Collection of Sales Tax by Out of State Businesses

Earlier this year, the U.S. Supreme Court threw a wrench into the taxation of businesses by states when those businesses have no physical presence within that state. In prior decisions, SCOTUS held that a business that sells goods into a state must have a physical presence in that state before the state could require the business to collect sales or use taxes. In the past, for example, when ordering from an online retailer such as Amazon, you did not have to pay sales tax unless Amazon had a physical presence in your state. These prior rulings relied heavily on the dormant commerce clause of the U.S. Constitution, which the court used to find that the clause implied limitation on states to burden interstate commerce as the clause expressly grants this power to Congress.

As online sales increased, states became increasingly frustrated since sales tax revenue was not collected (and the purchaser was supposed to voluntarily report and pay the sales tax, which rarely occurred). South Dakota passed a law in 2016 requiring tax collection by out-of-state retailers that lacked a physical presence in South Dakota, which was unconstitutional under prior SCOTUS holdings. The South Dakota law required out of state retailers to collect and pay sales tax if (a) they delivered more than $100,000 of services or goods, or (b) engaged in more than 200 transactions of services or goods within the state. Retailers filed suit with Wayfair leading the way, and the retailers won at the lower courts under the prior SCOTUS requirement of a physical presence.

This case, South Dakota v Wayfair, Inc, ___ US ___, 138 S Ct 2080 (2018), overturned the physical presence requirement in a 5-4 decision. The Court provided several reasons for overturning the physical presence rule, such as giving incentives for retailers to avoid establishing a presence in a state to avoid collecting taxes but at the expense of job opportunities for residents or the disparate treatment of a small store retailer having to collect sales tax, but a huge online retailer does not need to collect sales tax.

While the physical presence rule may have been due for a reversal, the Court eliminated a fairly bright line rule in favor of a “substantial nexus” test: a state may force an out of state retailer to collect sales tax so long as it applies to activities with a substantial nexus to the state. South Dakota’s law passed this test since the retailers actively sold items to South Dakotans and the retailers are large companies with a large virtual presence in the state. Michigan, following the Wayfair decision, adopted similar rules as South Dakota.

Questions remain as to what constitutes a substantial nexus or the monetary amount required before a state may require the collection of sales tax (South Dakota’s $100,000 amount was sufficient, but what about lower amounts?). Following the Wayfair decision, states have adopted differing thresholds which complicates collection requirements in each state. Alternatively, some states passed prior nexus laws, which means retailers may owe taxes retroactively but without the ability to collect from the purchaser.

Thus, retailers conducting business in states where they lack a physical presence must be cognizant of whether they must collect sales tax. While this requirement is clear for very small retailers (no collection required) or very large retailers (Amazon, for example, must collect in every state), the retailers in the middle may or may not be required. To discuss whether your business must collect sales tax or any other business law issue, please contact Benjamin Long of Schmidt and Long.