A much-anticipated U.S. Supreme Court ruling has given state and local governments the go-ahead to impose sales tax on out-of-state online sales.
The 5-4 decision in South Dakota v. Wayfair Inc. was good news for state governments eager to reap the tax windfall, as well as brick-and-mortar retailers who say they’ve been disadvantaged by existing sales tax laws.
What the previous rulings said
The Supreme Court’s decision in Wayfair overruled two of its precedents:
National Bellas Hess v. Dept. of Revenue, 1967: The court took on a challenge to an Illinois tax that required out-of-state retailers to collect and remit taxes on sales made to consumers who purchased goods for use within the state.
In that case, which involved a mail-order company, the justices found that, since the company’s only connection with customers in Illinois was by common carrier (the U.S. Postal Service), it lacked the required contacts with the state required by both the Due Process Clause and the Commerce Clause of the U.S. Constitution to impose taxes. The court held that the company must maintain a physical presence — such as retail outlets, solicitors or property in the jurisdiction — for a state to collect a local use tax.
Quill Corp. v. North Dakota, 1992: The court reconsidered the physical presence rule in another case that also involved mail-order sales. Although the justices overruled the earlier Due Process Clause holding, they upheld the Commerce Clause holding. The ruling was 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.
Problems with the physical presence rule
The rule — established in Bellas Hess and affirmed in Quill — has been heavily criticized, particularly in recent years as online sellers have gained traction against traditional stores. In 1992, the court noted that mail-order sales in the U.S. were $180 billion; in 2017 online retail sales were estimated at $453.5 billion, or almost 9 percent of total U.S. retail sales.
Because of the law, state and local governments nationwide missed out on up to $13 billion in sales taxes in 2017, according to a report from the Government Accountability Office. Other estimates have been even higher. States with no income tax — including Tennessee — have been hardest hit because they rely more heavily on sales tax.
Tennessee’s losses as a result of the previous online sales tax rule, for example, have been estimated to be as much as $400 million a year, according to Boyd Center for Business & Economic Research at the University of Tennessee. More than 50 percent of the state’s budget comes from sales tax.
As South Dakota argued in its petition for Supreme Court review: “Quill has grown only more doctrinally aberrant … But while its legal rationales have imploded with experience, its practical impacts 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.”
The sales tax debate
In response to growth in online sales and the impact on sales tax collections, South Dakota enacted a law in 2016 that required out-of-state retailers making at least 200 sales or sales totaling at least $100,000 in the state to collect and remit a 4.5 percent sales tax. The law declared the tax issue an emergency and cited the need “for the support of state government and its existing public institutions.”
South Dakota subsequently sued several online retailers that 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. A trial court dismissed the case before trial, and the state Supreme Court affirmed, citing its obligation to follow U.S. Supreme Court precedent, however persuasive the state’s arguments against the physical presence rule might prove.
The Supreme Court’s reasoning
The majority opinion — penned by Justice Kennedy and joined by Justices Alito, Ginsburg, Gorsuch and Thomas — described the physical presence rule as “unsound and incorrect” and becomes further removed from economic reality every year.
Quill, the opinion said, creates market distortions and put local businesses at a competitive disadvantage compared with remote sellers that did not charge customers for taxes.
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,” Kennedy wrote.
In addition, the court found that Quill treats economically identical actors differently. For example, a business with a small inventory in a state is subject to the tax on all its sales in the state, but a seller with a large online-only presence isn’t subject to the same tax for the sales of the same items.
Ultimately, the court concluded that the South Dakota tax satisfies the substantial nexus requirement because it “avails itself of the substantial privilege of carrying on business” in the jurisdiction.
An immediate impact
The significance of the ruling was almost immediate, with the share prices of major online retailers dropping quickly. It’s not just the behemoths that could be affected, though.
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.” But, it said, reasonably priced software eventually may 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.
Both of Tennessee’s U.S. Senators, Lamar Alexander and Bob Corker, welcomed the ruling.
“The Court’s decision is good news for Main Street business and for states,” Alexander said in a statement posted to his website. “It correctly leaves to states decisions about who should pay state sales and use taxes and how they should be collected. There still may be a need for Congress to adopt the simplified collection of sales tax procedures in the Marketplace Fairness Act that 69 United States senators voted for in 2013.”
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 legislation that provides consistent tax administration and other uniform rules.
Those laws often dictate that consumers still owe their home state money on items purchased through out-of-state, online retailers — even if the retailer doesn’t collect the sales tax and submit it to the state on the consumer’s behalf. That law also applies to consumers in Tennessee; the problem is that few people know about the law, and it’s difficult to enforce.
What happens now?
A little more than a dozen states have sales tax laws similar to South Dakota’s, so there likely will be a staggered imposition of sales tax collection on online retailers. Other states may revise or enact legislation to meet the constitutional tests, including the substantial nexus requirement.
If you have questions regarding sales tax collection requirements for your business after the court’s decision, please contact a KraftCPAs tax advisor. We’ll be glad to assist you.