18.4 State and Local Tax: Nexus, Allocation, Apportionment
Key Takeaways
- Nexus is the Due Process (minimum contacts / purposeful availment) and Commerce Clause (substantial nexus) connection that lets a state tax; it is not the apportionment fraction.
- Public Law 86-272 is a federal safe harbor from state net income tax when in-state activity is only solicitation of orders for sales of tangible personal property, with orders approved and filled from outside the state.
- UDITPA allocates nonbusiness income entirely to one state and apportions business income among states by formula.
- Classic equally weighted three-factor apportionment is (property + payroll + sales) / 3; many states now use a single sales factor.
- Federal taxable income of $500,000 with sales 0.40, property 0.20, and payroll 0.20, equally weighted, apportions at 0.2667 and produces $133,333 of state taxable income.
18.4 State and Local Tax: Nexus, Allocation, Apportionment
REG Area V, Group B, Topic 2 is state and local tax. The Blueprint asks you to define the general concept and rationale of nexus, define apportionment and allocation, and calculate state taxable income using the applicable apportionment factors. Federal taxable income from Sections 18.2 and 18.3 is the usual starting point; states then decide how much of that income they may tax.
Nexus
Nexus is the connection that allows a state to tax a corporation at all. Two federal constitutional floors sit under every state's statute.
Due Process requires minimum contacts and purposeful availment — the corporation has directed activity at the state so that taxing it is not a surprise.
The Commerce Clause requires substantial nexus and, under Complete Auto Transit, fair apportionment, nondiscrimination, and a fair relationship to services the state provides. South Dakota v. Wayfair (2018) confirmed that physical presence is not required for substantial nexus in the sales-and-use-tax setting; economic nexus (receipts or transaction counts) can suffice. Many states now apply economic-nexus ideas to income tax as well, alongside older physical-presence tests (property, payroll, in-state employees, inventory).
Nexus is not apportionment. Nexus answers whether the state may tax. Apportionment answers how much income that state may tax once nexus exists. A corporation can have nexus in a state and still apportion only a sliver of its income there if its factors in that state are small.
Public Law 86-272
Public Law 86-272 is a federal statute that preempts state net income tax in a narrow safe harbor. If the taxpayer's only activity in the state is solicitation of orders for sales of tangible personal property, and those orders are sent outside the state for approval and filled by shipment from outside the state, the state generally cannot impose a net income tax.
The protection is narrow:
- It covers tangible personal property, not services, intangibles, or digital products.
- It covers solicitation, not a warehouse, a repair function, in-state employees who hire or train beyond solicitation, or local credit approval.
- It is a shield against net income tax, not against sales-and-use tax, gross-receipts taxes, or franchise taxes measured other than by net income.
Crossing the line — leaving inventory, collecting delinquent accounts, or making repairs — loses the safe harbor. REG will give a fact pattern and ask whether 86-272 still applies. Independent contractors who only solicit TPP orders typically stay inside the harbor; a company office in the state typically does not.
Allocation versus apportionment (UDITPA)
The Uniform Division of Income for Tax Purposes Act (UDITPA) is the Blueprint's conceptual model. Many states have modified it, but the vocabulary is stable.
Business income — income from the regular trade or business, and income from property that is an integral part of that business — is apportioned: split among states by formula.
Nonbusiness income — typically isolated investment income, or rents and royalties from property not used in the business — is allocated: assigned entirely to one state. Real and tangible property rents and royalties generally go to the situs of the property. Interest and dividends often go to the taxpayer's commercial domicile.
Do not apportion a nonbusiness rent, and do not allocate operating profit from the assembly line. The classification drives the math. REG will usually tell you, or make obvious, which items are business income.
Factors: three-factor, single-sales, throwback
Classic UDITPA uses an equally weighted three-factor formula:
Apportionment fraction = (property factor + payroll factor + sales factor) / 3
Each factor is in-state over everywhere:
- Property: average in-state property / average everywhere property (usually original cost of real and tangible personal property; rented property is often included at eight times annual rent).
- Payroll: in-state compensation / everywhere compensation.
- Sales: in-state sales / everywhere sales. Tangible personal property is generally destination-sourced — the state where the purchaser takes delivery.
Many states have moved to a single sales factor — the sales factor is the apportionment fraction — to weight the destination of customers more than the location of plant and payroll. REG will tell you which formula to apply. Do not assume single-sales unless the facts say so.
Throwback. If a sale of tangible personal property is destination-sourced to a state where the taxpayer is not taxable (no nexus, or protected by Public Law 86-272), a throwback rule in the origin state pulls that sale back into the origin state's sales-factor numerator. Throwback exists to prevent nowhere sales that would otherwise sit in the denominator everywhere and the numerator nowhere. Not every state throws back; apply it when the facts say the origin state uses throwback.
Worked: federal taxable income $500,000, equally weighted factors
Facts. The corporation has nexus in State X. No nonbusiness income is identified, so the entire federal taxable income of $500,000 is apportionable business income. State X uses equally weighted property, payroll, and sales factors. The given factors are:
| Factor | Amount |
|---|---|
| Sales | 0.40 |
| Property | 0.20 |
| Payroll | 0.20 |
Apportionment fraction = (0.40 + 0.20 + 0.20) / 3 = 0.80 / 3 = 0.2667 (rounded; exactly 4/15).
State X taxable income = $500,000 × (0.80 / 3) = $133,333.
Traps: using only the sales factor ($500,000 × 0.40 = $200,000), summing the factors without dividing by three ($500,000 × 0.80 = $400,000), or picking a single 0.20 factor ($100,000). If State X used a single sales factor, the answer would be $200,000 — but the facts said equally weighted.
If $50,000 of the $500,000 had been nonbusiness interest allocated to commercial domicile in another state, only $450,000 would have been multiplied by 0.2667. Allocation happens before the fraction is applied.
A C corporation has $500,000 of federal taxable income, all business income, and nexus in State X. State X uses equally weighted property, payroll, and sales factors of 0.20, 0.20, and 0.40. What is State X taxable income?
Which activity is generally protected by Public Law 86-272 from a state's net income tax?
Under the UDITPA model, which statement correctly distinguishes allocation from apportionment?