In South Dakota v. Wayfair, a 5-4 decision, the Supreme Court overruled the long-standing physical presence standard for imposing sales tax. This standard, established by the Supreme Court in Quill Corp. v. North Dakota, effectively prohibited states from requiring online retailers and out-of-state businesses to collect sales tax on goods sold into that state in the absence of a physical location within the state. Thus, under Quill, an online retailer was not required to collect sales tax unless the purchaser lived in a state in which the retailer had a physical presence. This is no longer the case. Having set aside the physical presence rule, the Supreme Court held in Wayfair that it will now follow the standard it had previously articulated in Complete Auto Transit, Inc. v. Brady, which allows the imposition of tax as long as the tax applies to an activity with a substantial nexus with the taxing state. This standard makes it significantly easier for states to craft laws requiring online retailers to collect sales tax on sales of goods into a state, even if they have no employees or physical property (e.g., storefronts, manufacturing or storage facilities, etc.) located in the state.
The Wayfair case involved a 2016 statute requiring out-of-state retailers to collect and remit sales tax to South Dakota as if it had a physical presence in the state if, on an annual basis, the seller delivered more than $100,000 of goods or services into the state or engaged in 200 or more separate transactions for goods or services in the state. The Supreme Court upheld the South Dakota statute, noting that it is applicable only to sellers who engage in a significant quantity of business in the state. In applying the substantial nexus test to the online retailers involved in the case, Wayfair, Overstock, and Newegg, the court stated that the nexus was clearly sufficient because (1) the companies engage in a “significant amount” of business in the state and (2) these companies are among the top national online retailers in the country and “undoubtedly maintain an extensive virtual presence.” The Supreme Court’s analysis demonstrates that the focus of the substantial nexus test will be on the retailer’s ability to reach customers through the Internet.
In fact, the Supreme Court made clear that the reason it heard the case and reached this conclusion was directly related to the impact of electronic commerce on the national economy. The Court acknowledged that in light of the change in dynamics to the national economy brought on by the prevalence and power of the Internet, the physical presence rule was unsound and incorrect, created market distortions, did not align with modern e-commerce, was unworkable as applied to online retail sales, and was an imposition on the states’ ability to collect taxes and perform critical public functions.
It remains to be seen just how each state will react to this significant change in the Supreme Court’s position. Many states have already enacted laws designed to establish physical presence, such as “click-through nexus” laws (i.e. an out-of-state retailer with no physical presence in the state is deemed to have a sales tax nexus if it pays a commission to an in-state affiliate that refers or directs a customer to click through a link to purchase goods or services from the out-of-state retailer’s online business). These states may repeal those laws and, instead, enact new laws with a broader reach under the substantial nexus test. It is likely that new state laws will define a minimum level of sales or transactions that will be considered “substantial” enough to establish nexus. However, it is also possible that states may take the position that there is no need for a minimum threshold because virtual presence in the state is sufficient. In other words, a state could argue that where an online retailer has a virtual connection through the Internet to all of its residents, then it has established a substantial nexus, regardless of the level of sales occurring within the state. In addition, the fact that eliminating the physical presence requirement has made nexus easier to achieve for sales tax purposes may lead some states to take more aggressive positions in applying the nexus standard to other types of state taxes.
One of the many problematic issues that this Supreme Court decision creates for online retailers is that it did not explicitly foreclose the possibility of retroactive sales tax laws. The South Dakota law at issue in the Wayfair case did not apply retroactively and the Supreme Court made a point to mention that fact in the context of its discussion of whether the South Dakota law was “designed to prevent discrimination against or undue burden upon interstate commerce.” The Court did not, however, specifically state that new laws imposing sales tax on Internet retailers can never be applied retroactively. It simply listed the lack of retroactive application as one of the factors indicating that the law was not unduly burdensome. It is hard to imagine that retroactivity would be acceptable without additional safeguards against the significant compliance burden this would create, but it is not entirely clear how states will be allowed to draft their laws with respect to this issue.
It will likely take some time for retailers to feel the impact of the Wayfair decision, as states will just now begin the process of drafting new legislation or examining the authority to tax out of state retailers under existing statutes. As states expand their taxing authorities, all businesses will be forced to become aware of each state’s sales tax rate and tax base and to implement procedures to collect and remit sales tax in many more, if not all, of the states into which they sell goods.