Published in NH Society of CPA's Connections Newsletter (9/27/2018)
In a long awaited decision reversing 26 years of precedent, on June 21st the United States Supreme Court ruled in South Dakota v. Wayfair, Inc., that states and other taxing jurisdictions could require out of state retailers to collect sales tax on online sales even though the retailers had no physical presence in the taxing jurisdiction.
South Dakota’s Sales and Use Tax law
South Dakota, like approximately forty-four other states, taxes the retail sales of goods in the State. Like several other states, it also taxes the sale of services. If the selling retailer does not remit the sales tax, then in-state consumers are separately responsible for paying a use tax at the same rate. Under United States Supreme Court Commerce Clause decisions prior to Wayfair, a State could not require a retailer to collect sales tax if the business did not have a physical presence in the State. When out-of-state retailers sold to South Dakota residents, South Dakota had to rely on its residents to pay the use tax owed. As the Supreme Court noted in its opinion, use tax compliance rates are very low. The South Dakota Department of Revenue had estimated that revenue losses were from $48 to $58 million annually. To address the loss of revenue, in 2016, the South Dakota Legislature enacted a law requiring out-of-state sellers to collect and remit sales tax “as if the seller had a physical presence in the State.” The law covers sellers that, on an annual basis, deliver more than $100,000 of goods or services into the State or engage in 200 or more separate transactions for the delivery of goods or services into the State. The law prohibited the retroactive collection of taxes until the constitutionality of the law was established.
Case History and Prior Supreme Court Cases
To determine the validity of the law, South Dakota filed a declaratory judgment action in South Dakota state court against on-line retailers Wayfair, Inc., Overstock.com, Inc., and Newegg, Inc., seeking an injunction requiring the retailers to comply with state law requirements to register for licenses to collect and remit sales tax. The retailers, who were all large online retailers with no employees or real estate in South Dakota, filed a motion for summary judgment arguing that the law was unconstitutional under existing United States Supreme Court decisions in National Bellas Hess, Inc. v. Department of Revenue of Ill., and Quill Corp. v. North Dakota. The retailers prevailed throughout the South Dakota court system, as the South Dakota courts all agreed that the law violated the Commerce Clause of the United States Constitution, which grants to Congress the power to regulate commerce in the United States. Under prior Supreme Court precedent, the Supreme Court had interpreted the Commerce Clause to prohibit State regulations from discriminating against interstate commerce and prohibiting States from imposing undue burdens on interstate commerce. Thus, the Supreme Court had interpreted the Commerce Clause to not only grant power to Congress but also limit the ability of states to regulate interstate commerce. The Supreme Court had previously permitted state taxes if the tax (1) applies to an activity with a substantial nexus with the taxing State, (2) is apportioned fairly, (3) does not discriminate against interstate commerce, and (4) is fairly related to the services the State provides. In the Bellas Hess decision, the Supreme Court ruled that a mail-order company with no physical presence in Illinois such as retail outlets, solicitors, or property lacked the requisite minimum contacts with the State required by the Commerce Clause. In the1992 Quill decision, the Supreme Court reaffirmed that a state could not require an out-of-state mail-order house that had neither outlets nor sales representatives in the state to collect and remit sales tax on goods purchased for use within the State. The Court stated that the physical presence rule was necessary to prevent undue burdens on interstate commerce. Without the physical presence rule, the Supreme Court reasoned that a State tax law affecting interstate commerce would not meet the requirement that a tax have a “‘substantial nexus’” with the activity being taxed. Relying on existing United States Supreme Court precedent, the South Dakota Supreme Court agreed with the retailers that the tax violated the Commerce Clause. In its opinion the court stated, “However persuasive the State’s arguments on the merits of revisiting the issue, Quill has not been overruled [and] remains the controlling precedent on the issue of Commerce Clause limitations on interstate collection of sales and use taxes.” South Dakota appealed the decision to the United States Supreme Court.
Supreme Court Decision
In a split five to four decision, the Supreme Court in Wayfair ruled in favor of South Dakota, holding that the portion of the law requiring a remote seller without any connection to the state to collect and remit sales tax did not violate the Commerce Clause. The Court determined that a physical presence was no longer a requirement for a State to apply its sales tax laws to an activity with substantial nexus with the State. The Court viewed the compliance costs for remote sellers to be secondary to the importance of creating an even playing field for local businesses versus remote sellers such as Wayfair and the other parties to the case.
What Happens Next
In the past several years, multiple states have adopted laws seeking to circumvent the physical presence requirement. In anticipation of the Supreme Court ruling in Wayfair, numerous states have enacted new laws designed to require on-line retailers to collect sales tax. In New England, for example, Vermont adopted a law applying the same $100,000 or 200-transaction standard as South Dakota’s law, making the law effective upon a favorable decision in Wayfair. With the Wayfair decision validating South Dakota’s law, we expect many additional states will adopt laws using volume of sales as a trigger to require sales tax collection.
The Wayfair decision, and rush of states adopting similar remote seller nexus laws, creates enormous compliance costs for businesses that sell remotely. As noted in Justice Roberts’ dissenting opinion, there are over 10,000 sales tax jurisdictions in the United States. There are different tax rates, different rules governing tax-exempt goods and services, different product category definitions, and different standards for determining whether an out-of-state seller has a substantial presence requiring collection and remittance of sales tax. Examples cited in the opinion include Illinois, which taxes Twix and Snicker candy bars differently because Twix has flour and Snickers does not.
Fulfillment centers – an additional complication
Compliance issues are more complicated for remote sellers who utilize fulfillment services such as those provided by Amazon and Wayfair. When utilizing fulfillment services, a seller ships product to the fulfillment service provider. The fulfillment service provider stores that product at one of its facilities and then ships the product to buyers who purchase the product through the fulfillment service provider’s website. A remote seller has physical presence in every state in which its products are stored and, therefore, is responsible for collecting sales tax in those states. Because the remote seller does not control at which fulfillment centers its products are stored, the remote seller has no control over the states in which it is required to collect sales tax. Multiple states such as California and Washington are now auditing remote sellers who have inventory in an in-state fulfillment center. Based on our experience, it appears that the audits initiate from information obtained from auditing the fulfillment service provider. Many states are aggressive in fulfillment center audits, requiring tax payments back to the first year in which any remote seller product was located in the state.
Moving forward in a changing landscape
The Wayfair decision found South Dakota’s $100,000 or 200 transaction requirement established substantial nexus. The decision did not otherwise define what constitutes substantial nexus. Several states, including Oklahoma, Pennsylvania, and Washington have adopted statutes setting a much lower $10,000 sale threshold. Thus, businesses that are remote sellers should not assume that collection responsibility will attached at only the $100,000 or 200 transactions per year threshold. Whether $10,000 of sales constitutes substantial nexus enabling imposition of a sales tax collection responsibility is an open issue. In lieu of action by Congress setting a national standard, it would not be surprising if there is additional litigation on the issue of how much activity is required to establish substantial nexus.
The multiplicity of taxing jurisdictions, frequent changes in sales tax laws, and lack of consistency in the laws, will require remote sellers to devote significant time to sales tax compliance. Most problematic will be those states that seek to impose tax retroactively. Although the South Dakota law at issue in Wayfair does not impose retroactive liability, in general states can legally collect retroactively, and several have aggressively done so particularly with fulfillment center based audits. In the past, states have established limited amnesty programs whereby business could file retroactively, and receive some reduction in total amount of taxes, penalties and interest.
We recommend all businesses that are remote sellers that are not already collecting sales tax begin determining the number of sales and value of sales into each state. Those using a fulfillment service provider also need to obtain information from the fulfillment service provider on where their product has been stored in the past several years. With this information, remote sellers can begin to assess their current and future sales tax compliance obligations. In the event a state opens an amnesty program, the business will be ready to participate. Because of the complexity of complying with a multiplicity of inconsistent sales tax regimes, remote sellers should also consider seeking professional assistance.