Supreme Court Holds that State Sales Tax Can Be Levied on Out-of-State BusinessesJune 2018
In a landmark decision destined to affect businesses across the country, the U.S. Supreme Court ruled in South Dakota v. Wayfair, Inc., 585 U.S. No. 17-494 (June 21, 2018), that states could require remote sellers to collect sales tax on goods and services delivered into a state, even if the seller has no physical presence in the state.
The Court’s 5-4 decision overturned Quill Corp. v. North Dakota, 504 U.S. 298 (1992), which had held that the Commerce Clause of the U.S. Constitution precluded states from collecting sales tax from businesses that lack a physical presence in the state. Although the Court’s decision leaves many questions unanswered, Wayfair significantly expands the ability of states to tax remote sellers. States will likely move quickly to require remote sellers to register and collect sales tax, either by enacting new laws or by enforcing existing laws that were previously unenforceable under Quill’s physical-presence requirement. Businesses will need to carefully monitor these developments, reexamine their sales tax obligations, and determine whether their compliance and reporting systems need to be updated. These new compliance burdens will fall particularly heavily on small sellers.
The Commerce Clause of the U.S. Constitution limits states’ ability to enact laws that discriminate against or place an undue burden on interstate commerce. A tax law enacted by a state will be found valid so long as it (1) applies to an activity that has a substantial nexus to the state, (2) is fairly apportioned, (3) does not discriminate against interstate commerce, and (4) is related to the services the state provides. See Complete Auto Transit, Inc. v. Brady, 430 U.S. 274 (1977). Starting with Quill and prior to Wayfair, a business satisfied the “substantial nexus” prong of this test only if it had a physical presence in the taxing state.
At issue in Wayfair was a 2016 South Dakota law that requires out-of-state retailers to collect and report South Dakota sales tax if the retailer annually delivers more than $100,000 worth of goods or services to addresses in the state or engages in 200 or more transactions for delivery of goods and services to addresses in the state. Soon after, South Dakota filed suit against several large online retailers, seeking a declaration that the law was valid and therefore requiring those retailers to register for a license to collect and remit sales tax. Lower courts held that the law was invalid under Quill.
The U.S. Supreme Court reversed and found that physical presence is not required to satisfy the substantial nexus requirement, because a business can have sufficient contacts with a state without a physical presence. Although physical presence enhances the argument that a substantial nexus exists, it is not required. The Court found that the substantial amount of business transactions conducted by the online retailers involved in Wayfair satisfied the substantial nexus requirement.
The Court found Quill to be inconsistent with the Commerce Clause because it created economic distortions that put in-state businesses at a competitive disadvantage compared to out-of-state businesses. The Court also found that taxing out-of-state businesses that are delivering goods and services in the state, and in the same manner as in-state businesses, is consistent with South Dakota’s ability to tax.
Although the Court overturned Quill, it did not decide the constitutionality of the South Dakota law. Instead, the Court vacated the lower court decisions and remanded for a determination of whether the South Dakota law satisfies the other requirements of the Complete Auto Transit test. The case will be carefully watched on remand. Consequently, the decision leaves retailers without a bright-line test for validity of state laws that impose sales tax obligations on remote sellers.
In its decision, the Court noted that the South Dakota law had features that prevent discrimination and avoid placing an undue burden on interstate commerce:
- The law protected small retailers by taxing only sellers who annually deliver more than $100,000 worth of goods or services or engage in 200 or more transactions.
- South Dakota had adopted the Streamlined Sales Tax Act. This is significant because when both state and local sales and use tax laws are considered, sellers are potentially subject to the differing laws of more than 10,000 taxing jurisdictions. Complying with all of these laws represents an enormous compliance burden, particularly for smaller sellers. The Streamlined Sales Tax Act reduces this complexity by providing for a single rate of sales tax and uniform definitions of taxable goods and services at the state level. Therefore, it remains unclear whether the laws of states that by adopting the Streamlined Sales Tax Act or otherwise simplified their laws could be subject to greater scrutiny.
- South Dakota’s law did not apply retroactively, and Wayfair did not decide whether states can collect sales tax for prior years from out-of-state sellers. Many states have decades-old sales tax laws that were rendered unenforceable by Quill’s physical presence requirement. Numerous remote retailers relied for many years on Quill’s finding of an exemption from the application of those laws. Moreover, where no sales tax was collected, the purchaser might already have paid use tax to the state, which creates the potential for double taxation if states try to collect taxes retroactively based on Wayfair. The possibility that Wayfair might be applied retroactively will be of major concern in the weeks and months to come.
It is unclear, therefore, how state laws that lack some or all of the protections and limitations of South Dakota’s law will fare under Wayfair. In addition, it is unclear how Congress will respond to Wayfair. Congress has constitutional authority to enact legislation regulating states’ collection of sales taxes from out-of-state sellers. Congress could decide to protect businesses from retroactive state laws or overly burdensome new state requirements. Congress could even reverse the Court’s decision.
In light of Wayfair, it is likely that states will act quickly to enforce new or existing online sales tax regimes. In order to avoid risking penalties for unpaid sales taxes, it is recommended that out-of-state and online retailers begin to do the following:
- Review states in which the business sells goods but is not currently registered and is not collecting sales tax, to determine whether it might have substantial nexus in such states.
- Analyze customer data to determine the states in which customers are purchasing products and/or services.
- Register under applicable state laws with states in which the business has a nexus.
- Collect sales tax in states with which the business has a substantial nexus (possibly even if the business is not yet registered in a state, to avoid liability for unpaid taxes and penalties).
- Review and upgrade IT (information technology) systems to ensure that they are in compliance with individual state requirements.
Announcements from states on compliance initiatives may be forthcoming in the near future. In addition, some states could amend their laws in response to Wayfair. Some states may announce amnesty programs. Businesses should carefully monitor these developments and adjust their compliance strategies appropriately.
If you have questions regarding Wayfair or sales tax issues in general, please contact Michael T. Donovan at (314) 444-7715.
The authors would like to thank Rachel Kent for her contributions to this article.