State Tax Traps for Debt Collection Agencies

Whether operating as third-party agencies or debt buyers, companies that engage in collection activities in multiple jurisdictions face the issue of determining in which states they must file local returns and pay income tax.

When does a state have authority to tax a business that operates in multiple states? The term “nexus” defines the minimum level of contacts that a taxpayer must have with a state in order for that jurisdiction to impose a local tax. Thus, when a company has sufficient activities within a state to be lawfully taxed by that state, the taxpayer is said to have “nexus” with that state.

Under federal law, an out-of-state seller may engage in certain limited in-state activities without triggering nexus in the state. However, the activities of a debt collector typically consist of services and would not qualify for the protection granted to sellers of tangible personal property. As a consequence, when collecting accounts from debtors located in multiple states, the performance of any activity in the territory of a state – including filing debt collection actions – may easily result in an income tax filing requirement.

Some taxpayers have been successful in limiting their state tax exposure by hiring local service providers to perform in-state activities. The Commissioner of the Virginia Department of Taxation ruled that a collection agency that collected receivables on behalf of its clients did not have nexus when its activities were limited to making phone calls and writing to debtors in the state. When the taxpayer was unable to collect, it would hire a Virginia attorney and forward the receivable to a collection agency in Virginia. The Commissioner upheld a previous position of the Department that the provision of services in Virginia by an independent contractor on behalf of the taxpayer would not create nexus, as long as the contractor actually acts as an independent vendor.

The same scenario would probably result in a different outcome when the taxpayer has substantial control over the activities of the local service provider, for example because they are part of the same affiliated group. In addition, a number of states have recently adopted expanded definitions of nexus – so-called “economic nexus” – that tend to disregard the physical presence test and focus on the willful direction of business in the state. While many have argued that such departure from the physical presence standard violates the U.S. Constitution, the U.S. Supreme Court has so far declined to settle the matter.

Thus, the question arises whether nexus can be found even in the absence of physical presence, direct or indirect, of the taxpayer, because, for example, collection activities are limited to correspondence and calls from outside the state. While the issue of nexus is various and changing, debt collectors will want to look carefully at those jurisdictions where they have a substantial client base, as the new statutes may trigger “nexus traps.”

For instance, in 2011, California enacted a new “doing business” test that attributes nexus to out of state businesses that have sales to customers in the State in excess of $500,000 or 25% of the taxpayer’s total sales. For purposes of sourcing sales of services, such as collection services, California applies the market-based approach, which sources the sale to the state where the person receiving the benefit is located. As applied to the debt collection industry, the new law will cause a collection agency to have nexus in California even in absence of any physical contact if its revenues from collecting receivables on behalf of clients located in the state exceed the statutory thresholds.

As states become more and more aggressive in targeting out-of-state businesses, it becomes increasingly important for companies operating in the collection industry to be aware of possible income tax exposure when they operate in multiple jurisdictions. Collectors should strive to implement local tax strategies that minimize risks associated with state nexus and ensure effective compliance at the local level.

Pietro M. Stuardi, CPA is a senior tax associate at Holtz Rubenstein Reminick LLP, specializing in international taxation and state and local taxes. He also is a member of the firm’s manufacturing and distribution group. 

Mr. Stuardi is a CPA licensed in New York State and a member of the American Institute of CPAs (AICPA). He earned a Bachelor in Accounting and Business Management and a Master in Business Administration at the University of Torino, Italy. He completed his studies in Accounting and Taxation at Pace University, New York.