Taxpayer Created Income Tax Nexus from Licensing Software to Wisconsin Users

At a glance

• The main takeaway: In Wisconsin, a taxpayer created income tax nexus without any physical presence based on the licensing of software for use by customers located in the state. 
• Assess the impact: It’s important to remember that any activity that generates revenue or income derived from a state could give rise to income tax nexus.
• Take the next step: Aprio’s State and Local Tax (SALT) team can assist your business with understanding where you may have income tax nexus risks, so you do not incur unexpected tax liabilities and penalties.

Schedule a free consultation today to learn more!

The full story:

Unlike sales tax economic nexus rules (and except for the states that have factor-presence nexus rules for income tax), the nexus guidance for income tax is not always clear, particularly in the absence of physical presence. While states may be constitutionally permitted to impose income tax based on economic nexus, what types of activities and/or the amount of revenue required to trigger nexus is subject to state interpretation. A recently published Wisconsin Tax Appeals Commission ruling illustrates the application of income tax economic nexus.[1]

A closer look at the case

During the tax years involved in this appeal (2012 to 2018), Michael Kuta, a nonresident of Wisconsin, was the sole owner of Kuta Software, LLC (the LLC). Based in Maryland with no physical presence in Wisconsin, the LLC developed and licensed educational software to assist schools and educators when teaching math to students. From 2012 to 2015, the LLC was treated as a disregarded entity for income tax purposes, so Michael Kuta reported the income from the business on his individual return, IRS Form 1040, Schedule C. Effective January 1, 2016, the LLC elected to be treated as an S-corporation, and thus for tax years 2016 to 2018, the business income was reported on IRS Form 1120-S.

The business licensed the right to use the software to its customers and it did not sell any of the copyrights. Customers could purchase a license either online, by phone, or by submitting an order form to the LLC by email, fax or mail to the company’s Maryland address. The software was available via online download or by mail delivery from Maryland via a compact disc containing the software. The licenses were either single-user, meaning they were lifetime licenses that did not expire, or they were site-licenses that generally had a standard term of three years and were renewable. The license agreement specified that the customer owned any tangible media on which the software was delivered, but that the company retained ownership of the software. In addition, the Taxpayer provided customer support from its Maryland location to Wisconsin users.

During the years at issue, the business generated between $17,000 and $32,000 of licensing revenue from Wisconsin customers, and the percentage of Wisconsin revenue ranged from 0.8% to 1.37%.

The ruling explained

As the result of an audit, the state assessed Michael Kuta directly for state individual income tax for tax years 2012 to 2015, claiming that he had income tax nexus with Wisconsin based on the activities of the business. For 2016 to 2018, the state also assessed the LLC for failure to pay nonresident withholding taxes on the basis that the LLC had nexus with Wisconsin due to the activities of the business.

Wisconsin imposes individual taxes on nonresidents upon “income as is derived from property located or business transacted within the state.”[2] For purposes of determining whether a nonresident’s income is from Wisconsin sources, the statute states that “Gross receipts from the use of computer software are in this state if the purchaser or licensee uses the computer software at a location in this state.”[3]

For corporate income tax purposes, Wisconsin imposes tax on corporations and a withholding tax on pass-through entities with nonresident owners that are “doing business in this state,” which includes “regularly selling products or services of any kind or nature to customers in this state that receive the product or service in this state; regularly soliciting business from potential customers in this state; regularly performing services outside this state for which the benefits are received in this state; regularly engaging in transactions with customers in this state that involve intangible property and result in receipts flowing to the taxpayer from within this state.”[4] Similar to the personal income tax, Wisconsin sources gross receipts from the use of computer software to the state “if the purchaser or licensee uses the computer software at a location in this state.”[5]

The main argument by the Taxpayer was that its sales of licenses for the use of its computer software constituted tangible personal property, and therefore he and his business are protected from income tax nexus under P.L. 86-272. The Commission disagreed and viewed the licensing transactions as the sale of intangible personal property, notwithstanding the fact that software may be treated as tangible personal property for sales and use tax purposes.

Ultimately, the Commission viewed the licensing activity (i.e., lifetime or on three-year renewable terms) as “regularly engaging in transactions with customers in this state that involve intangible property and result in receipts flowing to the taxpayer from within this state” and the service activity as “regularly performing services outside this state for which the benefits are received in this state.” Accordingly, the Commission concluded that both Michael Kuta and Kuta Software, LLC had income tax nexus in Wisconsin and were subject to their respective taxes, notwithstanding the very low amount and percentage of revenue generated in Wisconsin.

The bottom line

Except for the states that have enacted factor-presence nexus thresholds, there are no specific quantitative thresholds for income tax economic nexus in the same manner that we have seen for sales tax following the Wayfair decision. Thus, any activity that generates revenues or income that is derived from a state could give rise to an income tax filing requirement, and absent a case such as this, state guidance is very limited. 

Aprio’s SALT team has experience with state income tax nexus issues. We can assist your business with understanding where it may have income tax nexus risks and a potential tax obligation so that you do not incur unexpected income tax liabilities and penalties. We constantly monitor these and other important state tax topics, and we will include any significant developments in future issues of the Aprio SALT Newsletter.

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[1] Kuta Software LLC, and Michael Kuta v. Wisconsin Department of Revenue, Docket Nos. 21-W-080, 21-W-081, and 21-I-082 (Wisc. Tax. App. Comm. July 28, 2023).

[2] Wisc. Stat. § 71.02(1).

[3] Wisc. Stat. § 71.04(7)(df).

[4] Wisc. Stat. § 71.22(1r), § 71.23(2), and § 71.775(2). In addition, Wis. Admin. Code § 2.82(4)(a) provides a list of activities that constitute nexus, and paragraph (9m) states “Licensing of intangible rights for use in Wisconsin.”

[5] Wisc. Stat. § 71.25(9)(df).