For years, retailers conducting business through eCommerce were advised that states could not require them to collect and remit sales tax on online sales unless they were ‘doing business’ in a taxing state based on the tax laws of that state. This concept was referred to as a “nexus” based on a seller’s physical presence within a state. Therefore, a seller who is determined to have a physical presence within a state would be obligated to withhold and remit sales tax to the taxing state. Examples of physical presence included but were not limited to having employees working in a taxing state, placing sales agents in a taxing state, moving business property into a taxing state, or renting property in a taxing state.
Many online merchants avoided establishing a physical presence within a state by storing merchandise in third-party warehouses throughout the United States and utilizing third-party fulfillment centers to effectively fulfill orders. The physical presence test put local and interstate businesses with a physical presence at a competitive disadvantage. While businesses with a physical presence within a state were subject to the state’s sales tax withholding and remittance obligations, businesses without a physical presence within a state were not.
This past summer, the United States Supreme Court decided South Dakota v. Wayfair., et al., 138 S.Ct. 2080 (2018), which overruled Quill Corporation v. North Dakota, 504 U.S. 298 (1992). Quill held that a business could only be subject to a state’s sales tax rules if they were physically present within that state. The Supreme Court’s decision in Wayfair, in overruling Quill, will not only change the way online merchants conduct business to avoid collecting sales tax, it may also affect anyone who purchases goods online. States are now no longer bound by the concept of physical presence for purposes of collecting sales taxes. As a result of the Wayfair decision, in the near future, any online seller (large or small) transacting with an out of state buyer may have an obligation to withhold sales tax and remit sales tax to the buyer’s home state.
The Prior Supreme Court Decision Regarding Withholding Sales Tax and Remitting Sales Tax Imposed on Out of State Sellers
We begin our discussion with Quill Corporation v. North Dakota, 504 U.S. 298 (1992). In Quill, the North Dakota Department of Revenue wanted to collect sales tax from the Quill corporation. Quill was incorporated in the state of Delaware. It had offices and warehouses outside of North Dakota.
At issue was North Dakota’s sales tax law. North Dakota state law assessed a sales tax on property purchased for storage, use, or consumption in that state. The North Dakota sales tax law imposed an obligation to collect sales on any merchant which made “regular or systematic solicitations” in that state. The Supreme Court had to determine whether North Dakota’s sales tax law was constitutional. Two constitutional issues were raised: the Commerce Clause and the Due Process Clause. The Commerce Clause of Article 1, Section 8 of the United States Constitution empowers Congress to regulate commerce “among the several states.” Pursuant to the Commerce Clause, Congress has complete power to authorize or forbid state taxation affecting interstate commerce. The United States Supreme Court has stated that the Commerce Clause contains a negative or dormant Commerce Clause which prohibits certain types of state taxation. This is the case even when Congress has failed to enact legislation on point. In Quill, the North Dakota Department of Revenue took the position that since Congress failed to enact legislation governing sales tax of mail order catalog business, the state of North Dakota had a constitutional right under the Commerce Clause to enact its own laws as to what constitutes nexus for tax purposes. North Dakota developed its own rules as to what constitutes nexus and through its laws, North Dakota required the Quill Corporation to collect and remit tax on its mail order sales in that state.
Quill asserted that since it had no sales representatives in North Dakota and limited property in that state, it had no obligation to collect and remit any tax to North Dakota. The Supreme Court agreed with the Quill Corporation in that it had no obligation to collect and remit sales tax to North Dakota. The Supreme Court determined that North Dakota’s tax rules would have placed an illegal and undue burden on interstate commerce. The Supreme Court went on to say that the Commerce Clause of Constitution requires that sellers have “substantial nexus” with a taxing state and that the “Due Process Clause” of the Constitution only requires sellers have “minimum contacts” with a taxing state. A state tax will be valid under the Commerce Clause only if there is a substantial nexus between the activity or property taxed and the taxing state. Substantial nexus requires significant or substantial activity within the taxing state. The Supreme Court in Quill did not define the term “substantial nexus.” Even though the Supreme Court did not define the term “substantial nexus,” a few computer disks without more did not create a “substantial nexus” for the purposes of collecting sales tax.
In addressing the Due Process Clause, the Supreme Court stated that “[t]he Due Process Clause requires some definite link, some minimum connection, between a state and the person, property or transaction it seeks to tax, and that the income attributed to the state for tax purposes must be rationally related to values connected with the taxing state.” The Supreme Court disagreed with North Dakota and held that it did not have the legal right to require the Quill Corporation to register and collect use tax on sales shipped into North Dakota. North Dakota’s plan would have placed an illegal burden on interstate commerce. The Supreme Court seemed to take the position that from a historical matter, some type of physical presence was required to satisfy the Due Process Clause. This physical presence standard was supported in National Bellas Hess, Inc. v. Department of Revenue of State of Ill, 386 U.S. 753, 758 (1967) which created a bright line rule with regard to the collection of sales and use tax. Under the Quill holding, sales tax was collected on online purchases only if the online seller had a “physical presence” (property or employees) in the State.
South Dakota Sales Tax Law a Departure from the Prior North Dakota Tax Law
In 2016, South Dakota enacted a law which required out of state merchants to collect and remit sales tax “as if the seller had a physical presence in the State.” The obligation to collect sales tax from out of state retailers applies only if, on an annual basis, the retailer delivered more than $100,000 of goods or services or engaged in 200 or more separate transactions for delivery into the state.
The Supreme Court Issued a Landmark Decision in Wayfair Regarding Sales Tax and How it Affects eCommerce Sellers
In South Dakota v. Wayfair., Overstock.com, Inc., and Newegg, Inc., 138 S.Ct. 2080 (2018), the United States Supreme Court decided the constitutionality of South Dakota’s 2016 tax law. In this case, Wayfair lacked any physical presence in South Dakota. However, Wayfair’s online sales satisfied South Dakota’s statutory amount required to collect and remit sales taxes. Even though Wayfair satisfy the statutory amount required to collect sales tax, Wayfair refused to collect tax and remit sales tax to the South Dakota Department of Revenue. South Dakota sought a declaratory judgment in a state court. At the same time, Wayfair filed a motion in summary judgment citing Quill. The state court granted Wayfair’s motion for a summary judgment which was affirmed by the South Dakota Supreme Court. This resulted in South Dakota appealing the State Supreme Court’s decision to the United States Supreme Court.
In a 5 to 4 opinion written by Justice Kennedy, joined by Justice Clarence Thomas, Ruth Bader Ginsburg, Samuel Alito, and Neil Gorsuch, the United States Supreme Court overruled Quill. The Supreme Court rejected the physical presence requirement enunciated in the Quill opinion for purposes of withholding and remitting sales tax. The Supreme Court stated that physical presence is not necessary to impose a sales tax collection and remittance obligation on a merchant located outside a taxing state. However, the Supreme Court did not promulgate a new test for nexus purposes. Instead, the Supreme Court held that the South Dakota tax law was “clearly sufficient” to establish a required nexus. With that said, the Supreme Court left open the question as to when an out of state online retailer will be obligated to collect sales taxes. The Supreme Court stated only that a sufficient nexus arises when an out of state merchant “avails itself of the substantial privilege of carrying on business in that jurisdiction.”
The Supreme Court’s refusal to establish a concrete standard is problematic because, there remains a difference between the nexus needed to satisfy the Due Process Clause versus the nexus needed under a dormant Commerce Clause analysis. In the Wayfair case, the Supreme Court avoided having to analyze the dormant Commerce Clause because the South Dakota law at issue was found not to discriminate interstate commerce. This was because South Dakota sales tax was imposed at the same rate for local and out of state retailers. In addition, there are several aspects of the South Dakota sales tax law which avoided producing an undue burden on interstate commerce. For example, the South Dakota law contained provisions for online retailers that make only a few sales within the state to avoid having to collect and remit sales taxes. In addition, the South Dakota sales tax law is not retroactive and therefore, it does not offend the Due Process Clause.
So what does the recent Supreme Court decision in which the physical nexus requirement was overruled mean for eCommerce? The Supreme Court decision in Wayfair was based on South Dakota’s S.B. 106 tax law. This law requires online sellers that transact a minimum of $100,000 in sales or conduct at least 200 separate transactions to collect and remit sales tax to South Dakota. Wayfair allows states with “economic nexus laws” to compel out of state online sellers to collect and remit sales tax. There are already a number of states with “economic nexus laws” in place. These states include Alabama, Pennsylvania, Rhode Island, Hawaii, Oklahoma, Indiana, Kentucky, Louisiana, Maine, Massachusetts, Washington, Mississippi, North Dakota, Georgia, and Wisconsin. In these states, the collection of sales tax from online sellers has become legally much easier. Other states will likely enact sales tax laws which mimic South Dakota’s S.B. 106 tax law in the very near future.
Other states may push the constitutional limits of Wayfair by drafting legislation that imposes retroactive sales tax, interest and penalties for failing to collect sales tax. It is even conceivable that a number of states might even allow local governments to enact sales tax rules that are the eCommerce equivalent of the unforeseen speed traps on a wide open highway: that is, the local sales tax rules will have terms intended to catch unsuspecting out of state online sellers. These type of aggressive sales tax law may not only impact large online retainers, these more aggressive sales tax rules could target occasional online sellers. South Dakota’s sales tax law applied a seller that transacted more than $100,000 in sales or at least 200 transactions. It is not difficult to imagine a scenario in which casual unsuspecting online seller could find themselves facing serious back sales tax liability, interest, and penalties.
How would more sales tax laws that are more aggressive than South Dakota’s S.B. 106 targeting eCommerce fare in state and federal courts? Since disputes regarding the collection of state sales tax are typically litigated in state court, let’s start with state courts. Those who represent businesses and individuals in sales tax controversies understand state courts tend to be sympathetic to local sales tax laws. Consequently, it is unlikely state courts will find aggressive sales tax laws targeting eCommerce unconstitutional. Should another sales tax case make its way to the United States Supreme Court, the fact that the composition of the Supreme Court is becoming more conservative will not likely mean greater scrutiny of sales tax laws. If anything, a more conservative Supreme Court may result in states being given more leeway to tax eCommerce.
After the Supreme Court ruling in Wayfair, any seller (large or small) that sells through eCommerce should pay close attention to state sales tax laws and municipal sales tax ordinances in throughout the United States. Online sellers should understand that the sale of an item which triggers a sales reporting obligation in one state may not trigger a sales tax reporting obligation in another state. Regardless of seller, all businesses conducting eCommerce business must prepare for a change in their obligations to collect and remit state sales taxes.
Anthony Diosdi is one of the founding partners of Diosdi Ching & Liu, LLP, a law firm with offices located in San Francisco, California; Pleasanton, California; and Fort Lauderdale, Florida. Anthony Diosdi concentrates his practice on tax controversies and tax planning. Diosdi Ching & Liu, LLP represents clients in federal tax disputes and provides tax advice throughout the United States. Anthony Diosdi may be reached at (415) 318-3990 or by email: Anthony Diosdi – firstname.lastname@example.org.
This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.