In South Dakota v. Wayfair, Inc., the U.S. Supreme Court handed down a landmark ruling giving state and local governments the green light to impose sales taxes collection requirements on out-of-state sellers.
States must have some minimum contact with a business to justify imposing the burden of tax compliance on that business. This is referred to as the "nexus" required to impose a state's tax law.
As discussed below, prior decisions had required a physical contact with the state before a business would be subject to sales tax laws. Now, a business need only have economic contacts with the state – measured in this case by gross receipts or the number of transactions.
The Decision Will Impact Almost All Businesses
Businesses making taxable sales will be subject to filing requirements in more states. Businesses making exempt sales (i.e., sales for resale) will also face additional compliance requirements.
For example, the statute of limitations preventing an audit for a given year may not close without the filing of a return — even if no tax is due. In addition, businesses will have to collect exemption certificates for sales into more jurisdictions.
The decision also unifies the tests for income taxes and sales taxes. It approved of the South Dakota statute that set a minimum threshold for economic contact at $100,000 of gross receipts or 200 transactions with customers in the state.
Approval of this kind of "factor nexus" will likely lead more states to adopt similar laws requiring filing of both sales and income taxes. Twenty-one states currently have some form of this law on their books (with varying effective dates).
What Your Business Should do Now
- Determine the states where you have customers, employees, or property.
- You and your advisor should analyze each state's law to determine whether your activities could require you to files sales or income taxes in those states.
- Begin filing where required, or enter a voluntary disclosure program if you should have begun filing at an earlier date.
The Law Before Wayfair
Wayfair overruled two prior Supreme Court precedents. In the 1967 National Bellas Hess ruling, the Court evaluated an Illinois requirement that out-of-state retailers collect and remit taxes on sales made to consumers who purchased goods for use within the state.
That case involved a mail-order company that only delivered in Illinois by "common carrier" or the U.S. mail. The court held that the company did not have the "minimum contacts" with Illinois for the U.S. Constitution to permit the state to impose taxes. It specifically held that the state could impose a requirement to collect local use tax only if the company had a physical presence in the state.
Twenty-five years later, the Supreme Court decision in Quill reconsidered the physical presence rule as applied to mail-order sales. The 1992 ruling abandoned the legal reasoning based on the Due Process Clause of the U.S. Constitution, but it upheld physical presence as the "substantial nexus" requirement under the Commerce Clause.
Criticism of the Physical Presence Rule
The physical presence rule has been the subject of extensive criticism, especially in recent years as traditional "brick and mortar" stores have lost business to online sellers. South Dakota's petition for Supreme Court review stated:
Quill has grown only more doctrinally aberrant . . . But while its legal rationales have imploded with experience, its practical impacts have exploded with the rapid growth of online commerce. Today, States' inability to effectively collect sales tax from Internet sellers imposes crushing harm on state treasuries and brick-and-mortar retailers alike.
South Dakota's Law
The South Dakota statute requires out-of-state retailers that make at least 200 sales or sales totaling at least $100,000 in the state to collect and remit a 4.5% sales tax.
The Supreme Court's Reasoning
The majority opinion was written by Justice Kennedy (joined by Justices Thomas, Ginsburg, Alito and Gorsuch). It described the physical presence rule as "unsound and incorrect." According to the Court, the rule becomes further removed from economic reality every year.
The opinion concluded that South Dakota law satisfies the substantial nexus requirement. Nexus arises when the taxpayer "avails itself of the substantial privilege of carrying on business" in the state. The high court went out of its way to observe that South Dakota's tax system included several features that seem designed to prevent discrimination against interstate commerce.
These include a prohibition against retroactive application of the statute and the safe harbor for taxpayers with less than $100,000 of sales and less than 200 transactions. In addition, the opinion observed that South Dakota was a member of the Streamlined Sales and Use Tax Agreement (SSUTA). More than 20 states have joined SSUTA by adopting conforming legislation that requires member states to follow more standardized definitions and rules to help make tax compliance easier for businesses.
The Impact
The ruling had an immediate impact when the share prices of major online retailers dropped (even for those that do collect and remit sales taxes). Big online retailers have already moved to collect sales taxes for many states in recent years.
As the court stated, the burden of nationwide sales tax collection poses "legitimate concerns in some instances, particularly for small businesses that make a small volume of sales to customers in many States." The court left it to businesses to find reasonably priced software that may make compliance easier. Shares in a company making a popular tax-processing software climbed after the ruling was released.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
