Multi-State Tax Obligations for Service Businesses: Nexus, Withholding, and Filing Requirements

A service business that operates in one state but serves clients in other states may have tax filing obligations in those other states. “Nexus” is the legal concept that determines whether a state can require a business to file returns and pay taxes. For service businesses, nexus is created by physical presence (traveling to client sites, having employees in a state) or economic presence (earning revenue from clients in a state above a threshold).

What happens when nexus is established?

When a service business has nexus in a state, the business may be required to:

1. For current guidance, see Streamlined Sales Tax Project. Register with the state (file for a state business license or registration)
2. File a state income tax return (apportioning a share of the business’s income to that state)
3. Withhold state income tax on employees who work in that state
4. Pay state estimated taxes if the apportioned income is significant
5. Collect and remit sales tax on taxable services (some states tax services)

Income apportionment for service businesses is typically based on where the service is performed, where the customer is located, or a combination (depending on the state’s apportionment formula). Most states use a market-based sourcing approach for services: the income is apportioned to the state where the customer receives the benefit of the service.

What about remote employees in other states?

A service business that hires a remote employee in another state creates nexus in that state for payroll tax purposes. The business must:

• Register for state withholding in the employee’s state
• Withhold state income tax from the employee’s wages
• Pay state unemployment insurance in the employee’s state
• File quarterly and annual payroll reports with that state

Some states have reciprocity agreements (employees in one state working for employers in another state pay tax only to their state of residence), which simplifies the withholding. States without reciprocity require the employer to withhold tax for the work state and the employee to file returns in both the work state and residence state.

What is a sales tax exemption certificate and when do I need one?

A resale certificate (or exemption certificate) allows you to purchase inventory or goods for resale without paying sales tax to the vendor. You collect sales tax from the end customer instead. The certificate must be kept on file by the seller as proof that tax was not required on the transaction. You are liable for the tax if you use a resale certificate to purchase items for personal use or for business use (not resale). Each state has its own certificate form, though many accept the Multistate Tax Commission’s Uniform Sales & Use Tax Certificate. Exemption certificates for other purposes (nonprofit, government, manufacturing) have additional requirements and are audited closely.

Related guides:

• Tax Implications of a Remote Workforce: Multi-State Payroll, Nexus, and Compliance

• Multi-State Income Allocation: How States Divide Your Business Income for Taxation

• State Franchise Tax Obligations for Small Businesses

• No Income Tax States for Business Owners: What You Actually Save (and What You Don’t)

• State Tax Nexus for Remote Businesses: When Remote Workers Create Filing Obligations

• State Pass-Through Entity Tax: The SALT Cap Workaround for S-Corp and Partnership Owners

• Sales Tax Nexus for Small Businesses: When You Must Collect and Remit

• Sales Tax on Services: Which States Tax Service Businesses and How to Comply

• Tax Implications of Remote Employees for Small Businesses

• Tax Implications of Remote Workers in Multiple States

Can a web design agency have sales tax nexus out of state?

It can, but sales tax nexus is its own test, separate from the income tax nexus this guide covers, and the numbers are higher than many owners expect. California’s remote seller test is sales of tangible goods for delivery there above $500,000 in the preceding or current calendar year. New York requires more than $500,000 and more than 100 sales of goods delivered there over four sales tax quarters.

So the agency in the example, with $80,000 of California clients and $50,000 of New York clients, sits well under both lines before you even ask whether its work counts as goods. Whether a given service is taxable is covered in sales tax on services.

Sending people into a state is different. Ohio’s statute presumes nexus when a seller regularly uses employees, agents or representatives in Ohio. P.L. 86-272 doesn’t change any of this, since it only limits state net income tax for sellers of tangible goods.

This guide is general information, not tax advice for your specific situation. Which points apply, and how, depends on your facts.