Are You Paying State Income Tax You Don't Owe?

AI tax tools are giving multistate services businesses a confident answer to the wrong question. Here's what the question actually is.

By Anthony Parent, J.D. | IRSMedic.com | Category: AI Fails

A client came to me with an output from a popular AI tax tool. They had asked whether their services platform — operating entirely out of one state, connecting customers with third-party providers — owed income tax to the states where their customers happened to be located.

The AI tool's answer was several hundred words long. It cited federal statutes, an advisory commission's policy statement, and something it called a "decision tree for internet sellers." It concluded that the business had no protection under federal law and needed to evaluate income tax filing obligations in every state where it had customers.

The analysis was not exactly wrong. It was an accurate answer to a question nobody asked.

The question the client actually needed answered — can these states legally tax our income, and if so how much of it — was never addressed. The tool found a federal statute that didn't apply, used it as the analytical frame anyway, cited an advisory body's recommendations as if they were binding court decisions, and then handed the client a conclusion that implied exposure in dozens of states without ever examining whether any of those states had a legitimate legal basis to tax a single dollar.

I see this constantly. And because the output looks thorough — it has citations, it has structure, it sounds authoritative — clients assume the analysis is complete. Often it is the beginning of the analysis dressed up as the end.

P.L. 86-272 and why it's the wrong starting point for a services business

The federal statute in question is Public Law 86-272, passed by Congress in 1959. It does one specific thing: it prevents states from imposing income tax on out-of-state businesses whose only in-state activity is sending salespeople to take orders for tangible goods, where those orders are fulfilled from outside the state. That's it. That is the entire scope of the law.

Congress passed it because states in the 1950s were starting to assert income tax jurisdiction over traveling salespeople who never did anything in a state except knock on doors and write up orders. Congress said that activity — soliciting orders for physical goods shipped in from elsewhere — could not be taxed. It was a narrow protection for a narrow situation that existed in 1959.

A services business asking about multistate income tax exposure in 2026 is not in that situation. P.L. 86-272 was not written for services businesses. Not because services businesses lose the protection — they were never in the statute. Applying P.L. 86-272 to a services business and then concluding "no protection applies" is like checking whether your boat is covered by a highway speed limit and concluding your boat must go 65. The speed limit simply governs a different thing.

The AI tool used P.L. 86-272 as its analytical framework, concluded the business fell outside it, and then proceeded as if that conclusion meant the states could freely tax the business's income. Those are two separate questions and the tool treated them as one.

The MTC Statement is not a law

The tool also cited extensively from something called the Multistate Tax Commission's 2021 Statement of Information. It quoted the MTC's "decision tree" as settling the question. It referenced specific sections of the Statement as if they had the force of regulation.

The MTC is an intergovernmental advisory body. Its Statement tells states how the MTC thinks they should interpret P.L. 86-272. States are free to adopt it, modify it, ignore it, or litigate against it. The MTC cannot bind any state to anything.

The legal reality around this particular Statement is that it is actively contested. California's Franchise Tax Board tried to adopt it through informal guidance and got sued. The California Superior Court threw out that adoption because informal guidance is not the same as a properly enacted regulation, and the FTB had skipped the required rulemaking process. Ohio applied the Statement retroactively to audits going back to 2014. Oregon hasn't adopted it at all. New York adopted its own version with different scope. Congress introduced a bill in 2025 — the Interstate Commerce Simplification Act — specifically to push back against state interpretations like the MTC's and reassert federal limits on state taxing authority.

When a tax tool presents a contested advisory document as the governing authority for a multistate income tax question, and presents that authority as uniform across all states, the output is going to mislead anyone who reads it at face value.

The actual legal framework

When P.L. 86-272 is irrelevant — which it is for any services business — the governing framework is the U.S. Constitution. Specifically, the Commerce Clause and fifty years of Supreme Court decisions applying it to state taxation of interstate commerce.

In Complete Auto Transit v. Brady, decided by the Supreme Court in 1977, the Court established the constitutional test that every state tax on interstate commerce must satisfy. The tax must be applied to activity with substantial nexus to the state. It must be fairly apportioned to reflect only the in-state portion of the business activity. It cannot discriminate against interstate commerce. And it must bear a fair relationship to the services the state actually provides to the taxpayer.

Every one of those four requirements is a potential argument against a state's assertion of income tax jurisdiction, and they have to be applied state by state on the actual facts of the business in question.

The fair apportionment requirement alone is significant and almost always underweighted in these analyses. Even if a state has legitimate nexus over a services business — and that's a big if — it can only tax the fairly apportioned fraction of income attributable to actual activity in that state. A business based in Connecticut with 4% of its revenue coming from customers in a particular state does not owe that state income tax on its entire revenue. It owes, at most, income tax on a small apportioned slice. State apportionment formulas vary, are complex, and are themselves subject to constitutional challenge when a state applies them in a way that over-reaches the in-state activity.

None of this appeared in the AI tool's output.

Fifty states are not one state

Beyond the constitutional framework, there is the basic reality that state tax law is not uniform. The AI tool's answer implied a single consistent set of rules that applied everywhere. There is no such thing.

Several states have no income tax at all. For a services business with customers in Texas, Florida, Nevada, or Wyoming, the income tax question simply does not arise. Several others have income taxes but economic nexus thresholds for services businesses that are high enough that a small or mid-sized operation never triggers them.

Among states that do assert economic nexus over services businesses, the specific threshold, the apportionment formula, the definition of in-state receipts, and the enforcement posture vary considerably. Some have formally adopted the MTC's 2021 internet activities guidance through proper rulemaking. Some have gestured at it administratively in ways that are legally vulnerable. Some have adopted entirely different standards through their own legislative process.

And then there is practical enforcement. A state can have a statutory position on paper that its revenue department has never meaningfully enforced against small out-of-state services businesses with no employees or property in the state. This matters. A sophisticated analysis accounts for the realistic audit probability given the business's size, profile, and footprint — not just the theoretical maximum exposure under the most aggressive reading of every state's most aggressive guidance.

A services business with customers in 40 states does not automatically face income tax exposure in 40 states. After eliminating states with no income tax, states below the economic nexus threshold, and states where enforcement is de minimis relative to the compliance cost, the realistic exposure is often concentrated in a small number of states that actually have both the legal basis and the practical capacity to assert it.

What a real analysis requires

The right approach to this question starts with the specific states at issue, not with a federal statute that doesn't apply. For each state that has potential nexus: what has that state actually enacted, not just recommended or gestured at? What does fair apportionment look like on these facts? Does the state's assertion of taxing authority satisfy Complete Auto's four-part constitutional test? What is the realistic enforcement probability? What does the compliance cost look like against the realistic exposure?

For some states the answer will be: you have exposure, it's meaningful, register and file. For others: you have theoretical exposure under the state's most aggressive interpretation, but that interpretation is legally vulnerable and the enforcement probability is low — document your position and revisit if the legal landscape shifts. For many: the question doesn't arise because the nexus threshold is never triggered.

That analysis produces a prioritized, defensible, honest picture of where the business actually has risk. The AI tool's answer produced an invitation to register and pay income tax in states that may have no legal basis to collect it.

States are more aggressive about interstate income tax claims than at any point in recent memory, and they count on businesses and their advisors not knowing where the legal limits actually are. Getting a confident-sounding answer from an AI tool and acting on it without scrutiny is exactly the outcome they're counting on.

If you've received this kind of analysis and you're not sure whether it reflects the law or just the most compliance-heavy interpretation of an advisory document, we're happy to take a look. Our Total Tax Diagnosis for businesses covers multistate income tax exposure as part of a complete picture of where you actually stand. Click here to get started.

Anthony Parent, J.D. is a tax attorney and founder of IRSMedic.com. He has represented over 3,000 clients in disputes with the IRS and state taxing authorities, including multistate tax issues, offshore compliance, criminal tax defense, and complex resolution cases. He is the author of IRS Confidential: The Largest Heist in American History…Exposed.

Disclaimer: This article is for educational purposes and does not constitute legal advice. State tax law varies by jurisdiction and changes frequently. Consult a qualified tax attorney to evaluate your specific situation.