Is your business ready for the new economic nexus standard?

August 20, 2018

By Scott Brawdy, CPA
Tax Manager and SALT Practice Leader

On June 21, 2018, state and local governments across the country, as well as brick-and-mortar retailers, received welcome news with the U.S. Supreme Court’s ruling in South Dakota v. Wayfair.

This decision overturned a 1992 court case that held states cannot require out-of-state retailers with no in-state physical presence to collect sales tax.

To help illustrate the impact of this decision on today’s retailers, a review of prior case law in this area is beneficial.

The prior physical presence nexus standard was a result of the court’s decision in Quill Corp v. North Dakota. Quill sold office equipment and supplies via mail order to customers around the country.

To facilitate these sales, Quill mailed catalogs to customers in all states, including North Dakota. That state sent a notice to Quill that it owed tax for purchases that North Dakota residents made through Quill’s catalog. After Quill responded that it didn’t have a collection requirement due to lack of physical operations in the state, North Dakota filed suit.

This case made its way through the court system where finally in 1992, the U.S. Supreme Court sided with Quill that the existence of customers alone (i.e. economic presence) was not sufficient to create North Dakota sales tax nexus due to the Commerce Clause of the U.S. Constitution.

At the time there were more than 6,000 taxing jurisdictions in the United States, and the court reasoned that imposing a collection requirement on all out-of-state retailers would be overly burdensome and would severely stifle interstate commerce.

With the exponential growth of online sales and e-commerce during the past decade, state and local governments have had a tougher time garnering sales tax revenue to fund their budgets.

Additionally, brick-and-mortar retailers have decried this disadvantage against their online competitors who were not required to collect sales tax.

In one effort to combat the erosion of its tax base due to unreported use tax, Colorado enacted a law in 2010 that imposed notice and reporting obligations on retailers that do not collect sales tax.

A group of businesses and organizations that market products via catalogs, advertisements, broadcast media and the internet filed suit against the state (Direct Marketing Association v. Brohl).

This case made its way to the U.S. Supreme Court, which in 2015 ruled against Colorado, concluding the state’s requirements for non-collecting retailers discriminated against and placed undue burdens on interstate commerce.

Although a loss for the state, this decision would ultimately set the stage for the overturning of Quill and the establishment of a new economic nexus standard. In his concurrence, Justice Anthony Kennedy opined that the court should revisit its ruling in Quill, given that the rise in online shopping has significantly harmed states. Taking this as an invitation to challenge the Quill decision, various states went on to enact economic nexus legislation, including South Dakota.

South Dakota’s law compels out-of-state retailers with annual sales of more than $100,000 or with more than 200 separate transactions to residents in the state to collect sales tax. This law was challenged by Wayfair (an online retailer that sells home goods). After sustaining losses in both trial and appellate courts, South Dakota appealed to the U.S. Supreme Court, which agreed to hear the case.

In an opinion handed down on June 21, 2018, and written for the court by Justice Kennedy, the court determined that the physical presence rule of Quill was “unsound and incorrect” given how “The Internet’s prevalence and power have changed the dynamics of our national economy.”

Approximately 23 states have enacted economic nexus legislation. Although the threshold amounts for sales and transaction volume could vary, most states have modeled South Dakota’s law.

We expect all states that impose a sales tax to follow suit. Accordingly, businesses should review their interstate sales activity and be prepared to comply with these new laws.

This article was previously published in the Tri-State Business Times.