State Income Tax Nexus for Foreign Sellers
Your adviser told you there is no permanent establishment, so there is no U.S. tax. That conclusion may be entirely correct and still leave you with returns to file and tax to pay in three or four American states. The federal government and the states are separate taxing sovereigns, they ask different questions, and the treaty your position rests on generally answers only one of them.
Federal and state taxation are two systems, not one system with two levels
A non-resident approaching the United States usually pictures a single tax authority. There are fifty-one. The Internal Revenue Service administers the federal income tax under the Internal Revenue Code. Each state administers its own tax under its own statute, with its own definition of who is taxable, its own measure of income, and its own filing calendar. A handful of states impose no tax on business income at all, several impose a tax measured by something other than income, and the rest impose a corporate income tax that looks superficially like the federal one and differs from it in every detail that matters to you.
The federal question is whether you are engaged in a U.S. trade or business and have income effectively connected with it, and then, if a treaty applies, whether you have a permanent establishment. The state question is whether your contact with that particular state is sufficient for it to tax you, under that state's statute and the limits the United States Constitution places on state taxation of interstate and foreign commerce. Neither answer determines the other. It is entirely ordinary for a foreign company to owe nothing federally and to owe something in a state, and the reverse happens too.
| Federal income tax | State income or franchise tax |
|---|---|
| One authority, one statute, one return | A separate authority, statute and return in each state where you are taxable |
| Trade or business and effectively connected income, then permanent establishment if a treaty applies | Nexus under that state's statute, within constitutional limits |
| Treaty relief available where the treaty is satisfied | Treaty relief generally unavailable unless the state chooses to allow it |
| Net income measured under the Internal Revenue Code | Net income, gross receipts, net worth or capital, depending on the state |
| Federal protections apply nationwide | A federal statute protects one narrow category of activity, described below |
Why a treaty usually stops at the federal line
Income tax treaties are agreements between the United States and another country. The taxes covered article of a typical U.S. convention lists the federal income taxes imposed by the Internal Revenue Code, sometimes with a named federal excise tax. It does not list state taxes, and the states are not parties to the agreement. So the permanent establishment article, the business profits article, and the reduced withholding rates are all federal instruments.
What happens at state level then depends on how the state built its own statute, and there are broadly three patterns.
Some states start their computation from federal taxable income as reported on the federal return. Where a treaty has already removed an item from federal taxable income, that removal can carry through to the state base by mechanical operation, not because the state honours the treaty but because it borrowed the federal number. Other states start from federal taxable income and then require treaty-exempt income to be added back expressly, which restores the item to the state base. And a third group defines income independently, or requires a foreign corporation to compute a hypothetical federal taxable income as if no treaty existed, which produces the same result by a different route.
The practical consequence is that the answer is state specific and has to be read out of the state's own statute and instructions. Nobody can tell you from your treaty alone whether a state will respect it. Anyone who does tell you that has not looked.
What actually creates nexus for a state income tax
Two limits apply to every state tax on a business operating across borders. Due process requires a minimum connection between the state and the person or activity taxed. The commerce clause requires that the tax apply to an activity with a substantial connection to the state, that it be fairly apportioned, that it not discriminate against interstate commerce, and that it be fairly related to services the state provides. Those are the outer boundaries. Within them, each state writes its own rule.
The traditional trigger is physical: people, property, or activity inside the state. For a foreign seller that usually means one of a short list of things.
- An employee, an officer, or a person you treat as a contractor working from inside the state.
- Inventory held in the state, including inventory in a third party fulfilment centre you do not control and may not have chosen.
- Leased or owned space, including a small office, a showroom, or storage.
- Owned equipment located in the state.
- Repeated in-person activity: installation, training, warranty work, service calls, trade show selling beyond a threshold of days.
The newer trigger is economic. Many states now assert that a business is taxable if its receipts sourced to the state exceed a stated amount, or if its in-state property, payroll, or sales exceed stated thresholds, whether or not anyone or anything of yours is physically present. These are commonly called factor presence or economic nexus standards. South Dakota v. Wayfair, Inc. (2018), which concerned sales tax rather than income tax, removed physical presence as a constitutional requirement for that tax and has emboldened states in the income tax space as well.
Do not plan around a particular number. The thresholds differ from state to state, some are indexed and move annually, some are measured on the current year and some on the prior year, and states amend them. What is durable is the shape of the rule: sales into a state, on their own, can make you taxable there.
The one federal protection, and how narrow it really is
There is a federal law that restricts state taxation, and it is routinely oversold. Public Law 86-272 prohibits a state from imposing a net income tax on income derived from within the state from interstate commerce where the only business activity in the state is the solicitation of orders for sales of tangible personal property, provided the orders are sent outside the state for approval or rejection and, if approved, are filled by shipment or delivery from a point outside the state.
Read the conditions rather than the headline. Five of them do real work.
It protects against net income taxes only. A tax measured by gross receipts is not a net income tax. Neither is a tax measured by net worth or capital, nor a fixed minimum tax or annual fee. None of those are within the statute.
It covers tangible personal property only. Services, software delivered as a service, digital products, licensing, rentals, and real property transactions are all outside it. For a large part of the modern inbound client base the statute simply does not engage.
It covers solicitation. Activities that are entirely ancillary to requesting orders are treated as within the protection. Activities that serve an independent business function are not, and they cost the protection even if they are small. Carrying inventory, making repairs, accepting returns in the state, approving orders in the state, and providing technical assistance beyond a sales context have all been treated by states as going beyond solicitation.
Registration and filing survive it. The statute limits the imposition of tax. It does not, of itself, relieve you of a state's requirement to register or to file a return reporting that you are claiming its protection. Several states expect exactly that filing.
Its application to internet activity is genuinely unsettled. The Multistate Tax Commission revised its interpretive statement in 2021 to take the position that a range of ordinary website activity, including certain cookies, in-app or on-page interaction with customers, and post-sale assistance delivered electronically, exceeds solicitation. Several states have adopted that position, some by regulation and some by administrative guidance, and it has been litigated. This is an area in flux. Anyone relying on Public Law 86-272 for a business with a substantial U.S.-facing website should confirm the position in each relevant state at the time they rely on it, not at the time they read about it.
The independent contractor rule is the part of the law that still surprises people favourably: a seller of goods does not lose the protection merely because independent contractors, as defined, make sales or maintain an office in the state on its behalf. That rule is narrow, it applies to independent contractors and not to employees, and it does not extend the statute to services or to intangibles.
Franchise, gross receipts and minimum taxes sit outside both protections
Several states impose a tax that is not an income tax at all. Some are measured by gross receipts, so they are owed whether the business is profitable or not, and a loss year produces a bill. Some are measured by net worth or by capital employed in the state. Some impose a flat annual amount on any entity registered or doing business there. Some do all three in combination with an income tax.
These matter to a foreign seller for two reasons. A treaty does not reach them, because they are neither federal nor, in several cases, taxes on income. And Public Law 86-272 does not reach them either, because it is limited to net income taxes. So the goods seller who is confident of federal and Public Law 86-272 protection can still find a gross receipts liability sitting on the same sales.
How a state measures what it says is its share
Once a state can tax you, it takes a portion of your income by apportionment rather than by tracing. The dominant modern approach weights or uses exclusively the sales factor, which is receipts sourced to the state over total receipts. That design is deliberate: it shifts tax toward businesses that sell into a state without employing anyone there.
How receipts are sourced then matters more than anything else in the computation. For sales of tangible goods, the destination of delivery generally governs. For services and intangibles, states have moved substantially toward market-based sourcing, meaning the receipt is assigned to where the customer receives the benefit, with a hierarchy of rules for identifying that place when it is not obvious. Older cost-of-performance approaches, which assign the receipt to where the seller did the work, still exist in places and produce opposite answers for a foreign provider.
Two mechanics affect foreign sellers specifically. Throwback and throwout rules deal with sales into a state where the seller is not taxable, either reassigning those receipts back to the origin state or removing them from the denominator. If you have no U.S. origin state, there is often nothing for a receipt to be thrown back to, which can work in your favour and is a fact worth establishing deliberately rather than discovering. Separately, a few states use combined reporting that can pull affiliated entities into a single group return, usually with a water's edge limitation that excludes most foreign affiliates, and with exceptions in some states for entities in listed jurisdictions. Whether your group is inside or outside a combined filing is a structural question that should be answered before the first return rather than in an audit.
What an unfiled state return actually costs
This is the part that turns a modest exposure into a serious one. A statute of limitations on assessment generally starts running when a return is filed. Where no return has ever been filed, in most states nothing starts running, and the state can look back to the first year in which you were taxable. Ten years of small liabilities, with penalties and interest compounding on each, is a materially different problem from the tax itself.
The standard remediation is a voluntary disclosure agreement. States operate these programmes in broadly similar form: an anonymous approach through a representative, a limited lookback period rather than an open one, filing and payment for the periods within that lookback, and abatement of some or all penalties. Interest is usually not waived. The critical structural feature is that these programmes are available only before the state contacts you. A notice arriving first closes the door, which is why an exposure identified quietly is worth a great deal more than the same exposure identified by a state.
Note also that registering to do business with a Secretary of State is a legal question, distinct from tax nexus, with its own consequences for contract enforceability and service of process. That belongs with your attorney. The firm coordinates with counsel on it; it does not answer it.
Building a state exposure map before a state builds one for you
The work here is unglamorous and it is mostly assembly. For a defensible picture you need four lists.
- People. Every individual performing work for you from a U.S. location, employee or contractor, with the state and the dates. Contractor status is a separate question with its own consequences and it does not automatically protect you.
- Property. Every U.S. location holding your inventory or equipment, including third party warehouses and fulfilment centres, with the periods held. Ask your logistics provider for the location history rather than assuming it.
- Receipts by state. Your U.S. sales broken down by the customer's ship-to or benefit location, by year, for at least the last several years. Most foreign sellers have never produced this and most can produce it from existing platform data in a day.
- Character of what you sell in each state. Tangible goods, services, software, or licensed rights, because that decides whether Public Law 86-272 is even in play and how receipts are sourced.
With those four lists a state by state assessment is a mechanical exercise. Without them it is guesswork. Where an exposure appears, the sequence is to quantify it, decide whether a voluntary disclosure is the right route, and only then register and begin filing prospectively; registering first in a state where you have prior year exposure can foreclose the better remediation path.
One related question sits alongside this one: whether your U.S. activity rises to a federal trade or business or a permanent establishment is a separate federal question, addressed through the exposure analysis pillar.
This is general information about how state taxing regimes are structured. Thresholds, rates, and sourcing rules vary by state and change, so no figure should be relied on without confirming it for the specific state and year. It is not advice on your situation, and questions about legal registration or entity qualification belong with your attorney.