On June 21, 2018, the U.S. Supreme Court decided that physical presence is no longer necessary for a state to collect sales tax on internet retail sales (see South Dakota v. Wayfair, Inc.). This major decision overturned two prior Court decisions and will greatly affect those online retailers that will be facing an increase in the administrative and compliance costs associated with the change in the law.
A little background on this case. The main issue stemmed from a South Dakota state law which required out-of-state sellers to collect and remit sales tax to the state, including those sellers that did not have a physical presence there (i.e. no employees or real estate in South Dakota). The law applied to sellers that deliver more than $100,000 of goods or services into the state annually or engage in 200 or more separate transactions for the delivery of goods or services into the state.
The Court’s holding was based on the idea that the physical presence test has proven to be a test that is both impractical and difficult to enforce. In addition, the Court determined that there have been estimates in which the two prior cases, now overturned, have caused states to lose between $8 and $33 billion in revenue every year. South Dakota estimates its revenue loss at $48 to $58 million annually. Moreover, because South Dakota has no state income tax, its proportional reliance on sales and use taxes as sources of state revenue is further augmented. Notably, sales and use taxes account for over 60 percent of the state’s general fund.
The Court’s ruling is based on the reasoning that, first, there is no violation of the Commerce Clause so long as there is a substantial nexus with the taxing State. Second, the Court compares the nexus requirement to the due process requirement that there be “some definite link” or “some minimum connection” between a state and the person, property or transaction it seeks to tax. Third, the due process requirements are deemed to be met regardless of whether a physical presence test has been met. Finally, the Court concluded that physical presence is not necessary to create a substantial nexus.
Although this ruling is not favorable for online retailers, there may be some mitigating options available. The Marketplace Fairness Act of 2017 authorizes each member state under the Streamlined Sales and Use Tax Agreement (a multistate agreement adopted in 2002 to administer and collect sales and use taxes) to require all sellers to collect and remit sales and use taxes with respect to remote sales under the Agreement. What makes this Act attractive is that, first, sellers with less than $1 million in annual sales is exempt from collecting and remitting taxes (a much higher threshold than under the Wayfair case). Second, the Agreement must contain certain basic requirements for the administration of the tax, of audits, and of streamlined filing. In essence, this Act sets some boundaries and limits as to how far states can reach in compelling its state tax collection.
Member states must agree to a set of simplified rules that aim to lighten the burden of compliance and reduce the risk of discrimination by the states. They are to provide software free of charge to remote sellers that would calculate sales and use taxes due on transactions and relieve sellers from any penalties if a liability is the result of an error or omission made by a certified software provider. Finally, the Marketplace Fairness Act would ensure that any state law changes will not have a retroactive effect on retailers. To date, there are 23 Member states participating under the Agreement.