On June 21, the United States Supreme Court held, in South Dakota v. Wayfair, Inc., that a state may require an out-of-state seller with no physical presence in the state to collect and remit the state’s use tax. The Court described as “unsound and incorrect” the physical presence requirement it had established in National Bellas Hess, Inc. v. Department of Revenue of Illinois, 386 U.S. 753 (1967) and reaffirmed in Quill Corp. v. North Dakota, 504 U.S. 298 (1992). Wayfair relied on three features of the South Dakota law that may very well serve as the basis for expedited legislative enactments in other states.
Bellas Hess and Quill
In Bellas Hess, the Court held that the Due Process and Commerce Clauses of the United States Constitution required some physical presence for a state to impose on an out-of-state seller the obligation to collect and remit use tax. Twenty-five years later in Quill, the Court held that physical presence was no longer required under the Due Process Clause (applying its then-recent long-arm jurisdiction jurisprudence) but nevertheless upheld the physical presence requirement under the Commerce Clause, citing stare decisis and “settled expectations.” The Court extended an express invitation to Congress to exercise its Commerce Clause authority if it desired a different outcome. Congress never accepted that invitation. In the face of Quill, numerous states sought to erode the physical presence standard through measures directed at affiliate nexus, online advertisers (“click through” nexus), and other arrangements under which the physical presence of one entity was attributed to another.
South Dakota’s “Economic Nexus” Legislation
In 2016, South Dakota enacted SB 106 to impose a use tax collection obligation on out-of-state sellers without physical presence in the state that make sales into the state of $100,000 or more or 200 or more separate transactions. As a part of the enactment and in recognition that SB 106 was contrary to Quill, the enactment contained provisions intended to expedite judicial review within the South Dakota courts while its application was made prospective only, and enforcement was stayed until the constitutionality of SB 106 was finally determined.
South Dakota initiated the review of SB 106 by filing a declaratory judgment action against online retailers Wayfair, Inc., Overstock.com, Inc., and Newegg, Inc. (respondents), which made its way to the South Dakota Supreme Court where SB 106 was found to be unconstitutional on the basis that Quill “remains the controlling precedent on the issue of Commerce Clause limitations on interstate collection of sales and use taxes.” The United States Supreme Court granted certiorari to reconsider the scope and continuing validity of the physical presence rule.
The Court’s Wayfair Ruling
The United States Supreme Court, in an opinion written by Justice Kennedy and joined by four other justices, concluded that “the physical presence rule, both as first formulated and as applied today, is an incorrect interpretation of the Commerce Clause.”
The Court noted that Quill was “flawed on its own terms” for three reasons. First, under Complete Auto Transit, Inc. v. Brady, 430 U.S. 274 (1977), substantial nexus does not require physical presence, and there is no sufficient basis for a separate nexus rule for imposing a use tax collection obligation (as compared to income, franchise or any other tax). Second, the physical presence rule has created market distortions, based on what the Court labeled “a judicially created tax shelter” for out-of-state retailers. Third, the physical presence rule relied on arbitrary, formalistic distinctions that treated economically identical actors differently. The Court characterized the physical presence requirement as “an extraordinary imposition by the Judiciary on States’ authority to collect taxes and perform critical public functions,” as it unfairly allowed out-of-state sellers and their customers to escape payment of lawful state taxes.
Finally, the Court concluded that stare decisis did not require it to reaffirm the physical presence requirement. The Court reasoned that changes to interstate commerce since Quill was decided in 1992, including the rise of e-commerce and the increasing budgetary challenges faced by states, justified revisiting the physical presence standard, which it described as “no longer a clear or easily applicable standard.”
The dissent by Chief Justice Roberts and joined by three other justices noted the additional issues of the compliance challenges on which Bellas Hess and Quill were based (the United States has more than 10,000 separate taxing jurisdictions), and the unanswered invitation to Congress to exercise its Commerce Clause authority to legislate a different standard that were “breezily” dismissed in the majority opinion.
Implications and Open Questions
The Wayfair decision is expected to trigger a wave of legislative action by other states that will likely use SB 106 as a model for what passes constitutional muster and will likely comply with the three most salient characteristics of SB 106 highlighted by the Supreme Court:
- a minimum threshold of sales (dollars or transactions) to impose the collection obligation, providing a safe harbor for small sellers or those with very few sales into a jurisdiction
- no retroactive tax imposition
- some effort at the streamlining of the collection process, such as through the Streamlined Sales and Use Tax Agreement
In overruling Quill, the Supreme Court left open many questions about the future of use tax nexus requirements.
- What constitutes “substantial nexus”? The Court found that the economic nexus requirements in SB 106 satisfied Complete Auto’s “substantial nexus” standard. According to the Court, the nexus was “clearly sufficient based on both the economic and virtual contacts respondents have with the State.” It is unclear whether the other states will use the tested standards validated in SB 106 or attempt to use different or lower thresholds (such as “click through” nexus or other virtual contacts).
- Will economic nexus laws be invalidated on other Commerce Clause grounds? Wayfair struck down the physical presence requirement, but the Court did not address any other potential claims for invalidating the South Dakota law under other Commerce Clause principles, instead leaving those claims to be addressed in the first instance on remand.
- Is compliance with sales tax rules overly burdensome for small businesses? The Court acknowledged, but dismissed, the issue of whether complex state tax systems create an unfair administrative and regulatory burden for startups and other small businesses. The courts or state legislatures may respond to these concerns, including by providing relief for businesses with de minimis contacts with a state or continuing efforts to streamline and simplify use tax collection.
- Will Congress step in? In his dissent in Wayfair, Chief Justice Roberts reasoned that Congress, not the Court, was the right actor to overturn the physical presence rule and that the Court’s Wayfair decision has complicated the legislative process, noting that Congress has previously considered and is now considering various proposals to overturn the physical presence rule. The patchwork of state nexus laws that have now potentially been validated under Wayfair, and the open questions about the contours of the Commerce Clause in this context, may finally prompt Congress to act to reduce any undue burden on interstate commerce.
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