obligation to collect and pay sales and use taxes and file returns. Perhaps the
most fundamental example of sales tax nexus is when a company operates a brick and mortar location
in a state. It has a connection to that state and that nexus creates the sales and use tax obligations.
Alternatively, states require U.S. and non-U.S. companies “doing business” in their states to impose
withholding and Forms 1099 and W-2 reporting rules on payments to their residents following a
different ruleset. “Doing business” in a state is not necessarily aligned with the rules that constitute
sales tax nexus. In most states, definitions of “doing business” are broadly defined and do not limit tax
information reporting requirements to companies that maintain physical presence.
Nexus and sales and use tax
First enacted during the Great Depression, sales taxes now make up more than 34% of state revenue
across the 45 states with a retail sales tax in effect, including the District of Columbia and the
Commonwealth of Puerto Rico. Sales tax generates revenue for states based on the sales of goods.
3
However the decrease of goods sold in the US economy coupled with the federal law prohibiting the
full taxation of e-commerce, have resulted in decreasing sales tax numbers and less revenue for states.
Until recently, the primary tool states used to make up for this loss in tax revenue was to increase the
tax rate.
South Dakota v. Wayfair dramatically changed the tax and nexus landscape by eliminating the
requirement that states can only impose sales tax on sellers with physical presence in their state. This
inspired a slew of new statutes and regulations imposing tax based on the economic connection the
seller may have with the state. Today, almost every U.S. state (excluding Florida and Missouri) have
expanded the reach of sales tax to capture sales made by remote, e-commerce sellers. The positive
impact of this change on state revenue is just now emerging.
Nexus and residency-based reporting
Residency-based taxation occurs when residents of a state or country are taxed on income earned
worldwide and non-residents are taxed on income they earn in a local jurisdiction. As a result, payers of
income to residents located in the state have an obligation to report 1099s and in some cases, withhold
taxes on those transactions. In some states, payments for services occurring within the state are also
withholdable and reportable to that state whether the recipient is a resident or not.
There are many examples of both statutory and agency-published guidance related specifically to state
W-2 and 1099 information reporting rules that are independent of sales & use tax rules.
For example, California Code, Revenue & Taxation (RTC) 18631 generally requires that all Forms 1099
that were filed with IRS also be filed with the state following administrative rules set forth by the CA
Franchise Tax Board (FTB).
4
The FTB further clarifies that any business that engages in any transaction for the purpose of
financial gain within California, is considered a filer for tax reporting purposes. And the guidance for
information return reporting indicates that W-2 and 1099 reporting is required when the recipient is
a California resident or part-year resident or, when the source of the transaction was in California.
In Delaware, doing business in the state includes an employer that is “...transacting business in
Delaware who makes payment of wages or other remuneration to a resident or non-resident of this
state”. And employer is defined as ‘...maintaining an office or conducting business in Delaware’. Similar
to California, the Delaware code section 1154 describes residency-based and source of payment
withholding and reporting requirements.
The language in these requirements targets companies distributing taxable income to residents of
their state. While it can always be debated whether a company activity qualifies as “doing business”
in a state, it is difficult to argue that repeatedly disbursing pension and annuity income to a states’
residents or hiring third-parties to perform services in a state do not trigger the requirement to also
withhold and report on those activities.
Withholding
In addition to reporting tax information based on recipients state of residency, withholding taxes
on payroll and non-payroll payments is also required whether a payer has physical nexus in a state
or not.
Non-payroll withholding taxes both apply to payments to non-employees as well as recipients of
pension and annuity payments. Most states have a specific regime of withholding and reporting
requirements for pension and annuity distributions made to residents of the state. For example, for
IRA distributions in Iowa, a mandatory withholding rate of 6.99% of the gross payment is required
to be withheld unless the IRA owner furnishes a state Form CT-W4P requesting 0% withholding.
Reporting is required via the federal Form 1099-R to Iowa reflecting state tax withholding amounts as
well as the gross amounts distributed to that states recipient.
Some states have backup withholding rules similar to IRS. For example, Maine requires state backup
withholding at a flat rate of 5% if backup withholding was also administered at the federal level.
The withholding amounts would be reported on the corresponding 1099 form along with the gross
income that was paid.
Still other states impose withholding taxes on gambling, lottery and prize winnings. In Oklahoma, a
flat 6% withholding is required when federal withholding was also applied to payments of gambling
winnings. This requirement is not based on the location of the gambling establishment and whether
there is payer nexus in New Mexico. It is based on whether the payer had the requirement to
withhold taxes at the federal level on gambling winnings paid to an Oklahoma resident.
5
The confusion about nexus
When it comes to tax nexus, there is an immediate instinct for tax professionals to apply sales tax
nexus to tax information reporting requirements despite the fact that the two are different state
tax regimes. In fact, if you google the phrase ‘tax nexus’ you will find that the first page results are all
topics aimed exclusively at sales tax nexus.
And it’s no wonder that sales and use tax has such an influence. The regime dates back to the Great
Depression and has matured over the years. Conversely, information reporting tax has only gained
notoriety in the last 10 years because the tax laws and related IRS enforcement were fairly stagnant
until then.
The graphic below draws a correlation between the significant withholding and information reporting
tax law changes over the last 30 years and highlights a tipping point in the number of tax information
returns filed with IRS during that same time.
2008
Cost Basis
regulations
impacted Form
2.4B 1099-B reporting
2015 2.4B
PATH act enacted
2.2B 2011 accelerating W-2 2.2B
and 1099-Misc Box
972CG penalties
7 filing due dates
2B 1995 increased substantially
2013 2B
E-filing is Affordable Care Act 2020
1.8B implemented 1.8B
regulation created 2.2B forms
1.6B 1991
Form 1095 series 2016 projected
2010 1.6B
972CG penalties
1.4B
Form 1042-S Merchant payment 2014 increased 2019
was added reporting creates 1.4B
Uk regulations
Form 1099-K 1099-NEC
1.2B 2012 created CDOT requirement 1.2B
reporting; OECD
43 states required introduced
introduced CRS
1B reporting; FATCA
obligations
2018 1B
regulations
1099-LS/SB and
released
800M 1986 section 6050Y 800M
enacted
Tax Reform Act of
600M 1986 passed; Convey 600M
is founded
400M 400M
200M 200M
The tipping point occurred when cost basis reporting regulations were enacted in The Emergency
Economic Stabilization Act of 2008 which required significantly more Forms 1099-B information from
the broker/dealer industry. Since then, we’ve seen sweeping information reporting changes, like in IRC
6050W. This law required third-party settlement organizations and payment card processors to report
goods and services transactions through the addition of the newer Form 1099-K. We also saw landmark
legislation in the Foreign Account Tax Compliance Act (FATCA) in 2012, which sought to fill the tax gap
created by U.S. taxpayers who hid funds in offshore accounts. FATCA required non-U.S. banks to report
details related to accounts that they maintained for U.S. customers on Form 8966. In 2013, the Affordable
Care Act (ACA) required U.S. employers and insurers to submit forms 1094 and 1095 to report health
insurance coverage.
6
The Protecting Americans from Tax Hikes of 2015 (PATH Act) brought legislation that accelerated the
due dates for filing Forms W-2 and 1099-MISC non-employee income to January 31st. More than 38
states followed suit and accelerated filing due dates for those same forms, forever changing how
organizations tackle the busy January tax reporting season.
The Tax Cuts & Jobs Act (TCJA) of 2018 introduced new internal revenue code section 6050Y and the
IRS created Forms 1099-LS and SB for life insurance policy acquisitions and sales.
And in 2019, the IRS revived Form 1099-NEC for reporting non-employee compensation payments in
order to address unnecessary penalty issues created by having two different due dates for the same
form (i.e., Form 1099-MISC).
Why states require information
reporting for residents
Takeaways for this section:
More and more states are requiring tax information be reported directly to the
state in lieu of the CF/SF,
States want tax information for three primary reasons: to enforce individual and
business income tax compliance, raise tax revenue and promote the adoption of a
real-time tax system.
In the U.S., residency-based tax information reporting is used by state governments similarly to the way
the IRS uses it: to enforce income tax compliance. When taxpayers claim income and deductions on
returns, governments use the corresponding taxpayer 1099’s and W-2’s to confirm those amounts. The
following are some of the primary reasons that states want income information reported directly rather
than through the IRS’s CF/SF program.
I. E nforce income tax compliance: The area of income where the states and IRS typically invest in
enforcement is the tax information reporting required by payers. There is no example better than the
payroll tax and accompanying Form W-2 reporting requirements. States require employers to withhold
state income taxes and to report those details on Form W-2 to the employee and the state.
7
II. R
aise tax revenue: When states see an opportunity to raise revenue they use that to offset other
proposals. For example, in 2017, Vermont predicted it could raise more than $5 million in tax
revenue by aligning Form 1099-K filing thresholds for third-party settlement organizations (TPSOs)
with the IRS’s $600 Form 1099-MISC threshold and eliminating the transaction limits. Other states
soon followed. In 2017, Massachusetts also aligned the 1099-K reporting requirements with the
1099-MISC threshold estimating an additional $20 million in tax revenue. The most recent state
to enact stricter 1099-K reporting requirements was Illinois. For 2019, Illinois requires TPSOs to
report Form 1099-K to the state following the current federal thresholds. But, beginning in 2020
the threshold changes to $1k paid over four transactions.
III. P romote adoption of a real-time tax system: An idea initially raised by the IRS in 2012, a real-
time system would enable the IRS to match information returns to taxpayer income tax returns
before refunds could be issued. Currently, the IRS spends a significant amount of compliance effort
after refunds have already been issued. States use information returns to ensure proper refunds
are issued too, so it makes sense to adopt rules that advance the idea of a real-time system.
As part of the PATH Act legislation in 2015, the due dates for filing tax information with IRS for Forms
1099-MISC with nonemployee compensation amounts reported in Box 7 were accelerated to the end of
January. The IRS subsequently eliminated the ability to request an automatic extension-of-time to file
1099 information for Box 7 income, citing only specific catastrophic examples where an extension would
be granted.
These changes triggered a domino effect where virtually every income tax state followed suit and
adopted an accelerated due date for the same income type. As of 2019, only seven states do not have a
due date in January for reporting information returns.
January February March April No state filings required
Last updated on November 5, 2019 for tax year 2019 state reporting requirements.
8Another way states are moving towards a real-time tax system is through the adoption of electronic
filing requirements rather than the antiquated ‘CD’ method or even worse, on paper. From 2017 to 2019,
at least eleven states adopted electronic filing requirements in an effort to match information faster
than ever before. For example, Pennsylvania adopted electronic filing requirements in 2017 for filers of
250 more returns and by 2018, filers were required to file at a threshold of 10 or more returns. For 2020
reporting, Minnesota will no longer accept any paper return filings.
Challenges & best practices
Takeaways for this section:
The CF/SF does not satisfy all state tax reporting obligations - more than 41 states
require some form of DSR,
Primary challenges include determining what to report, how to report and when to report,
Automation and planning is key to compliance.
State tax information reporting is challenging. Each states’ reporting requirements vary, whether its
payroll taxes, backup withholding taxes, annuity & pension disbursement taxes, non-resident taxes,
and so forth. Depending on the states’ revenue & enforcement agenda, a state may be more keen to
require reporting of a specific form type or at differing thresholds than IRS. And all states have their
own method for submitting information following a specific format. Many follow the IRS technical
Publication 1220 format Publication 1220 (Rev. 9-2019) for submitting data while others require a more
specific layout. Some require the data to be burned to a CD format or even on paper. All states require
data to be submitted and methods vary in that process too.
Many states participate in the Combined Federal State Filing (CF/SF) program where the IRS shares
specific 1099 information included by the filer in the Publication 1220 file with the state directly.
However, this information is not always timely. According to spokespersons from two states at a recent
industry meeting CF/SF, information is not generally received for more than a year after the filer submits
it to the IRS.
As states strive to enforce tax compliance through matching 1099 income to returns filed by resident
taxpayers, the delays in receiving information from the IRS gives rise to more burdensome Direct State
Reporting (DSR) obligations; where states require certain forms to be submitted directly to the local
tax authority rather than giving payers the opportunity of utilizing the advantages of the free CF/SF
program through the IRS.
9The lopsided adoption of direct state reporting obligations has created even more difficulty for filers.
The graphic below illustrates that more than half of the states have enacted laws that require DSR
obligations while also still requiring filers to report some information through the CF/SF program.
Snapshot of State Reporting – CF/SF vs. DSR
Participants in CFS, but has No state filings required Only DSR required CFS Satisfies
DSR requirements
Separating form data into different formats and files requires additional technical and operational
resources to ensure those processes are completed accurately and timely.
10Here are some of the top issues companies have reported when managing the state tax
withholding and information reporting processes, and some tips for improving them.
Where to look for requirements
The primary issue reported is where to find the state reporting requirements. Since each
state operates its own tax authority, the information reporting-specific rules are not
consistently located in the same areas of a web page or publications. This differs from
what they are accustomed to seeing with the IRS.
Some states publish FAQ’s with limited answers to questions that represent minority
scenarios. Some states release detailed publications of requirements - both operational
and technical (for data submission).
Tax and Compliance professionals pour hours of time into researching the rules year-
over-year as a result of the continuous change. Time spent sifting through unnecessary
information and researching various sources to find information reporting specific
updates, can be cumbersome and costly to an organization.
Tip: Automation of research details and storage of state-specific rules (past and
present), mitigates the risk of errors and helps the organization better comply
with regulatory mandates and improve efficiency. Many automated research
solutions in the market offer a variety of ‘tax’ updates, but on closer inspection,
the offerings often come up short on the topic of tax information reporting.
11Untested data
Threshold requirements for reporting vary across states for different forms so there could
be scenarios where the data being reported to the state is not being reported to the IRS.
Since most state reporting occurs utilizing the IRS data, organizations often fail to review
the data that is in scope for the states with differing requirements. These scenarios are
often overlooked in quality control processes and can result in incorrect reporting.
Tip: Use technology to analyze data anomalies. Modern tax technology can apply
differences between IRS and state tax information reporting requirements to
ensure that the data ultimately filed with those states with different reporting
requirements is accurate.
Meeting deadlines on time
Managing the various state and IRS due dates in January - and all the way through
June in many cases - can be complex. Data is often flowing from various sources and
managing when those files will be produced, tested, and converted for tax reporting
can also be tricky.
Filers of 1099s are also responsible for issuing recipient copies of statements by
January 31st every year. Generating files for printing and mailing while simultaneously
generating files for filing to the IRS and the states by that same due date, puts an
enormous strain on a companies’ operations, tax compliance, and technology resources
in January.
Tip: Create a plan before the busy tax season. Know the due dates for each filing
to each state and the sequence of the steps needed to achieve compliance.
Identify accountable business partners and review plan details with them
further input.
The devil is in the details
With a variety of files being produced for different states, filers often find themselves
plagued with unexpected issues. States require separate logins to their unique portals
in order for information to be submitted, and those logins may expire during the year.
Files need to be generated with specific data points in certain formats and waiting to
find out in January that changes occurred to the state formats or processes is unwise.
Tip: Run a pilot of the tax reporting process in November or December in order
to pinpoint any key issues before the busy season starts. Login to the state
electronic portals and make sure you have access. Create transmittals for all
states where tax filing needs to occur and check the output to make sure it is
accurate. Many states also offer testing of your file format in advance in order to
minimize the risk of issues during the busy filing season..
12Managing notices and inquiries
Filing data with various tax authorities is cumbersome. It is even more challenging
to deal with the triggering processes that can often occur with the states after the
data has been submitted. States balance withholding dollars reported on information
returns to the amounts remitted by payers during the year (through a separate
process) and when there are mismatches, penalty notices are generated. States
experience system issues during the peak seasons and it is not uncommon for a state
to ‘lose’ a file that was submitted during those times. States have manual processes for
information return processing and sometimes have questions about files months after
the data was filed.
Additionally, the IRS and states legally require filers to retain 1099 information and
that includes internal work papers and reports along with details associated with
the production and filing of 1099 information. Generally, the IRS requires retention of
personal income taxpayer return data for at least three years but some states have
even longer retention period requirements. For example, California and Arizona,
generally require four years. This can also vary by the form type.
Tip: C
reate an electronic audit trail that accounts for all data filed. Capture the
source of the data and the decisions and steps that were followed to ensure
data was captured accurately and timely. Create a risk-management process
that enables the organization to document discussion details with tax
authorities. Create processes that can quickly access and reproduce data in the
event of a regulator request.
13About Sovos
Sovos is the #1 Private Filer of IRS 1099 Forms 620M forms
representing billions of transactions 23% of all forms filed with the IRS
100% dedicated to Tax Information Reporting for 30+ years
Leadership Positions on Regulatory Committees, Including: OECD,
IRPAC, ETA
14About Sovos Contact us
Sovos is a leading global provider of software that safeguards businesses from +1 866 890 3970
the burden and risk of modern tax. As governments and businesses go digital, www.sovos.com/contact
businesses face increased risks, costs and complexity. The Sovos Intelligent Atlanta, Boston, Boulder, Cedar Rapids,
Compliance Cloud is the first complete solution for modern tax, giving Minneapolis, Colombia, Lima, Santiago,
São Paulo, Tucumán, Amsterdam, Istanbul,
businesses a global solution for tax determination, e-invoicing compliance and
London and Stockholm
tax reporting. Sovos supports 5,000 customers, including half of the Fortune
500, and integrates with a wide variety of business applications. The company
has offices throughout North America, Latin America and Europe. Sovos is
owned by London-based Hg.You can also read
