July 25, 2018
In what has already been dubbed the “tax case of the millennium,” the Supreme Court, in a 5-4 decision written by Justice Kennedy, ruled that individual States can now pass legislation requiring out of state businesses to charge in-state sales tax, even if they have no physical presence in the state. While on-line retailers are obviously affected, any business offering products or services remotely could face significant obligations.
South Dakota charges ahead. In South Dakota v. Wayfair, Inc., 585 U.S.__, 138 S. Ct. 2080 (2018), South Dakota filed a declaratory judgment action in state court against three substantial out-of-state online retailers – Wayfair, Inc., Overstock, Inc. and NewEgg, Inc. – to enforce South Dakota’s newly passed tax legislation, seeking a ruling that the law is valid and applies to these on-line retailers and requiring them to register for South Dakota licenses to collect and remit sales tax. The new law requires “out-of-state sellers” to collect and remit a sales tax on sales to South Dakota residents regardless of whether the retailer has a physical presence in the state.
Wayfair and the other retailers filed a motion for summary judgment on grounds that the new legislation was unconstitutional, relying on three previous Supreme Court cases, Complete Auto Transit, Inc. v. Brady, 430 U.S. 274 (1977), Quill Corp. v. North Dakota, 504 U.S. 298 (1992), and National Bellas Hess Inc. v. Department of Revenue of Ill., 386 U.S. 753 (1967). Complete Auto sets out a four-prong test for valid taxes: they must (1) apply to an activity with a substantial nexus with the taxing State, (2) be fairly apportioned, (3) not discriminate against interstate commerce, and (4) be fairly related to the services the State provides. Complete Auto, 430 U.S. at 279. Read together, this trio of cases has required businesses to have a “physical presence” in a state for that state to impose sales tax on its transactions.
From Unfair to Wayfair. In June, the Supreme Court turned away from this longstanding rule in Wayfair, granting South Dakota the ability to impose taxes on out-of-state retailers, including Wayfair, Overstock and NewEgg. In doing so, the Court overturned National Bellas and Quill, which substantially extends the reach of the Complete Auto standard. The Court recognized the changes in the commercial landscape in the 41 years since Complete Auto, 26 since Quill, and 51 since National Bellas, finding that “the physical presence rule, both as first formulated and as applied today, is an incorrect interpretation.” Instead, the “substantial nexus” prong of Complete Auto may be satisfied based on “the economic and virtual contacts [a retailer has] with the State.”
The Court observed that its interpretations of Commerce Clause matters have long sought to apply a “sensitive, case-by-case analysis.” In the Court’s view, the “physical presence rule” of Quill and National Bellas created an arbitrary and formalistic distinction that could be gamed by sophisticated companies to the detriment of smaller players. Under the old rule, a local business with any presence in a state would need to charge sales taxes, while massive online retailers could sidestep taxes by avoiding maintaining in-state facilities. To the Court, this was an inequitable situation, resulting in a judicially-created tax-shelter and an artificial competitive advantage for “remote sellers.” Finally, taking note of the 41 States, two territories and one district that joined South Dakota in the suit, the Supreme Court ruled that the “physical presence” standard impermissibly limited the Constitutional taxing authority of the States, necessary to help them perform critical in-state functions.
A Safe Harbor for small fry. The Court rejected arguments that an out-of-state online tax would discriminate unfairly against smaller online businesses. The South Dakota law has a “safe harbor,” limiting application of the law to retailers with “more than $100,000 in annual sales into South Dakota” or “200 or more separate transactions for the delivery of goods and services into the State” annually. The Court found that this level of commerce was sufficient to find a “substantial nexus” with South Dakota, and that a safe harbor below this amount answered the concerns of smaller online retailers. While the Court took comfort in the safe harbor, the Court did not find that such a safe harbor was required. Instead, the Court pointed to a variety of options to minimize the burden on smaller retailers responding to taxing authorities. The Court also noted with approval that the law was not retroactive.
And away we go. It is highly likely that the Wayfair ruling will result in numerous states imposing state sales taxes on out-of-state retailers and service providers. The Court specifies a “sensitive, case-by-case analysis” in applying the Complete Auto standard, so it is not easy to draw a line where a “safe harbor” might end and a “substantial nexus” begins. This ruling could reverberate beyond tax concerns, influencing more expansive views of when an out-of-state company must register to do business in a state.
How big is your harbor? Translating the South Dakota safe harbor levels to other states provides some idea of what other laws could look like. On a per capita basis, the South Dakota safe harbors amount to sales of 11.5 cents per resident or one transaction for every 4,350 residents. For New York State, this would result in safe harbors below roughly $2.28 million in annual sales and 4,560 transactions. For Connecticut, this would be approximately $413,000 and 825 transactions. Unfortunately, there is no reason to assume that the “safe harbor” approach would be followed in any other state and, if so, where the lines would be drawn.
To collect or not to collect. On-line and out-of-state retailers and service businesses could proceed with an abundance of caution and begin collecting and remitting sales tax in all applicable states (i.e., where there is a sales tax and where the company has made sales of any kind or amount). A number of tools exist online to facilitate this process, but they should be chosen carefully and their terms of service reviewed by counsel, in order to ensure that such services properly address this risk and are useful for the retailer. Alternatively, companies could take a “wait and see” approach (outside of South Dakota and states where they are physically present), given the safe harbors and lack of retroactivity in the law that did pass Supreme Court muster.
Your Way Forward. Either way, companies will have to decide how to account for this risk in their businesses practices, planning, financial statements, budgets and tax reserves, among other things. Wells Fargo reportedly incurred a $481 million expense on its books for the second quarter of 2018, increasing its state tax reserves by that amount to account for the possibility that its businesses will be subject to taxes in more states.
If you have questions concerning your or your company’s potential exposure as a result of the Wayfair decision, please contact Greg Shatan, or the Moses & Singer lawyer with whom you regularly work.
This alert does not constitute tax advice; any advice regarding tax matters needs to be discussed with your tax lawyer or other tax professional.