South Dakota Attempts To Change Internet Sales Taxation – What Might Be The Impact On Small Businesses?

Overview

The South Dakota Supreme Court has given the South Dakota legislature and Governor what it wanted – a ruling that a recently enacted South Dakota law was unconstitutional.  Confused?  It is strange.  But South Dakota’s insatiable thirst for additional revenue led it to enact a law imposing sales tax on businesses that have no physical presence in the state.  That’s something that the U.S. Supreme Court first said 50 years ago that a state cannot do.  Accordingly, the South Dakota Supreme Court struck the law down as an unconstitutional violation of the Commerce Clause.   

So why did the South Dakota legislature deliberately enact a law that it knew was unconstitutional?  South Dakota is a state without a state income tax, and wants to grab sales tax from (primarily internet) sales to South Dakota residents by businesses without any physical presence in the state. They also enacted the law so that it would be challenged as unconstitutional in order to set up a case in hopes that the U.S. Supreme Court would review it and reverse its longstanding position on the issue.  However, if that happens or the Congress takes action to allow states to impose sales (and/or use) tax on businesses with no physical presence in the state, that would not be good news for small businesses, including home-based business and small agricultural businesses.  It would also raise serious questions about how strong the principle of federalism remains.

U.S. Supreme Court Precedent

In 1967, the U.S. Supreme Court determined that the Commerce Clause grants “exclusive authority [to] Congress to regulate trade between the States” in holding that Illinois could not subject a mail order seller located in Missouri to use tax where the seller had no physical presence in Illinois.  National Bellas Hess, Inc. v. Illinois Department of Revenue, 386 U.S. 753 (1967).  In holding the law unconstitutional, the Court reasoned that subjecting the seller’s interstate business to local “variations in rates of tax…and record-keeping requirements” would violate the purpose of the Commerce Clause “to ensure a national economy free from…unjustifiable local entanglements.” 

Twenty-five years later, the Court reaffirmed the limitations of the Commerce Clause on state regulatory authority in Quill Corporation v. North Dakota, 504, U.S. 298 (1992).  In Quill, the Court held that a mail order house with no physical presence in North Dakota was not subject to North Dakota use tax for “property purchased for storage, use, or consumption within the State.”  The Court followed closely its holding in National Bellas Hess, Inc. because doing so “encourage[d] settled expectations and …foster[ed] investment by businesses and individuals.”   As applied to internet sales, Quill (which predated the internet) does not exempt all internet sales from state sales taxes – just sales by sellers who don’t have a physical presence in a particular state.  National retailers have a presence in many states.

More recently, in 2015, the Court examined a Colorado “tattletale” law that required out-of-state sellers with no physical presence in the state “to notify…customers of their use tax liability and to report” sales information back to Colorado.  Direct Marketing Association v. Brohl, 135 S. Ct. 1124 (2013).  The trial court enjoined enforcement of the law on Commerce Clause grounds.  On appeal, the Tenth Circuit held that it couldn’t hear the challenge to the law because the Tax Injunction Act (28 U.S.C. §1341) divested it of jurisdiction and the matter belonged in state court and, ultimately, the U.S. Supreme Court.  The Tenth Circuit remanded the case for dismissal of the Commerce Clause claims and dissolution of the permanent injunction.  The U.S. Supreme Court reversed and remanded the decision of the Tenth Circuit on the jurisdiction issue and, on remand, the Tenth Circuit, invalidated the Colorado law on Commerce Clause grounds.  Direct Marketing Association v. Brohl, 814 F.3d 1129 (10th Cir. 2016). 

In the U.S. Supreme Court’s reversal and remand of the Tenth Circuit’s decision in Direct Marketing Association, Justice Kennedy wrote a concurring opinion that essentially invited the legal system to find an appropriate case that would allow the Court to reexamine the Quill and National Bellas Hess holdings.  Hence, the South Dakota legislation. 

South Dakota Legislation and Litigation

S.B. 106 was introduced in the 2016 legislative session of the South Dakota legislature.  It requires the collection of sales taxes from certain remote sellers – those with “gross revenue” from sales in South Dakota of over $100,000 per calendar year or with 200 or more “separate transactions” in the state within the same timeframe.  Interestingly, S.B. 106 authorized the state to bring a declaratory judgment action in circuit court against any person believed to be subject to the law.  The law also authorized a motion to dismiss or a motion for summary judgment in the court action, and provided that the filing of such an action “operates as an injunction during the pendency of the” suit that would bar South Dakota from enforcing the law. 

S.B. 106 was signed into law on March 22, 2016, and the state Department of Revenue soon thereafter began issuing notices to sellers that it thought were in violation of the law.  Several out-of-state sellers that received notices did not register for sale tax licenses as the law required.  Consequently, the state brought a declaratory judgment action against the sellers in circuit court, and sought a judicial declaration that the S.B. 106 requirements were valid and applied to the sellers.  The state also sought an order enjoining enforcement of S.B. 106 while the action was pending in court, and an injunction that required the sellers to register for licenses to collect and remit sales tax. 

The sellers tried to remove the case to federal court based on federal question jurisdiction, but the federal court rejected that approach and remanded the case to the South Dakota Supreme Court.  South Dakota v. Wayfair, Inc., 229 F. Supp. 3d 1026 (D. S.D. Jan. 17, 2017).  On remand, the South Dakota Supreme Court invalidated S.B. 106 on Commerce Clause based on the U.S. Supreme Court precedent referenced above.  State v. Wayfair, Inc., et al., No. 28160, 2017 S.D. LEXIS 111 (S.D. Sup. Ct. Sept. 13, 2017).  The state of South Dakota announced shortly after the South Dakota Supreme Court’s decision that it would file a petition for certiorari with the U.S. Supreme Court by mid-October.

Taxing Out-of-State Sellers

The Congress, in recent years, has made attempts to allow states to apply sales/use tax to out-of-state (primarily internet-based) sales.  In 2013, the Senate passed the Marketplace Fairness Act in an attempt to override the U.S. Supreme Court’s Quill decision.  The legislation went nowhere in the House.  The bill would have required that retail sellers identify and collect sales taxes for the thousands of jurisdictions in which their customers purchase products.  That would have been a nightmare for businesses, particularly smaller and home-based ones.   

In 2016, draft legislation (Online Sales Simplification Act of 2016) was released that again would have allowed states to subject out-of-state businesses with no physical presence in a state to sales and/or use taxes (sales and use taxes are often complementary).  See, e.g., South Dakota Codified Laws 10-46-2).  The bill was an improvement on the 2013 Marketplace Fairness Act because it based taxation on the rules that apply to the tax base of the seller’s home state.  Thus, the actual rate of tax would be required to be set by the seller’s home state.  But, it still mandates that states impose a tax in situations where they have chosen not to do so. 

The South Dakota development is just the most recent attempt to give states the power to tax out-of-state businesses that sell products in the non-home jurisdiction.  Apparently, South Dakota reasoned that if the Congress couldn’t get the job done, it would take the matter into its own hands in an attempt to generate more revenue.

What could be wrong with states taxing businesses that don’t have a physical presence in their state?  For starters, a law that requires a business that is located only in Kansas, for example, to collect and remit taxes to any other state is synonymous with regulation without representation.  The whole notion is incompatible with the principles of federalism that bar states from taxing (whether income, property or sales tax, for instance) non-resident individuals or businesses (with few, minor exceptions).  In addition, such taxes are not just a tax on the individuals in a particular state that buy products from an out-of-state seller.  Those out-of-state sellers would have to calculate, charge and remit the taxes on behalf of a political jurisdiction (state and local government) that they have no connection with.  In essence, a state that imposes such a taxing regime would be able to generate revenue from taxpayers who use none of the services provided by the taxing jurisdiction. 

Another problem with allowing states to tax out-of-state businesses with no physical presence in the state is where the line will ultimately be drawn.  If the Congress or the Supreme Court allows states to tax the sales of out-of-state businesses, they likely won’t stop there.  Will they then go after a portion of business income of the out-of-state business via income tax?  That seems plausible.  However, the Interstate Income Act of 1959 (15 U.S.C. §381-384), requires that a business have some sort of connection with a state before its income can be taxed (at least with respect to the solicitation of orders for tangible personal property).  The law was enacted to overturn the U.S. Supreme Court’s decision in Northwestern States Portland Cement Co. v. Minnesota, 358 U.S. 450 (1959).  However, the law may not apply to bar a state from taxing receipts, as opposed to income. 

From a practical standpoint, the burden of compliance and associated costs would fall disproportionately on small businesses.  In the United States, there are over 10,000 sales/use tax jurisdictions.  Tracking all of those various taxing schemes and staying current would be incredibly time consuming.  In addition, the accounting for the collection and remission of sales/use tax would be nightmarish.  All of this would fall disproportionately heavy upon smaller businesses and home-based internet businesses. 

Conclusion

It will be interesting to see if the U.S. Supreme Court decides to grant certiorari in the South Dakota case.  If so, will the Court distance itself from 50 years of jurisprudence on the Commerce Clause analysis at issue?  If so, what will the Congress do?  Many states are desperate for revenue and don’t seem able to control spending.  But, will the Constitution remain as a bar to states getting revenue from taxpayers that can’t vote the politicians out of office that enact the taxes?    These are all important questions.