President Donald Trump recently lashed out at Amazon.com Inc., tweeting: “they pay little or no taxes to state & local governments, use our Postal System as their Delivery Boy (causing tremendous loss to the U.S.), and are putting many thousands of retailers out of business!”
The president focused his attention on one company – Amazon – but the broader context for the statement is the retail business landscape and an expected sea change in the scope and reach of state sales taxation. The U.S. Supreme Court is now considering a legal challenge to the established principle that states may not impose sales and use tax collection duties on remote businesses unless they have an in-state physical presence. Meanwhile, efforts in Congress to legislate in this area are heating up.
We now have all three branches of the federal government arguing over state sales taxation – and it’s enough to make your head spin. Below, we breakdown all the moving pieces and identify strategies for your business to prepare.
THE BUSINESS ENVIRONMENT
Brick-and-mortar retailers have long argued that they are at an unfair competitive disadvantage relative to their online counterparts that may not be collecting sales tax from their customers.
For example, Toys R Us’ recent announcement that it would close all its U.S. stores arose in large part due to competition with online retailers like Amazon. Until recently, Amazon did not collect sales tax in states where it did not have a warehouse or office that created a physical presence. Though consumers are legally obligated to self-report use tax if they do not pay sales tax on their online transactions, Amazon enjoyed a competitive advantage because consumers often do not self-report and pay use tax.
There is no question that brick-and-mortar storefronts are struggling to keep pace with e-commerce. Consumers today often purchase items online that they might have otherwise purchased at a physical storefront 25 years ago. And they do so faster and cheaper. Those consumers who still visit brick-and-mortar stores often comparison shop on their phones while in the store and ultimately purchase items from online outlets. In fact, this practice is so common that there is now a name for it – showrooming.
In this environment, Amazon has grown from relatively modest beginnings as an online bookseller into a multibillion dollar retailer with a cloud computing business, a Hollywood studio, a smart device business, and a grocery store chain to boot. The increased footprint across multiple industries and geographic regions has led Amazon to collect sales tax in every state that has one. But the tax disparity in the retail landscape persists. Many resellers using the Amazon platform, for instance, still do not collect sales tax on their transactions.
JUDGES STEP IN WHILE CONGRESS SNOOZES
For the first time since 1992, the U.S. Supreme Court has accepted a legal challenge to the “physical presence rule” that could shake-up the retail business environment and consumer trends. In South Dakota v. Wayfair, the Supreme Court is reviewing a South Dakota law that requires remote sellers to collect sales tax regardless of their physical presence, if they either deliver goods or services to the state generating more than $100,000 in revenue or have 200 or more in-state transactions.
Judge-made case law has long set the boundaries for extraterritorial state sales tax. The leading case is Quill v. North Dakota, which was decided in 1992. In Quill, the U.S. Supreme Court held that North Dakota could not impose a sales tax collection duty on a company that sold office furniture to in-state residents via catalog marketing and common carrier delivery, but otherwise lacked a physical presence in the state. The Quill case affirmed the longstanding principle that states may not require out-of-state sellers without a physical presence in the state to collect sales tax.
While the court in Quill affirmed the physical presence rule, they also invited Congress to act if they disagreed with the rule. Congress has considered various pieces of legislation over the years to give states more leeway to impose sales taxes. To date, however, Congress has not actually passed any such laws.
With the rise of the internet and e-commerce, states have recently become more aggressive with respect to sales tax. States argue that the factual context for e-commerce is distinct from the direct mail industry addressed in Quill. Computerized technology and in-state marketing efforts, they say, exploit state marketplaces more than mere catalog mailings and goods delivered via common carrier.
South Dakota has taken a particularly aggressive stance to directly confront the Quill physical presence rule head-on and imposed an “economic nexus” standard regardless of physical presence in the state. Other states such as Ohio and Massachusetts have expanded the reach of their sales tax to additional digital transactions, but have stopped short of expressly confronting the physical presence standard head-on. Still other states have adopted notice and reporting requirements that do not require vendors to collect tax, but rather report sales transactions to the state and notify consumers of their use tax obligations.
For now, the Wayfair case is the mechanism for change in the sales tax arena. The U.S. Supreme Court heard oral argument in the case on April 17, 2018, and a decision is expected by late June.
POSSIBLE OUTCOMES FOLLOWING WAYFAIR
Many observers initially expected a win for South Dakota in the Wayfair case. By accepting a challenge to Quill for the first time in a generation, the Supreme Court signaled that it may not continue to defer to Congress as it expressly stated in the Quill decision. There are also strong tailwinds from a recent decision in which Justice Anthony Kennedy questioned the ongoing validity of Quill.
But the justices were less clear as to their intentions at oral argument. As we detailed in a recent blog post, the questions posed at oral argument suggest that South Dakota may not necessarily have the five-vote majority required to prevail. Justices voiced several concerns about overturning Quill. Among them were the burden that an economic nexus standard could have on small business and commerce, the possibility that some states would seek back taxes by applying the new rule retroactively, adherence to their own case law precedent, and the failure of Congress to act in this area since Quill was decided.
If South Dakota does prevail, few commentators can predict what that actually means. There will always be constraints on states being able to tax beyond their borders. But without a bright line rule such as the Quill physical presence standard, we may see more costly audits and even litigation in state courts across the country as businesses fend off state taxing authorities. It is not clear what constraints on the state taxing power may look like in a post-Quill world and it may require costly audits and litigation to figure that out in real, fact-specific applications. Furthermore, as an alternative to a new judge-made rule to replace Quill’s physical presence standard, Congress could still step into the fray, though those efforts have recently stalled.
At the end of the day, we can expect states to be more aggressive in sales and use tax audits if South Dakota prevails in the Wayfair case. We have witnessed a similar development in Ohio following the Ohio Supreme Court’s ruling in Crutchfield v. Testa that upheld the Ohio commercial activity tax (CAT) against a nexus challenge from internet retailers. In the wake of the Crutchfield case, the Ohio Department of Taxation has been much more aggressive in CAT audits on a variety of issues.
HOW YOUR BUSINESS CAN PREPARE
In an environment where state coffers are strapped for cash due to Medicaid and state pension entitlements, state taxing authorities have more incentive than ever before to raise revenue and tax compliance is critical. Those businesses that are proactive – rather than reactive – in addressing areas of non-compliance may avoid or limit costly interest, penalties, and professional fees for tax audits and litigation.
Identify your sales and use tax exposure
Multistate businesses should identify states where they may have sales or use tax exposure because they run afoul of the existing physical presence test. Businesses should analyze the data, potential exposure, and consider voluntarily disclosing potential liability anonymously though an attorney. Most states have programs to eliminate penalties and/or interest for taxpayers that voluntarily come forward prior to notice of an audit. These programs additionally provide major tax advantages relative to waiting for an audit because they generally limit liability for non-compliance to the prior three or four years.
Conduct due diligence
The recent flurry of merger and acquisition activity also raises planning considerations. Sellers should strive to avoid exposure due to non-compliance and buyers doing due diligence should be wary if their target has potential sales and use tax exposure. If there is tax exposure due to non-compliance, the parties may renegotiate the purchase price, obtain state tax releases absolving buyers from successor liability, and/or escrow additional funds to cover potential sales and use tax liability.
Contact your tax attorney
For those businesses that may see additional exposure due to a shift to an economic nexus standard post-Quill, tax professionals may help digest the Supreme Court’s eventual decision in Wayfair and analyze potential exposure. In all likelihood, any move towards and an economic nexus standard for state sales tax would apply on a forward-looking, prospective basis rather than a retroactively.