Public Law 86-272: When a Seller of Goods Is Protected From State Net Income Tax, and When In-State Activity Ends the Protection

A state may not impose a net income tax on a company whose only in-state business activity is soliciting orders for sales of tangible personal property, if the orders are sent outside the state for approval and filled by shipment or delivery from outside the state. That is the rule of Public Law 86-272, codified at 15 U.S.C. 381. It protects against net income taxes only, and it is lost when the company does anything in the state beyond solicitation, including activity that looks minor. Tax preparers use it to answer one question for a multistate seller: does an income tax return have to be filed in this state?

What does the statute say?

Congress enacted the rule on September 14, 1959 (73 Stat. 555). Under section 381(a), a state may not impose a net income tax on income derived within the state from interstate commerce if the person's only business activities within the state are one or both of the following:

1. Solicitation of orders by the person or a representative in the state for sales of tangible personal property, where 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.
2. Solicitation of orders in the name of or for the benefit of a prospective customer, where the customer's orders to the person are of the type described in item 1.

All three elements in item 1 must hold. Solicitation, approval outside the state, and fulfillment from outside the state each have to be true. A sales representative who takes an order that the field office can accept on the spot, or goods shipped from an in-state warehouse, takes the company outside the statute.

What does the statute not cover?

The protection has edges that matter for a nexus review.

• Only tangible personal property. The statute speaks of sales of tangible personal property. Services are not described in section 381(a), so a seller of services cannot rely on it.
• Only net income taxes. Section 383 defines a net income tax as any tax imposed on, or measured by, net income. A sales tax, or a tax not measured by net income, is outside the statute. See sales tax nexus after Wayfair and the standard on state economic nexus for the separate sales tax analysis.
• Corporations and residents of the state. Section 381(b) preserves a state's power to tax a corporation incorporated under its laws and an individual domiciled in or resident of the state.

A client with a goods line and a services line therefore has a split analysis: the goods line may be protected for income tax while the services line is not.

What counts as solicitation? The Wrigley decision

The Supreme Court read the statute in Wisconsin Department of Revenue v. William Wrigley Jr. Co. (1992). It held that the company's Wisconsin activities went beyond solicitation of orders, so Wisconsin could tax its income.

The Court's test: protected activities are those entirely ancillary to requesting purchases, meaning they serve no independent business function apart from soliciting orders. The Court rejected an industry-practice test, and noted that protection is not limited to acts strictly essential to making a request. The Court also recognized a de minimis exception, asking whether an activity creates a nontrivial additional connection with the taxing state.

Applied to the facts in that case:

The unprotected activities were small relative to the company's other Wisconsin operations, yet the Court held they were not de minimis when taken together. The lesson for the file is that the analysis is cumulative: several small activities that each serve an independent business function can add up to more than a trivial connection.

How do independent contractors fit?

Section 381(c) provides that a company is not treated as doing business in a state in a taxable year merely because independent contractors sell or solicit orders for tangible personal property there on its behalf, or because independent contractors maintain an in-state office. The office safe harbor holds only if the contractors' in-state activities consist solely of making sales or soliciting sales orders for tangible personal property.

Section 381(d) defines an independent contractor as a commission agent, broker or similar intermediary who sells or solicits orders for more than one principal and holds itself out that way. A "representative" does not include an independent contractor. An employee who works from a home office in the state is a representative, not an independent contractor, so the question becomes whether that employee does anything beyond solicitation.

A worked review of a seller

A client manufactures furniture in State A. Employees travel to State B, call on retailers, and send purchase orders to the State A headquarters for approval. Approved orders ship from the State A plant. The sales employees hold a sales meeting each quarter in a rented hotel room.

Each element of section 381(a)(1) holds, and the hotel meetings match the kind of activity Wrigley treated as protected. State B cannot impose a net income tax.

Now change the facts in three ways, one at a time:

1. The company stocks inventory in a rented State B warehouse to speed up deliveries. Goods are no longer filled from a point outside the state, and storage space was an unprotected activity in Wrigley.
2. The sales employees repair damaged product at the retailer's store. Servicing has an independent business function.
3. The company adds a paid installation service performed by its own technicians in State B. Services are not within the statute's description of protected activity, and the technicians' work is not solicitation.

Any one of these changes ends the protection for the state. The state may then tax an apportioned share of net income, subject to its own nexus and apportionment rules.

What belongs in the nexus workpaper?

1. Activity inventory by state. Who travels there, for what, and how long, with employee names and titles.
2. Order flow documentation. Where orders are approved and where goods ship from, with sample invoices.
3. Inventory and property. Any warehouse, consignment stock, display racks or demonstration equipment in the state.
4. Post-sale activity. Installation, repair, training, collections and customer service performed in the state.
5. Contractor analysis. Whether any in-state agent meets the independent contractor definition in section 381(d).
6. Revenue split. Goods versus services, so the protected and unprotected streams are separate.
7. The state's own position. Whether the state has published guidance on the statute, and any current notice.

Tie the conclusion to the state return filing decision and keep the facts memo for each tax year. For the entity-level choices clients face when they expand into multiple states, see S corporation vs LLC.

CORAA prepares ready-to-review audit files for US CPA firms; see /us.

Sources

• Legal Information Institute, 15 U.S.C. 381, Imposition of net income tax: https://www.law.cornell.edu/uscode/text/15/381
• Legal Information Institute, 15 U.S.C. 383, Definitions: https://www.law.cornell.edu/uscode/text/15/383
• Legal Information Institute, Wisconsin Department of Revenue v. William Wrigley Jr. Co., 505 U.S. 214 (1992): https://www.law.cornell.edu/supremecourt/text/505/214

AU-C references are to AICPA Professional Standards, paraphrased here; read the standard itself before relying on a requirement. This page is guidance, not professional advice. Report an error