Are Online Businesses Subject to Corporate Income Tax in the United States?

Yes, online businesses may be subject to corporate taxes in the U.S. state where they have 'substantial nexus.' Although this answer seems simple, its practical application requires careful analysis of what legally constitutes ‘substantial nexus." A subsequent and also complex question would be what if an e-business has ‘substantial nexus' in different states? As any tax concern, answering these questions requires the analysis of a competent tax attorney. Yet, this articles provides some guidance on how an e-business may be subject to corporate tax and the importance of the ‘substantial nexus' discussion.

Corporate Taxes and Interstate Commerce

A simple principle is that U.S. businesses are subject to corporate taxes in the state where they are physically located. Additionally, businesses may be subject to corporate taxes in other states where they have ‘physical presence.' Hence, e-commerce raises questions on when an online business is considered to have physical presence or nexus in a specific state. The online business may be registered under the laws of a specific state, let's say Ohio, and subject to corporate taxes in Ohio. But, does this mean the Ohio e-business selling goods to other states is going to be subject to corporate taxes in other states as well?

The U.S. Supreme Court declared constitutional those state statutes charging corporate taxes to out-of-state companies. In Complete Auto Transit, Inc. v. Brady, 430 U.S. 274, 279 (1977), the U.S. Supreme Court held that the state statute charging taxes to out-o-state companies is upheld if it meets the following 4-prompt test,

1. The activity to be taxed is connected to the state;
2. The tax is fairly apportioned to be based on intrastate commerce;
3. The tax is not discriminatory; and
4. The tax is related to state services provided.

Traditionally, tax controversies applying this 4-prompt test have concentrated on the ‘substantial nexus' issue (whether the activity taxed is connected to the state), since it is the more complex question among the four.

Thus, to know whether a state can tax out-of-state businesses, it is required to know ‘what substantial nexus' means. Litigants have focused the substantial nexus question on whether substantial nexus requires corporate physical presence (since we already know physical presence triggers corporate taxation).

There is no uniform rule as to whether substantial nexus requires physical presence. Some state, like South Carolina, Florida, Arkansas, Massachusetts, Texas, Hawaii, Iowa Wisconsin, etc. have held that substantial nexus requires no physical presence. In Geoffrey, Inc. v. S.C. Tax Comm'n, 437 S.E.2d 13 (S.C. 1993), the court found that a Delaware company had substantial nexus or connection with the state of South Carolina even though the Delaware company had no physical presence in South Carolina. The court held that the Delaware company had established connections or nexus with South Carolina through the existence of ‘account receivable,' the presence of the company's logo (advertising), and a franchise in that state.

Other states have rejected the South Carolina approach. New Jersey, New Mexico, Massachusetts, Maryland, and Tennessee, for instance, have established their own approach in denial of the South Carolina's. In Syl, Inc. v. Comptroller of Treasury, No. C-96-0154-01 (1999), the Maryland court held that a Delaware company had not nexus in Maryland because it had no office, employees, property, or agents in that state. Similarly, New Jersey courts state that out-of-state companies must be physically present in the state before New Jersey can tax that corporation's income (Lanco Inc. v. Director, Division of Taxation No.5329-97 (N.J. Tax Ct. 2003).

The above examples show that some U.S. states are willing to tax out-of-state companies alleging substantial nexus on economical or intangible connections, no physical presence, with those states. Instead, other states expressly require physical presence or the presence of corporate agents in those states for corporate income to be levied.

Online Businesses & Corporate Taxes

Based on the above reasoning, states may levy corporate income taxes on out-of-state corporations, even e-businesses, if they are deemed to have sufficient nexus with the taxing state. Internet has been considerd an interstate commerce means. For online businesses, the question of physical presence has centered on where the company's server is located. Some jurisdictions consider that a company's server constitutes physical presence while others deny this position.

Thus, an e-business may be subject to corporate income tax in the state where the e-business' server is located but many factors need to be considered. First, the type of goods or services sold online; Second, whether the online company is incorporated within some specific state; Third, the state where the server is located and the states with which the online business will transact; Fourth, the server state position on what constitutes physical presence for the authorities of that particular state and whether a server provides physical presence; Fifth, the corporate tax approach of the states with which the e-business will deal; Sixth, if the e-business is engaged in selling goods, where the warehouse of that business is located. Warehouses are considered to establish physical presence. These are just few of the most important questions an online business entrepreneur must ask.

Hence, the logical procedure for a start-up e-business is to incorporate its business in the same state where its server and the warehouse, if any, will be located. This first step, at least, provides certainty as to primary corporate taxes. Then, the business entrepreneur must consider the specific states it will deal with and their positions on corporate taxes.