On June 21, 2018, the U.S. Supreme Court overturned a 26-year-old ruling that will now make it possible for individual states and local governments to impose sales taxes on out-of-state online sales. The ruling in South Dakota v. Wayfair, Inc. was narrowly passed by a margin of 5-4. Brick-and-mortar retailers had been eagerly awaiting the reversal which, if enforced at the state and local levels, will benefit not only retailers, themselves, but many states which have been missing out on the collection of sales tax derived from out-of-state online sales.
A Look Back at Prior Rulings
The Supreme Court’s decision in South Dakota v. Wayfair overruled two of its precedents. In 1967’s National Bellas Hess v. Dept. of Revenue ruling, the Court considered a challenge to an Illinois tax that required out-of-state retailers to collect and remit sales tax from consumers who purchased goods for use within the state.
As the case involved a mail order company, the Supreme Court found that, since the company’s only connection with customers in Illinois was by way of the U.S. mail, it lacked the requisite minimum contacts with the state required by the Due Process and Commerce Clauses of the Constitution to impose taxes. The Court held that the state could require a retailer to collect a local use tax only if the retailer maintained a physical presence, such as retail outlets, solicitors, or property in the jurisdiction.
Several decades later, in Quill Corp. v. North Dakota, the Supreme Court reconsidered the physical presence rule in another case involving mail-order sales. The Court upheld the prior ruling based on the Commerce Clause principle that prohibits state taxes unless they apply to an activity with a “substantial nexus” — or connection — with the state.
Challenges to the Physical Presence Rule
As the ways in which retailers conduct business have changed drastically with the advent of online retailing and the simultaneous decline in brick-and-mortar sales, the physical presence rule, established in Bellas Hess and affirmed in Quill, has become the subject of extensive criticism. In 1992, the Court noted that mail-order sales in the United States totaled $180 billion, while in 2017 retail online sales were estimated at $453.5 billion. Online sales represented almost 9% of total U.S. retail sales last year.
This market dynamic is highlighted in the Wayfair case. The petition for Supreme Court review reads, in part:
“[The practical impacts of Quill Corp. v. North Dakota] 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.”
In fact, it’s been estimated that states lose between $8 and $33 billion in annual sales tax revenues because of the physical presence rule. States with no income tax, such as South Dakota with estimated losses of between $48 and $58 million annually, have been particularly hard hit.
The Sales Tax Specifics
In response to the rise in online sales and the corresponding effect on sales tax collections, South Dakota enacted a law requiring out-of-state retailers that made at least 200 sales or sales totaling at least $100,000 in the state to collect and remit a 4.5% sales tax.
South Dakota subsequently sued several online retailers which had no employees or real estate in the state. It sought a declaration that the sales tax was valid and applicable to the retailers, along with an injunction requiring the retailers to register for licenses to collect and remit the tax. However, a trial court dismissed the case before trial. The State Supreme Court deferred the decision to a higher authority, citing its obligation to follow U.S. Supreme Court precedent, however persuasive the state’s arguments against the physical presence rule might prove.
The View from The Supreme Court
The majority opinion described the physical presence rule as “unsound and incorrect.” According to the Supreme Court, with each passing year, the rule becomes further removed from economic reality.
Quill, the opinion stated, creates market distortions. It puts local businesses and many interstate businesses with a physical presence at a competitive disadvantage as compared with remote sellers that don’t need to collect sales taxes from customers. The opinion, written by Justice Kennedy confirmed that the earlier ruling “has come to serve as a judicially created tax shelter for businesses that decide to limit their physical presence and still sell their goods and services to a state’s consumers — something that has become easier and more prevalent as technology has advanced.”
In addition, the Court found that Quill is upheld arbitrarily. For example, a business with a few items of inventory in a small warehouse in a state is subject to the tax on all of its sales in the state, while a seller with a pervasive online presence but no physical presence isn’t subject to the same tax for the sales of the same items.
Ultimately, the Supreme Court concluded that the South Dakota tax satisfies the substantial nexus requirement. Such a nexus is established when the taxpayer “avails itself of the substantial privilege of carrying on business” in the jurisdiction. The quantity of business the law required to trigger the tax couldn’t occur unless a seller has availed itself of that substantial privilege.
Impact of the Wayfair Ruling
The significance of the Supreme Court’s ruling was felt almost immediately in the business world, with the share prices of major online retailers quickly dropping (even those that do collect and remit sales taxes). It’s not just the large online retailers that could be affected, however.
The Court recognized that the burdens of nationwide sales tax collection could pose “legitimate concerns in some instances, particularly for small businesses that make a small volume of sales to customers in many states”, though it conceded that reasonably-priced software may eventually make it easier for small businesses to cope. The ruling also pointed out that, in this case, the law “affords small merchants a reasonable degree of protection,” such as annual sales thresholds.
The Court further noted that South Dakota is one of more than 20 states that are members of the Streamlined Sales and Use Tax Agreement (SSUTA). These states have adopted conforming legislation that provides uniform tax administration and definitions of taxable goods and services, simplified tax rate structures, and other uniform rules.
Future Outlook of Online Sales Tax
Only about 15 states currently have sales tax laws similar to South Dakota’s, so it’s likely there will be a staggered imposition of sales tax collection and remittance responsibilities on online retailers. Other states may need to revise or enact legislation to meet the relevant constitutional tests — including, but not limited to, the substantial nexus requirement.
If you have questions regarding sales tax collection requirements for online sales in light of the Supreme Court’s decision, please contact your Untracht Early advisor.