State Taxation of Online Sales

Overview

Last week, the U.S. Supreme Court, in South Dakota v. Wayfair, Inc., No. 17-494, 2018 U.S. LEXIS 3835 (U.S. Sup. Ct. Jun. 21, 2018), handed South Dakota a narrow 5-4 win in its quest to collect taxes from online sales.  The Court held that the Constitution’s Commerce Clause did not bar South Dakota from statutorily requiring remote sellers without a physical presence in the state to collect and remit sales tax on goods and services that are sold to buyers for delivery inside the state of South Dakota.  In so doing, the Court overruled 50 years of Court precedent on the issue. 

Other states will certainly take note of the Court’s decision, and some (such as Iowa) were banking on the Court ruling in the manner that it did and passed legislation similar to the South Dakota legislation that will take effect in the future.  But, as I wrote last fall, a victory for South Dakota could do damage to the Commerce Clause and the concept of due process and contemporary commerce. 

An update on state taxation of internet sales, the possible implications of the Court’s recent decision and what the impact could be on small businesses – that’s the focus of today’s post.

Historical 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., 901 N.W.2d 754 (S.D. 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.  They did, the U.S. Supreme Court granted the petition and heard the case which lead to last week’s opinion. 

U.S. Supreme Court Decision

Article I, Section 8 of the U.S. Constitution says that, “The Congress shall have the power...to regulate commerce…among the several states…”.  That was the key point of the Court’s 1967 Bellas Hess, Inc. decision.  As noted above, in that case the Court stated that the Commerce Clause grants “exclusive authority [to] Congress to regulate trade between the States.”  Apparently, that is not the case anymore, at least according to the majority in Wayfair – Justices Kennedy, Thomas, Ginsburg, Alito and Gorsuch.  Under the new interpretation of the Commerce Clause, states can impose sale tax obligations on businesses that have no physical presence in the state.  But is that completely true?  Can the Court’s opinion be construed as giving the states a “blank check” to tax out-of-state businesses?  Maybe not.

In Complete Auto Transit, Inc. v. Brady, 430 U.S. 274 (1977), the Court ruled that a state tax would be upheld if it applied to an activity having a substantial nexus with the state; was fairly apportioned; did not discriminate against interstate commerce; and, was fairly related to the services that the state provided.  Later, in the Quill case, the Court determined that a physical presence in the taxing jurisdiction was what satisfied the Brady “substantial nexus” requirement. 

In Wayfair, the Court determined that a “substantial nexus” could be present without the party subjected to tax having a physical presence in the taxing jurisdiction.  But, the key point is that the “substantial nexus” test of Brady remains.  Likewise, the other three requirements of Brady remain – fair apportionment; no discrimination against interstate commerce, and; fairly related to services that the state provides.  In other words, taxing a business without a physical presence in the state cannot unduly burden interstate commerce.  The Wayfair majority determined that the South Dakota law satisfied these tests because of the way it was structured – limited application (based on transactions or dollars of sales); not retroactive; the state was a member of the Streamlined Sales and Use Tax Agreement; the sellers at issue were national businesses with a large online presence; and South Dakota provided tax software to ease the administrative burden. 

The dissent in Wayfair, authored by Chief Justice Roberts, noted that there was no need for the Court to overturn Quill.  The Chief Justice noted that, “E-commerce has grown into a significant and vibrant part of our national economy against the backdrop of established rules, including the physical-presence rule. Any alteration to those rules with the potential to disrupt the development of such a critical segment of the economy should be undertaken by Congress.”  That’s precisely the point of the Commerce Clause, and Chief Justice Roberts pointed it out – the Court had no business wading into this issue.  In fact, several members of the Congress filed briefs with the Court in the case to inform the Court that various pieces of legislation were pending that would address the issue. 

Conclusion

The question then is what, if any, type of a state taxing regime imposed on out-of-state sellers would be determined to violate the Commerce Clause post-Wayfair.  Of course, the answer to that question won’t be known until a state attempts more aggressive taxation on out-of-state sellers than did South Dakota, but a few observations can be made.  Presently, 23 states are “full members” of the Streamlined Sales and Use Tax Agreement.  For those states, the Wayfair majority seemed to believe that had the effect of minimizing the impact on interstate commerce.  Also, it would appear that any state legislation would have to have exceptions for small businesses with low volume transactions and sales revenue.  Whether a series LLC (in some states such as Iowa) or subsidiaries of a business could be created, each with sales below the applicable threshold, remains to be seen.

Now, it appears that state legislatures crafting tax statutes need not give much, if any, thought to the reason for the tax or who the parties subject to the tax might be.  The only consideration appears to be the relative burden of the tax.  With Wayfair, states have gained more power – the power to tax people and businesses for whom the state provides no services and who cannot vote the people out of office that created the tax.  That would not appear to square with traditional concepts of due process. 

The whole notion of a state taxing a business that has no physical presence in the state 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 a few, minor exceptions).  As noted earlier, 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. 

Post Wayfair, where will the line be drawn?  Wayfair involved state sales tax.  Will states attempt to 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 (or individual – the business form does not matter because corporations have long held personhood status under the Constitution (see, Bank of the United States v. Deveaux, 9 U.S. 61 (1809); Burwell v. Hobby Lobby Stores, Inc., 134 S. Ct. 2751 (2014)) 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).  Is that legislation now unconstitutional too? Or, is there a distinction remaining between taxing receipts as opposed to income?

Only time will tell.