Wayfair, Newegg, and Overstock, all large online retailers, challenged the constitutionality of a South Dakota sales tax law and the United States Supreme Court issued its opinion on June 21, 2018. Since then, the states have been busy modifying their sales tax laws for this new decision.
To understand most of the big arguments in state and local taxation including the sales tax issue in the Wayfair case, you just have to look to the United States Constitution to understand the problem. When written, the founding fathers of our country were concerned that the new states would try to tax business in such a way that the new United States could not prosper economically. This fear is what prompted them to add what is known as the Commerce Clause to the Constitution. The Commerce Clause says that Congress has the power to pass laws regulating commerce between the states. The United States Supreme Court has read this clause to also mean that since Congress has the power to regulate commerce between the states, it in turn means that the states cannot regulate commerce between the states. This court-interpreted prohibition on the state power by the Commerce Clause has come to be known as the “Dormant Commerce Clause”.
So, what does this constitutional clause have to do with state sales taxes you ask. For a state to impose a tax, the tax has to be constitutional. The main challenge to state tax laws are the challenges under the Commerce Clause. In other words, taxpayers challenge the law by saying that it is a form of state regulation of commerce between the states and is therefore unconstitutional. For example, in 1977, the Supreme Court decided the Complete Auto Transit, Inc. v. Brady case. In this case, the Supreme Court said that a state tax would be constitutional if it passed all 4 prongs of a 4-prong test. The 4 prongs of the test are: (1) the tax applies to an activity with substantial nexus in the taxing state, (2) the tax is fairly apportioned, (3) the tax does not discriminate against interstate commerce, and (4) the tax is fairly related to the services the state provides. So, with this definition, I think you can probably see why it might be hard to figure out whether a state’s tax law is constitutional or not. For one thing, you have to figure out what this “substantial nexus” thing is. Mr. Merriam-Webster says the word “nexus” means a connection or link. In constitutional law, this word is used to describe how much activity somebody has in a certain state and that state’s jurisdictional power as a result of that activity. For example, if you live in North Carolina and never travel, work, or have anything to do with California, you would expect, and you would be right, that California cannot impose a tax on you because there is no nexus between you in North Carolina and the state of California which would allow them to tax you. On the other hand, if you start a North Carolina business that grows and then opens an office in California with California residents as your employees, you are taking advantage of the roads and infrastructure and other items that the state of California offers, and you would have a substantial nexus where a tax could be imposed on your business. To make matters even worse, the definition of nexus varies depending on who is asking the question. For example, the nexus for a state court to have jurisdiction to decide a lawsuit is different from the nexus for a state to tax you, and the nexus for a state to tax you is different under the commerce clause than it is under the due process clause of the Constitution[FN 1].
If right now you don’t understand what “substantial nexus” is for a state to impose a tax, you are not alone. In fact, after the Supreme Court decided the Complete Auto case in 1977, taxpayers and state governments came back to court in 1992 for an explanation of these very words. That case was Quill Corp. v. North Dakota. In this case, the court held that a physical presence was necessary for a state to have enough nexus to impose an obligation to collect sales tax on a retailer under the Commerce Clause. If you have ever wondered why you always pay sales tax in North Carolina when you buy from a brick and mortar store but sometimes Amazon does not charge you a sales tax when you buy online, this case (and some of its relatives) is the reason. North Carolina could not require out-of-state online retailers to collect the sales tax. Instead, where North Carolina can’t collect from out-of-state retailers, each taxpayer in North Carolina is required to declare and pay a use tax on any out-of-state purchases where sales tax is not collected. Most people don’t pay this tax and North Carolina doesn’t really have the resources to enforce it. In fact, South Dakota presented evidence in the Wayfair case that only about 4% of their taxpayers complied with their voluntary use tax on out-of-state purchases where no South Dakota sales tax had been paid at the time of purchase.
The Wayfair decision now changes the requirement that a retailer have a physical presence in the state before a state can require the retailer to collect sales tax. The South Dakota tax law that was upheld requires retailers physically located out of South Dakota to withhold sales tax based on an economic nexus once they have at least $100,000 worth of sales in the state of South Dakota or 200 sales transactions in a single calendar year. If a retailer did not meet either of the these thresholds, the out-of-state retailer is not required to collect sales tax. Note that under this case, the physical presence test is still valid and can give a state substantial nexus regardless of the economic nexus thresholds.
So, as you might expect, states that have been losing sales tax revenues as more and more purchases are made online from out-of-state vendors who previously could not be required to collect sales tax, are now rewriting their sales tax laws to require these out-of-state sellers to collect the sales tax. The problem now is that many states have sales taxes that vary by county even though the state revenue departments may be responsible for collecting the sales taxes. Trying to keep up with the sales tax rules not only for every state where an online retailer does business but also for the counties within the state creates a burden particularly on small businesses. As of right now, there doesn’t seem to be a lot of choices in the way of software to help retailers comply with the sales tax collection and filing for all the states and counties where it sells products.
So, expect some changes in your future Amazon and other online purchases.[FN] In 1967, in the case of Bella Hess v. Department of Revenue of Illinois, the United States Supreme Court held that a state lacked the necessary nexus to force a retailer to collect a state sales tax under both the due process clause and the commerce clause unless the retailer maintained a physical presence in the state. In Quill, the Court held that a physical presence was not necessary under the due process clause but was necessary under the Commerce Clause.