State Tax Nexus: When Foreign Investors Owe State Taxes

What Is Nexus?

Nexus is the legal connection between you and a state that gives that state the right to tax your income. Unlike federal taxes, which apply uniformly across the country, state taxes only apply when you have sufficient connection - nexus - with that state.

For foreign investors, understanding nexus is critical because different investment activities create different levels of connection with different states. Getting this wrong can result in unexpected tax bills, penalties, and interest.

Types of Nexus

Physical Presence Nexus

The traditional standard. You have nexus if you (or your employees) are physically present in the state conducting business activities. For foreign investors, this can include:

• Owning real property in the state
• Operating a business with employees in the state
• Having inventory stored in the state
• Regularly traveling to the state for business meetings

Economic Nexus

Following the Supreme Court's Wayfair decision (2018), states can tax businesses with significant economic activity in the state, even without physical presence. Thresholds typically range from $100,000 to $500,000 in sales or 200 transactions.

Affiliate/Agency Nexus

Using an in-state representative, agent, or affiliate to conduct business can create nexus. This includes using a local property manager, attorney acting as your agent, or marketing partner.

Common Nexus Triggers for Foreign Investors

States With No Income Tax

Nine states impose no individual income tax. For certain investment structures, operating in these states can eliminate state-level taxation entirely:

High-Tax States to Watch

If you have nexus in these states, be prepared for significant state tax obligations:

Real Estate Investors: State-by-State Considerations

When you own rental property in a state, you automatically have nexus and must file a nonresident return reporting that rental income. Key considerations:

Apportionment

If you operate in multiple states, income is typically apportioned based on factors like sales, payroll, and property location. For real estate, the income is generally sourced entirely to where the property is located.

Pass-Through Entity Taxes

Many states now offer optional pass-through entity (PTE) taxes that allow the entity to pay state tax, providing a federal deduction that circumvents the $10,000 SALT cap. If you invest through an LLC or partnership, ask about PTE elections.

Composite Returns and Withholding

Many states require withholding on income paid to nonresident partners or LLC members. Some also allow or require composite returns where the entity files and pays on behalf of all nonresident owners.

States With Nonresident Withholding

• California: 7% withholding on distributions to nonresidents
• New York: Composite return or individual filing required
• Illinois: 4.95% withholding requirement
• Georgia: 4% withholding on nonresident distributions
• Many others: Requirements vary by state

Avoiding Unintended Nexus

Careful planning can minimize state tax exposure. Consider these strategies:

1. Choose entity state wisely: Delaware and Wyoming are popular for formation, but your activities may create nexus elsewhere regardless.
2. Limit physical presence: Avoid having employees, inventory, or offices in high-tax states unless necessary.
3. Monitor economic nexus thresholds: Track sales by state to avoid surprise nexus creation.
4. Structure property holdings carefully: Multi-state real estate portfolios may benefit from state-specific entities.
5. Document business activities: Keep records of where activities occur to support sourcing positions.

State Tax and Federal Tax Interaction

State taxes paid can sometimes be deducted for federal purposes, but the Tax Cuts and Jobs Act capped the State and Local Tax (SALT) deduction at $10,000 for individuals. For foreign investors filing 1040-NR, you may not get full benefit from state taxes paid.

However, if you operate through a pass-through entity with a PTE tax election, the entity-level tax payment is not subject to the SALT cap, potentially providing significant savings.

How I Help Foreign Investors Navigate State Taxes

State tax compliance is complex, especially when you have activities in multiple states. When you work with me, I help you:

• Identify which states you have nexus with
• Determine filing requirements in each state
• Evaluate composite return versus individual filing options
• Structure investments to minimize state tax exposure
• Analyze pass-through entity tax elections
• Coordinate state and federal tax planning