The recent decision from the Supreme Court of the United States in South Dakota Department of Revenue v. Wayfair, Inc. et al. is a major win for a State’s ability to extend its taxing authority beyond its physical borders and a potential pitfall for an unwary online retailer. The decision will have far-reaching consequences for any business that sells tangible personal property to customers in multiple states. Until this decision, companies freely relied upon on a bright-line test that absent actual, physical presence in a State—via employees, brick and mortar stores or sales representatives—no obligation existed for the imposition of that State’s sales or use tax laws and regulations on the online company—i.e. there was insufficient “nexus” between the remote seller and the State to impose the State’s taxing obligations on the seller. The United States Supreme Court has now changed the taxing landscape in a major victory for the States and their taxing authorities.

Prior to this decision, the Court had consistently held that the Commerce Clause of the Constitution (and initially the Due Process Clause of the Constitution) required in-state physical presence before a State could impose the burdens of sales and use tax obligations on remote sellers.[1] For example, a Massachusetts’s online retailer that had no physical, in-state presence in Arizona was able to rest easy knowing that it was under no obligation to track its online sales to customers in Arizona, no obligation to register with the appropriate Arizona taxing authority, and no obligation to calculate, charge, and remit the appropriate amount of Arizona sales or use taxes for each purchase made by a resident of Arizona. The Wayfair decision changes all of this (in certain circumstances) and closes the tax-free online shopping “loophole” created by the prior case law.

Prior Law and Decades of Reliance

The Supreme Court first addressed the sales/use tax nexus issue in 1967 with the case of National Bella Hess v. Illinois, 386 U.S. 753 (1967). In that case, Illinois taxing authorities attempted to impose use tax requirements on a Missouri company that sold products via catalog orders to customers in multiple states including Illinois. The Missouri company had no employees, no sales force, no in-state stores, and no telephone listing in Illinois and all orders were mailed to the Missouri place of business for fulfillment. The sole contact with Illinois was the Missouri company mailing the products for fulfilled orders to Illinois customers via US mail or common carrier. The Supreme Court held that both the Due Process Clause and the Commerce Clause of the Constitution prohibited Illinois from imposing its own use tax obligations on the remote seller whose sole contact with the State was utilizing US mail or common carrier to ship products to customers within the State.

Then, in Quill Corp. v. North Dakota, 504 U.S. 298 (1992), the court reaffirmed its National Bella Hess holding and its bright-line test but overruled the portion of the case that indicated notions of Due Process required actual in-state presence. Instead, the Court ruled only the Commerce Clause requires in-state, physical presence before a taxing authority could impose the burdens of sales and use tax requirements. The facts in Quill were strikingly similar to the National Bella Hess case. Quill Corp. was a Delaware company selling office supplies and stationery via online and e-commerce routes to customers across the United States. It had no in-state presence in North Dakota and shipped all orders to North Dakota customers via post or common carrier mail. The Supreme Court again struck down the State’s attempt to enforce use tax obligations on a remote seller.

The standards set forth by the National Bella Hess and Quill cases established the bright-line test that was followed for decades—if a remote seller had no physical presence in a State, there was no obligation to charge, collect, and remit sales or use tax on purchases to consumers within that foreign state. Additionally, there was no obligation to notify the ultimate consumers of their obligations to pay use tax in their own states for their online purchases.

State’s reaction—click through nexus, representational nexus, etc.

The Quill ruling was the last time the Supreme Court spoke on the sales/use tax nexus issue and, with the right set of facts, the prior decisions were susceptible to challenge of both the foundation and logic of these rulings. The physical presence standard established by the Court’s ruling left the States at a disadvantage to any remote seller who remained outside its borders, while maintaining significant economic presence in the State via voluminous sales to the state’s residents. Under the prior rulings, the remote seller was under no obligation to charge, collect and remit the sales tax on these purchases. This meant the in-state, resident consumers were obligated to proactively identify themselves to the tax authority of its own state, disclose their online or remote purchases and “voluntarily” remit the appropriate use taxes owed to the State for those purchases. However, the remote seller was under no obligation to advise either the State taxing authorities or the consumers of their use tax obligations. This created a situation in which the State was left in the dark as to the transactions of the in-state consumers who were legally obligated to remit use tax on these purchases while at the same time being unable to collect the complimentary sales tax from the remote seller at the time of the purchase—the “tax-free” online loophole.

As a result, over the next few decades the States reacted to the physical presence requirement and developed alternative means of expanding their taxing powers and authority. The areas of expansion included legislation to assert nexus through in-state representation through contractual parties and affiliates with in-state presence. These states enacted legislation classifying the remote seller as a “retailer” for state sales and use taxing purposes if that remote seller utilized the services of an in-state representative to assist with advertising for the online sales. See R.I. Gen. Laws Section 44-18-15—Retailer defined (the broad definition of “retailer” includes “Every person making sales of tangible personal property…through an independent contractor or other representative, if the retailer enters into an agreement with a resident of this state, under which the resident, for a commission or other consideration, directly or indirectly refers potential customers, whether by a link on an Internet website or otherwise, to the retailer…”).

More recently, some states have enacted legislation requiring registration with a State’s taxing authority if the “remote seller” conducted a certain amount of sale transactions with consumers in that State. See R.I. Gen. Laws Section 44-18-15.2 (enacted in 2013 to impose sales and use tax obligations on “remote Sellers”); See also R.I. Gen. Laws Section 44-18.2-1 (enacted in 2017 and requiring non-collecting retailers [remote sellers] to register with the Division of Taxation and provide use tax obligation notices to consumers purchasing from the remote seller).

The furthest expansion for taxation came in 2017 with Massachusetts DOR Directive 17-01, whereby Massachusetts determined in-state presence could be established by the use of licensed software or cookies available for download and use on a consumer’s electronic devices in the State (i.e. use of an Uber application on a consumer’s iPhone in MA would constitute in-state presence of Uber).

All of these efforts by the taxing authorities to expand its taxing jurisdiction, together with changing times and the reality of technological progress, made the National Bella Hess and Quill decisions ripe for challenge. The successful challenge came in the form of South Dakota’s emergency legislation enacted in response to major deficits to its tax revenues as a direct result of online, remote sales to consumers in its State.[2]

The Wayfair Case and Decision

In 2016 the South Dakota legislature enacted emergency legislation to address the loss of revenue directly related to residents purchasing tangible property online and not remitting the appropriate use tax coupled with the online retailer’s refusal to charge and remit sales tax for purchases mailed into South Dakota. The legislation was particularly important in South Dakota because it relies heavily on sales and use tax revenues for its general fund as it has no income tax like several other states. The legislative history estimated that South Dakota lost between $48 and $58 million dollars annually as a result of the online purchases and failure to remit use tax. In response, the State passed a law requiring remote sellers making sales of tangible property or services to residents of South Dakota in excess of $100,000 annually or engaging in 200 or more separate transactions for the delivery of goods or services into the State per year to charge the appropriate South Dakota sales tax on those sales and remit it to the department of revenue (DOR). The South Dakota DOR immediately began enforcing the legislation and issued tax deficiency notices to remote sellers that had sufficient in-state sales to meet the legislative threshold requirements. Three remote sellers (Wayfair, Inc., Overstock.com, Inc. and Newegg, Inc.) challenged the imposition of the DOR’s deficiency determinations.

The South Dakota state courts reluctantly struck down the DOR determinations relying on the previous holdings of National Bella Hess and Quill, but the South Dakota Supreme Court urged reconsideration of those holdings. The South Dakota DOR sought review from the Supreme Court, and that Court seized the opportunity to reevaluate the prior holdings.

The Court’s opinion focused on the change in technology since the 1992 Quill decision, the prevalence of internet access for the average citizen, and the exponential growth in online shopping as opposed to localized shipping. The decision also focused on the immense and overwhelming statistical evidence regarding the lost revenue to the various states via the online shopping and noted the prior rulings had created a “judicial loophole” by which the remote sellers were granted a de facto tax exemption at the expense of local in-state businesses that were required to charge and remit sales/use taxes on similar sales. The local brick and mortar stores were at a competitive disadvantage to the online retailers because the online retailers were able to charge lower prices for the same goods because no tax use due to the various taxing authorities. In fact, Wayfair went so far as to advertise lower prices because of the lack of sales/use taxes on its sales. The Court noted that this taxing scheme was not the intent of the prior rulings and seized the opportunity to correct the discriminatory effect of the prior rulings. The court overruled the holding of Quill and held that the Due Process Clause and Commerce Clause are not violated when an online retailer who has purposely availed itself of the privilege of doing business within a State is required to comply with that State’s taxing obligations.  Thus, South Dakota was free to impose its sales and use tax obligations on the remote sellers that met the statutory requirements.

Its limitations and reasonable protections

The Court was cautious in its holding and discussed the reasonable protections embedded in the South Dakota legislation. The result may have been different if the legislation did not provide these reasonable limits. First, the statute provided that no retroactive application would occur for tax obligations of the remote sellers for prior sales or prior periods—the legislation was not an open door for taxing agencies to audit prior periods with the new expansion principles. Second, the legislation provided a safe harbor protection intended to eliminate undue burdens on interstate commerce. The legislation provided threshold limits before imposing the taxing burdens. Small, online merchants that do not engage in 200 sales to South Dakota residents or have annual sales to such residents of less than $100,000 are not impacted by the legislation and are not required to charge and remit the South Dakota sales tax. The legislation is tailored to affect only those online retailers that have purposely availed themselves to the South Dakota residents with persistent and substantial sales or services provided in South Dakota. Finally, the court noted South Dakota’s adoption of the Streamlines Sales and Use Tax Agreement that serves to facilitate the various sales and use tax obligations of the various taxes and provides information, software, and educational materials to retailers.[3]

What does this mean for online retailers—it still depends

1. Buyer Beware—Rhode Island and states with legislation giving remote retailers an “option”

In States like Rhode Island where legislation has passed providing remote retailers with an “option” to either charge and collect the sales tax for RI sales or notify the ultimate consumers of their obligation to remit the use tax, the Wayfair decision is unlikely to be immediately enforced or immediately effective. By providing a legislative option for the remote sellers, the State has allowed sellers to remain outside its borders and keep the tax burden at bay by notifying the consumers of their use tax obligations. The State is likely to lose revenues that Wayfair would have otherwise permitted without the “option” legislation.

In these jurisdictions, the burden still rests with the ultimate consumers to come forward to the DOR and identify their use tax obligations on transaction(s) that only the remote seller and the consumer are likely to know about—there is no obligation for the remote sellers to provide sales information to the DOR. The remote seller will have the option of proactively registering with the RI DOR and remitting the sales tax on purchases to RI resident consumers or notifying the consumers of their obligation to remit the use tax to the RI DOR.

2. Seller Beware—South Dakota and States that have reasonable and limited legislation

The Court has spoken, and you are required to comply with the legislative mandates in these States if you meet their requirements—threshold sale amounts, etc. The remote seller is obligated to calculate, charge, collect, and remit to the taxing authorities the proper amount of sales tax on sales to in-state consumers. As noted by the Wayfair decision, there is computer software readily available to assist with the calculations, but the remote seller must now be aware of the various sales tax obligations and amounts in each state where the legislative thresholds are triggered by its business activities.

3. Seller AND Buyer Beware: The others—the unknown realm

For remote sellers conducting business in States that have not yet enacted similar legislation, it is unknown and potentially risky to assume you no longer have sufficient in-state presence to trigger the sales and use tax obligations of that State. The remote seller will need to diligently monitor legislative actions aimed at defining in-state presence and monitor its activities in the various states to determine if their activities will constitute nexus in the various states. Buyers must also scrutinize online purchases to determine if sales tax was charged or if the buyer is obligated to calculate and remit the use tax on each of its online purchases.

Bottom-Line: As an online seller of tangible property your business is now required to do your research to determine how each State in which you sell tangible property imposes its own sales and use tax obligations and any threshold requirements of each State imposing tax obligations on your remote company. The laws and tax regulations of the various States will determine if you must:

  • register with the taxing authority of that State;
  • notify consumers of that State of their use tax obligation on purchases; and/or
  • charge, collect and remit sales tax to the taxing authority of the State for purchases made to residents of that State.

Failure to comply with a State’s sales and use tax obligations could result in financial consequences in the form of interest and penalties on any deficiencies determined via subsequent audit—up to three years later.

 

[1] It is important to note the difference between sales/use tax nexus as opposed to business source income nexus. There were several cases in the interim period that challenged this area of law. Sales/use tax nexus was the only type to be granted a steadfast “in-state” physical presence requirement; whereas an “economic presence” was applied for the other forms of nexus—allowing a State to charge corporate or business income taxes on businesses that had no physical presence within its borders.

[2] Other challenges included Amazon.com, LLC v. New York State Dept. of Taxation & Finance, in which online retailers Amazon.com and Overstock.com challenged New York Legislation defining online internet retailers as “vendors” for the purposes of New York’s sales and use tax laws if they engaged the services of in-state affiliates or rewards programs. Also, in Direct Marketing Assn. v. Brohl, 814 F. 3d 1129, 1148, 1150–1151 (CA10 2016), the United States Supreme Court ruled a Colorado statute imposing similar registration and collection requirements with the Colorado DOR was not barred by the Tax Injunction Act. The case was remanded to determine if the legislation would violate the Commerce Clause. On remand the Appeals court upheld the Colorado statute holding the legislation does not violate the dormant Commerce Clause. The US Supreme Court denied cert in December 2016—a clear sign that a challenge to the Quill and National Bella Hess holdings was on the horizon.

[3] The court noted that 20 other states have adopted and participate in the Streamlined Sales and Use Tax program with a uniform set of rules and regulations.