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States Get Aggressive With Self-Employed Nonresidents

Seven years ago Hilary LaMonte, then a resident of Virginia, made a mistake: She failed to file an Iowa state tax return. She repeated the mistake in each of the following two years. Now she owes Iowa around $35,000, according to a Letter of Findings from the state’s Department of Revenue.

From 2003 to 2005, LaMonte worked as an independent contractor for the Iowa Association of School Boards, receiving between $82,000 and $85,000 each year in compensation. While LaMonte did the majority of the work for the Association in her home state, she also traveled periodically to Iowa for on-site visits. According to the Letter of Findings, she spent 15 to 20 percent of her time working on the contract in Iowa each year.

LaMonte didn’t file an Iowa return for any of the years in question, but she did receive Form 1099s from the Association, which indicated the amounts she had been paid. While later combing through old 1099s, the Iowa tax authorities noticed that she had received payment from an entity in Iowa but had not filed a return. In 2009, they sent her a letter pointing out that she may have been required to file. A few months later, “after a series of correspondences,” as the Letter of Findings puts it, they sent her a bill.

LaMonte acknowledged that she should have paid some taxes to Iowa. But she argued that she should owe taxes only on the fraction of her income equivalent to the fraction of time she’d actually spent in the state — 15 to 20 percent of the $82,000 to $85,000 she received each year. She cited a section of Iowa’s Administrative Code that states, “The salary or other compensation of an employee or corporate officer who performs services related to businesses located in Iowa, or has an office in Iowa, are not subject to Iowa tax, if the services are performed while the taxpayer is outside of Iowa.”

The Department of Revenue, however, countered that this section relates only to employees. Since LaMonte was instead operating as a self-employed individual, the department said that she was subject to the rules governing businesses, not employees. And, according to another section of state law, nonresident business income is subject to Iowa tax if the business “transacts business both within and without the state” and “the recipient of the service receives benefit of the service in this state.” (This standard does not apply to income from “the manufacture or sale of tangible personal property.”) Based on this, the Department claimed that LaMonte owed Iowa tax on all the income she received from the Iowa Association of School Boards, whether she was in Iowa when she did the work or not.

Iowa’s position is aggressive, but probably not too aggressive. It would have at least a decent chance of surviving a court challenge. The key is that LaMonte conducted some of her business within Iowa’s borders. By performing her on-site visits within the state, she created the “nexus” (to use the technical language) that gave the state jurisdiction to tax her.

The Supreme Court has held that a state must have at least some direct connection to a taxpayer in order to gain nexus. States push the envelope to try to claim nexus every way they can. In LaMonte’s case, her presence in the state of Iowa left no doubt about nexus.

There would still have been a question about whether Iowa’s rule, allocating service income based on the location of the service recipient rather than the service provider, could survive a challenge. Reading Iowa’s rules literally, the state could claim LaMonte owed Iowa tax even if she had never set foot in the state. Such a claim would probably run afoul of the Supreme Court’s nexus standard. But when it ruled in LaMonte’s case, Iowa was careful to point out that nexus was not an issue. If LaMonte were to challenge Iowa, she would have to argue that the state was taxing an unreasonable share of her income, even though it has nexus. Her chances of winning the argument would be iffy, and as a practical matter, the costs of mounting such a challenge likely would not be justified by the taxes at stake.

Revenue-hungry states are now pushing nexus arguments as far as they can. In 2008, New York passed a law requiring online retailers, such as Amazon, to collect sales tax for the state if they have any affiliates in New York. The law defined these affiliates in such a broad way that hundreds of thousands of entities, from big publishers to tiny blogs, qualified as affiliates of Amazon. Amazon is challenging the law. As I wrote in 2009, I believe this stretch of the definition of nexus is unconstitutional. But since then, other states have followed in New York’s footsteps. Just this month, Amazon severed relations with websites in Connecticut because of a similar law passed there, and it has severed such relationships in other states as well.

LaMonte could have spared herself considerable expense and aggravation simply by filing an Iowa tax return. Even if she had only reported the part of her income from the school boards’ association she believed was taxable in Iowa, by filing the returns she would have triggered the statute of limitations. The state would have had only three years to come back and demand more money. By not filing, LaMonte never started the statutory clock, allowing Iowa all the time it wanted to find her.

Also, had she filed, LaMonte would have been able to claim a credit for the Iowa tax against her income taxes in Virginia. By this time, assuming she filed timely Virginia returns, the statutory deadline has passed. She cannot claim credit in Virginia, and her Iowa-sourced earnings will have been fully taxed by two different states.

We have long advised our clients to file returns if they have any significant physical presence in a state from which they derive income. When it comes to nonresident taxes, trying to slip through the cracks may be tempting, but it’s a mistake that might catch up with you years down the road. The new, more aggressive state posture toward nonresidents is likely to be with us for a long time. Taxpayers might as well ante up now, because waiting can be costly in the long run.

Larry M. Elkin is the founder and president of Palisades Hudson, and is based out of Palisades Hudson’s Fort Lauderdale, Florida headquarters. He wrote several of the chapters in the firm’s most recent book, The High Achiever’s Guide To Wealth. His contributions include Chapter 1, “Anyone Can Achieve Wealth,” and Chapter 19, “Assisting Aging Parents.” Larry was also among the authors of the firm’s previous book, Looking Ahead: Life, Family, Wealth and Business After 55.

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