E-Commerce Sales Tax Enforcement Finally Enters 21st Century

Prior to last week’s decision by the United States Supreme Court in South Dakota v. Wayfair, Inc., many online retailers were not paying use tax to states in which they did not have a physical presence on sales made in those states.  

Prior to the Wayfair decision, the states were limited in their enforcement options even after passing legislation to specifically target out-of-state retailers to require them to remit these taxes.  As the law was construed prior to Wayfair, this enforcement gap caused states to lose out on an estimated $8 to $33 billion each year.

Sales tax is imposed on transactions completed inside a state, while use tax applies to purchases from out-of-state vendors.  The sales and use tax are mutually exclusive, which means only one could apply to a single transaction, but not both. And while sellers were required to collect and remit the tax to the state, if they did not then in-state consumers are responsible for paying the use tax at the same rate. It is estimated that as low as 4 percent of residents properly paid their use tax.  

Prior to Wayfair, the United States Supreme Court had created a physical presence rule. This meant that for a business to be subject to the collection of tax to a particular state required an actual physical presence within the state’s borders. This could be shown by as little as one employee being located in the state.  

What this rule unintentionally created were tax loopholes. A company could strategically pick and choose where to house employees or distribution centers to take advantage of states without sales tax or with a lesser rate than a neighboring state.

As the Supreme Court recognized in Justice Kennedy’s majority opinion in Wayfair, the physical presence rule became almost immediately outdated when the decision was made in 1992 with the expansion of computers and internet use. The Supreme Court stated that modern e-commerce does not align analytically with a test that relies solely on where a business is physically located. Accordingly, Wayfair abandoned the physical presence rule.

Now that a physical presence within a state is no longer a requirement to be subject to taxation, a state may tax sales made in or into its borders. The tax will be held to be valid if it:

  1. Applies to any activity with a “substantial nexus” with the taxing state;
  2. Is fairly apportioned;
  3. Does not discriminate against interstate commerce; and
  4. Is fairly related to the services the state provides.

The substantial nexus requirement simply means “some definite link, some minimum connection, between a state and the person, property, or transaction it seeks to tax.” Miller Brothers Co.  v. Maryland, 347 U.S. 340, 344-345 (1954). Virtually any transaction that takes place in the state will satisfy this requirement; whether it is picking up groceries at the corner market or having something shipped to you from an online vendor.

In Wayfair, South Dakota had passed a statute with the minimum requirements to be subject to the tax as either $100,000 of goods sold into the state or a minimum of 200 transactions. The Supreme Court found these minimum requirements meet the four-prong test as the reporting and remittance of tax was not overly burdensome for a company capable of meeting this minimum requirement in transactions.

Now that the Wayfair has been decided in favor of the states, what is yet to be seen is which states will begin to go after those businesses that have not been paying their use tax over the years. There are currently 45 states and the District of Columbia that have imposed sales tax laws. This means that businesses that were not collecting and remitting sales tax to these states will need to begin doing so immediately.

It is imperative to make sure your business is following the law as announced in Wayfair. This means not only collecting any use taxes applicable to intra-state sales, but also to timely remit those taxes to the appropriate states. If this sounds confusing, let us know – we can help.

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