• Andrew Domer

Supreme Court breaks with precedent on “physical presence” test for sales and use taxes.

In one of his final opinions before retiring on July 31st, Justice Kennedy wrote the decision for a 5-4 majority in South Dakota v. Wayfair, Inc. In it, the Court overturned a half century of Commerce Clause precedent, finding that the “physical presence” standard, used to determine whether a retailer may be required to collect state sales tax, was unfit for the modern commercial era. In 1967, the Court established the notion that a seller must have a physical presence in a State to be liable for collecting sales tax. National Bellas Hess, Inc. v. Department of Revenue of Ill. The standard was designed to satisfy the Court’s Commerce Clause doctrine, which prohibits a State from taxing an activity lacking a “substantial nexus” to the taxing State.


What does that mean in 2018? It means that e-commerce juggernauts like Wayfair, Overstock and Newegg (which have no employees or real estate in South Dakota) cannot be required to collect sales tax on web-based sales they make to South Dakota residents. Instead, the responsibility for remitting the tax for online purchases falls on South Dakota consumers by way of a use tax. In theory, South Dakota forgoes no tax revenue; it is simply a matter of whether Overstock collects the tax from the purchaser, and remits it to the State, or the purchaser pays the tax to the State directly. State use taxes, however, are “self-assessed”, which is another way of saying: rarely paid. As the Court noted, American consumers have a less-than-stellar record of complying with use tax laws.


The upshot is that the “physical presence” rule eliminated South Dakota’s one effective means for collecting the tax due on e-commerce transactions. In fact, in a 2017 report cited by the Court, the Government Accountability Office estimated that, by forcing States to rely on consumers to pay the use tax (rather than on sellers to collect sales tax), the “physical presence” rule of Bellas Hess costs the States collectively between $8-$13 billion annually.


For South Dakota and others, the lost revenue is only part of the problem. The fact that consumers are unlikely to pay the use tax on e-commerce purchases means that online retailers have an upper hand over brick-and-mortar stores. Let’s say Tom is sitting in his apartment in Sioux Falls surfing Overstock for a new memory foam mattress. He settles on his favorite and gets all the way to the Checkout page, where he sees the total price. Before he clicks “Submit”, he decides to run down to the local mattress store to compare prices. He finds the same mattress in stock, with an identical sticker price. Preferring to support local business, Tom opts to buy the mattress from the store. He swipes his card and heads home. Not until that evening, when Tom looks at the receipt and sees the sales tax line item, does he realize he paid an extra 6.5% for the mattress compared to Overstock’s total. Frustrated, he resolves to only buy online in the future.


Tom’s example illustrates how a Court decision from 1967 gives an advantage to online sellers in 2018. The fact that the total prices (including the tax legally due) are identical is irrelevant, because the chance that Tom self-assesses a 6.5% use tax on his online purchase is nil. In fact, Tom may not even know he owes a use tax. Either way, when Tom buys online in the future, the state coffers and local businesses in South Dakota take a hit.


To address these problems, the South Dakota legislature passed a statute in 2016 that required out-of-state businesses to collect and remit sales tax “as if the seller had a physical presence in the State.” It was not the most nuanced strategy. In effect, South Dakota lawmakers were telling e-commerce merchants: “The Supreme Court says we can’t make you our tax collectors unless you are physically present in our State, which you aren’t, but let’s pretend like you are.” The law did, however, limit its reach to sellers who (a) deliver more than $100,000 of good or services annually into South Dakota, or (b) engage in 200 or more transactions annually for the delivery of goods or services into South Dakota. Not surprisingly, Wayfair and other e-retailers challenged the statute as unconstitutional and prevailed in the lower courts.


On review, however, the Supreme Court found ample reason to depart from the “physical presence” rule first established in Bellas Hess and reaffirmed in 1992 in Quill Corp. v. North Dakota. The Court held that the Commerce Clause does not require a seller to have a physical presence in a State to establish a “substantial nexus” therewith. Rather, the Court found the thresholds in the South Dakota law regarding the volume of sales and transactions were sufficient to ensure that only companies with a substantial nexus to the State would fall within the ambit of the statute. Making heavy use of the changing times, Justice Kennedy wrote that, each year, the “physical presence” rule “becomes further removed from economic reality and results in significant revenue losses to the States.” Furthermore, it undermines local business competitiveness by “giving some online retailers an arbitrary advantage” and enables “a judicially created tax shelter for businesses that limit their physical presence in a State.”


Those untoward results, the Court held, are not required by the Constitution or the Court’s Commerce Clause jurisprudence. Ultimately, as Justice Kennedy wrote, “modern e-commerce does not align analytically with a test that relies on the sort of physical presence defined in Quill.” Good news for your local mattress store.


South Dakota v. Wayfair, Inc. (Opinion)


June 25, 2018

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