In the US, 45 states have a sales tax and 44 of them operate a state income tax. These state systems have their own rules and operate independently of Federal taxes. On 21 June 2018, the Supreme Court of the United States issued its widely anticipated decision in South Dakota v. Wayfair, et al. No. 17-494. The Court held that the physical presence rule for state tax jurisdiction is incorrect and not a requirement under the Commerce Clause of the US Constitution. This article contains an in-depth analysis of the Court’s Wayfair opinion and some thoughts as to the impact of what is likely the most significant state tax decision from the US Court in at least 50 years.
In Quill Corp v. North Dakota (1992), the Court affirmed its 1967 court decision that the substantial nexus requirement of the Commerce Clause of the US Constitution requires a taxpayer (or tax collector) to have a physical presence in a state before the state can impose a sales tax (or tax collection obligation).
In a direct challenge to the physical presence rule, South Dakota, like a number of other states, enacted an economic presence nexus statute for sales and use tax collection in 2016. Under that statute, a remote seller is required to collect and remit sales tax if:
- The seller’s South Dakota sales exceed $100,000, or
- The seller has more than 200 separate sales transactions into South Dakota.
Wayfair Inc, and two other internet retailers, Overstock.com Inc. and Newegg Inc. have no physical presence in South Dakota and challenged the statute in state court. Because the lower state courts could not overturn US Supreme Court precedent, they held for Wayfair et al. South Dakota petitioned the Court for a writ of certiorari, which was granted in January 2018.
The Court ruled that the “physical presence rule, both as first formulated and as applied today, is an incorrect interpretation of the Commerce Clause.” Further, it was ruled that South Dakota’s $100,000 of sales or 200 separate sales transactions statutory standard to impose the tax collection obligation satisfied the Court’s substantial nexus requirement with regard to the Commerce Clause. However, the case was remanded to the South Dakota Supreme Court for further proceedings to determine if any other features of the South Dakota law discriminated against or unduly burdened interstate commerce.
In concluding that Quill and the physical presence rule is flawed, the Court viewed the rule as a judicial imposition on states’ sovereign taxing authority. The Court agreed that the physical presence rule allows remote sellers to take advantage of the benefits of a state’s market without sharing the burden of tax collection. Again, by creating competitive disadvantages, the Court viewed the physical presence rule in 2018 as harming federalism and free markets.
The impact of the decision extends beyond internet retailers and beyond sales and use taxes.
In addition to South Dakota, over 20 other states have enacted similar economic nexus statutes for sales and use tax purposes, and there are also about 9 states that currently impose economic “factor presence” nexus statutes for state income tax purposes. More than targeting remote sellers, a number of these statutes are also aimed at “marketplace facilitators” and “referrers”. While some of these state statutes have been enforced for some time, the effective dates for some of the statutes were contingent on the Quill decision being overturned, which has now occurred. It should also be noted that the economic nexus test may bring remote sellers, including non-US companies, within the scope of income taxes in certain states. Non-US companies cannot rely on double tax treaties to eliminate all of these liabilities.
Overnight, remote sellers, marketplace facilitators, service providers, licensors of software, and other businesses that have provided services to or delivered their products to customers from a remote location will have to start complying with state and local sales and use taxes.
The Court’s Wayfair decision creates a greater focus on sales and use tax automated compliance software and its continuing evolution, but the devil is in the details. Not only must sales tax compliance software fit a particular remote seller’s or service provider’s business parameters, it must also be capable of administering sales and use tax compliance across numerous state and local jurisdictions, myriad and often changing exemptions, managing different product and service taxability definitions across states, among other necessary features.
- Wayfair is a watershed moment in state taxation. The decision has wide-ranging implications for all businesses, not just internet retailers, as well as consumers, and state and local governments.
- Overnight, Wayfair changes a remote seller’s considerations from “do I have physical presence” to “how do I comply with all of the state and local jurisdictions where I deliver my products or services?”
- Almost half of the states that impose sales and use taxes had economic nexus statutes similar to South Dakota’s prior to the Wayfair. It is reasonable to expect that most, if not all, of the remaining states that impose sales and use taxes will now go this route.
- The decision is also sure to embolden states that have been imposing economic nexus for income tax purposes for a number of years and is supportive of economic “factor-presence nexus” statutes that some states have enacted in recent years.
- Taxpayers affected by the Wayfair decision should consult with their auditor and tax advisor to evaluate and determine the potential accounting implications, including the impact on current and deferred taxes, uncertain tax benefits, and disclosures, as well as with respect to sales/use and indirect taxes, including impact on reserves and accruals.