August 1st, 2018

U.S. Supreme Court Ends “Tax Free” Internet sales

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Author: Michael Y. Goldberg

Typing on laptop closeup, chatting in Facebook

The days of tax free internet sales are numbered after the U.S. Supreme Court recently ruled that South Dakota’s sales tax law on out-of-state sellers is constitutional. In South Dakota v. Wayfair Inc., the Court overturned a half century of precedent that previously necessitated a business be physically present in a state in order to be required to collect sales tax. This “about-face” will have far-reaching effects for online retailers. All of the Justices appeared to agree that the previous interpretation was dated in the internet era and the main disagreement was whether this was the responsibility of Congress or the Court to “apply a fix.”

The growth of the internet over the past 25 years made the previous physical presence standard outlined in Quill Corp. v. North Dakota unworkable. In the eyes of the Court, Quill resulted in a “judicially created tax shelter.” In 1992, when Quill was decided, less than 2 percent of Americans had internet access, whereas in 2017 it was 89 percent and the largest retailer in the country was no longer a “bricks and mortar” seller.

Tension between the physical presence test and State’s authority to collect sales tax grew rapidly after the Great Recession as cash hungry states looked for different ways to protect their declining revenues. Creative states enacted workarounds such as New York’s so-called “click through” nexus, Ohio’s “cookie nexus” and Colorado and Washington’s notice requirements. In 2015, when the Court ruled that Colorado’s notice requirement was constitutional, Justice Kennedy explicitly noted the urgency in revisiting the unfair damage that Quill’s physical presence test was causing states. Many states took close notice but South Dakota acted with the most urgency as it does not have an income tax to supplement its sales tax revenue.

The Court did not establish a new standard in the ruling. However, it noted that businesses that meet South Dakota’s thresholds establish a “substantial nexus” with the State. Its law requires sales tax withholding upon $100,000 of sales or 200 total transactions as determined on an annual basis. The Court decided that the law was constitutional because:

  1. It has a “safe harbor” for those who conduct limited business;
  2. It has no retroactive application; and
  3. South Dakota is a party to the Streamlined Sales and Use Tax Agreement.

The Sales and Use Tax Agreement aspect is important because it creates a single state level tax with uniform definitions and rules and a simplified rate structure.

The way that Maryland, Virginia and Washington D.C. respond to the decision will likely be very different.  The District of Columbia is probably the most prepared to roll out a new nexus standard as it participates in joint taxing agreements with other states. The decision creates issues for Maryland and Virginia, which are not full participants in any multistate pacts that help ease some of the regulatory burden of dealing with the differing rules in various jurisdictions.  In addition to its state level sales tax, Virginia has a local sales tax, which rate varies among counties and independent cities.

As a practical matter, expect states to act swiftly to implement sales tax collection procedures for out of state sellers that parallel those of South Dakota.  Multistate businesses will need to be alert for rapid legislation and regulation affecting internet sellers with significant penetration into a state.

If you need assistance in state or federal tax planning, contact a member of Stein Sperling’s tax department at 301-340-2020.