The Supreme Court just made state tax filings a lot more complicated…
The Summer Solstice brings the longest day of the year and the official start to summer in the U.S. This year, however, it also brought a major State Tax heat wave for companies, and likely the longest day at the office for many state tax professionals. On June 21st, the U.S. Supreme Court, in South Dakota v. Wayfair (No. 17-494, June 21, 2018), abandoned over 50 years of settled law that prohibited states from taxing companies without some type of physical connection to the state. The Court validated South Dakota’s economic nexus law requiring out-of-state companies with no physical presence in the state to collect sales tax once they reach $100,000 in sales or 200 transactions each year. The state tax compliance burden impact to small and mid-size businesses making sales into states where they do not have a physical connection cannot be overstated. And this is likely true not only for sales taxes but also for state income and business activity taxes.
How did we get here?
To understand the Court’s decision, it’s important to remember that “nexus” determines when a taxpayer has to file tax returns in a state based on the activities conducted in the state. We’ve never known a time when physical presence was not the nexus standard, which was reaffirmed again in 1992 with Quill Corp. v. North Dakota, 504 U.S. 298.
Immediately after Quill was decided, states started eroding the physical presence rule with regard to state income and business activity taxes on the pretext that Quill’s physical presence requirement applied only to sales and use taxes. Today, for example, businesses with no physical presence in Michigan are required to file an income tax return if they make greater than $350,000 sales per year to Michigan customers, and if they have customers in Washington, that threshold drops to $285,000. Many other state Departments of Revenue have economic nexus standards contending that a single sale triggers nexus for their state’s income or business activity tax.
States have been attempting to circumvent Quill in the sales tax arena by interpreting existing laws, or enacting new nexus rules, based on activities of affiliates, website “clicks,” and browser “cookies” (which, for example, Massachusetts, deems to constitute physical presence since they are placed on a customer’s computer). Other states have enacted unreasonably onerous and invasive use tax notification and reporting requirements, requiring sellers to notify customers of their obligation to self-assess use tax on their purchases and/or report customer sales to the state so the state can directly assess the customer. Some companies have opted to voluntarily collect sales tax, finding these notice and reporting requirements more cumbersome than sales tax collection and remittance, particularly since they do not want to disclose and damage their customer relationships. Interestingly, the Court upheld these notification and reporting requirements in Direct Mktg. Ass’n v. Brohl, 135 S. Ct. 1124, 1134-35 (2015) (Kennedy, J. concurring), which opened the door to Wayfair when Justice Kennedy suggested that Quill could be overturned. Kennedy stated that given the changes in technology and consumer sophistication, it “is unwise to delay any longer” a reconsideration of Quill, and invited the “legal system” to “find an appropriate case” for the Court to reexamine the Quill decision. He noted that when Quill was decided in 1992, the internet was in its infancy, but by 2008, e-commerce sales alone totaled $3.16 trillion per year in the United States.
South Dakota’s economic nexus rule delivers
South Dakota delivered on that invitation with their 2016 economic nexus legislation, requiring remote sellers to file sales tax returns upon making greater than $100,000 sales/year or 200 transactions. This legislation provided an expedited appeals process by delaying enforcement of the law until its constitutionality could be established by a binding judgment, such as by the Supreme Court. Wayfair appealed the law, and South Dakota’s Judicial and Supreme Courts ruled in 2017 that the legislation was unconstitutional under Quill. The state immediately appealed to the U.S. Supreme Court, which heard oral arguments coincidentally on Tax Day, April 17th. On June 21st, the Supreme Court validated the law requiring out-of-state companies with no physical presence in the state to collect sales tax once they reach $100,000 in sales or 200 transactions each year. Needless to say, it was no surprise that Justice Kennedy delivered the majority opinion in the Wayfair decision.
To say that the tax and business community was passionate about the Wayfair case is an understatement. Over 40 amicus briefs were filed by members of the tax community, trade associations, states and politicians. Forty-one states, including all but 4 states that impose a sales tax and one state that does not even have a sales tax, 2 US territories, and the District of Columbia all chimed in to support South Dakota. Democrats and Republicans from Wyoming to Tennessee talked about how under Quill, not only were state tax revenues being lost, but competition in the marketplace was unfair for brick and mortar retailers. New Hampshire and Montana were among the supporters of Wayfair, discussing concerns regarding the cost of compliance, including audit defense, making and monitoring taxability determinations, as well as registering, and filing returns while applying over 10,000 different tax rates in over 6,000 taxing jurisdictions. (Ohio alone has over 1,000 local taxing jurisdictions, each with their own tax rates.) Interestingly, Amazon did not file an amicus brief, likely since it already collects sales tax on its own sales in nearly every state.
What happens now?
Wayfair opens the door for states to apply economic nexus standards for state sales and use taxes and likely also for state income and business activity tax purposes. More than 18 states have currently enacted economic nexus provisions imposing sales and use tax collection obligations on remote sellers who make sales that exceed a certain threshold or a number of transactions in one year. Illinois jumped on the bandwagon earlier this month by including in its FY 2019 Budget an amendment to their nexus provisions (effective October 1, 2018) requiring remote sellers to collect sales tax if sales to Illinois’ purchasers exceed $100,000 or 200 separate transactions in a year. Many other states have remote seller nexus legislation pending, and the Wayfair decision makes their enactment almost certain.
Even though Wayfair resolved the debate as to whether Quill’s physical presence standard is required, it opened the door to a long and tortuous process to determine exactly what triggers nexus. The million-dollar question the Court left open for interpretation is what threshold of sales triggers nexus? Is it the South Dakota $100,000 limit? Could it be less—even a single sale? Does it matter how large the company is or whether they sell to consumers or businesses? The Court suggests that the $100,000 sales “quantity of business” shows the seller “availed itself of the privilege of carrying on business” in South Dakota, and noted that Wayfair is a “large national company with an extensive virtual presence.” Does this suggest that Wayfair’s application might be limited to larger companies, or instead suggest that any company that avails itself of the privilege of doing business to target customers in another state is subject to tax?
The Court said that “the physical presence rule of Quill is unsound and incorrect” and that the original decision was “flawed” and imposes an “arbitrary, formalistic distinction.” Does this mean that states will attempt to apply Wayfair retroactively? In supporting South Dakota’s new law, the Court cited to the provision specifically limiting its application to prospective periods. However, not all states agree with this approach so it remains to be seen if we will see further litigation in this area.
This is an area ripe for Congress to step in to provide clarity. Congress has repeatedly failed to enact guidance regarding nexus as requested by the business community in recent years. However, enacting legislation to provide clarity and limit Wayfair’s application is a much more tenable prospect politically. Congress stepped in once before in 1959 in response to outcries to limit the application of the Court’s income tax nexus decision in Northwestern States Portland Cement v. Minnesota (358 U.S. 450) with the enactment of The Interstate Income Act of 1959, also known as Public Law 86-272. The uncertainty around Wayfair’s application encourages Congressional action once again.
What should companies do?
The Wayfair decision’s overruling of Quill’s “physical presence” requirement will affect millions of companies that do not currently collect sales or use taxes in states where they make sales but are not physically present. Since most of the largest online sellers like Amazon and eBay are already collecting sales taxes, the impact will be felt primarily by smaller unsuspecting businesses that make sales in states where they are not physically present or collecting sales tax, including many of Amazon’s third party sellers and sellers based outside the U.S.
Additionally, states are likely to impose and enforce economic nexus (if they don’t already) with regard to state income and business activity taxes, especially since economic nexus has been the standard applied to those tax types by many states long before the Wayfair decision. Wayfair only provides more certainty to the validity of these standards in the state income tax area.
Companies now need to undertake the daunting task of analyzing their business across state lines and communicating their sales tax collection requirement to customers. They need to invest in systems that track how products and services are taxed throughout the different states, and manage the over 10,000 sales and use tax rates throughout the nation. They have to ensure their accounting and billing systems can handle the reporting requirements for all the states and localities in which they conduct business.
Companies also need to decide where they have nexus for state income and business activity taxes, and determine whether they have prior year exposure since many states have had state income tax economic nexus provisions long before state sales taxes adopted these standards. Companies should work with their tax advisors to determine whether they will need to file retroactively, currently, or prospectively only, and the best course of action for managing any prior year exposure.
How Can True Partners Help?
True Partners Consulting’s state and local tax teams offer a combination of highly experienced tax advisors and an approach that puts our clients at a competitive advantage. We are prepared to work closely with clients to analyze their current business operations, identify states in which they have nexus, determine past, present, and future filing requirements, implement software solutions for compliance responsibilities, and develop successful strategies to avoid the inevitable pitfalls that come with a once-in-a-generation change in the law.